Paid Tax Return Preparers: In a Limited Study, Preparers Made Significant Errors
Released: 2014-04-08T00:00:00

Letter

IRS’s Authority to Regulate Paid Preparers Is Limited, Although Use of Preparers is High

A paid preparer is simply anyone who is paid to prepare, assist in preparing, or review a taxpayer’s tax return. In this statement, we refer to two categories of paid preparers—tax practitioners and unenrolled preparers. CPAs, attorneys, and enrolled agents are tax practitioners. Tax practitioners differ from unenrolled preparers in that they can practice before IRS, which includes the right to represent a taxpayer before IRS, prepare and file documents with IRS for the taxpayer, and correspond and communicate with IRS. We use the term unenrolled preparer to describe the remainder of the paid preparer population. In most states, anyone can be an unenrolled preparer regardless of education, experience, or other standards.

Tax practitioners are subject to standards of practice under the Department of Treasury Circular No. 230. Enrolled agents are generally required to pass a three-part examination and complete annual continuing education, while attorneys and CPAs are licensed by states but are still subject to Circular 230 standards of practice if they practice before IRS. Generally, unenrolled preparers are not subject to these requirements.

In April 2006, we made a recommendation to IRS to conduct research on the extent to which paid preparers meet their responsibility to file accurate and complete tax returns. conducted a study of the quality of paid preparers and issued a report recommending increased oversight of paid preparers. Recommendations included (1) mandatory registration, (2) competency testing and continuing education, and (3) holding all paid preparers— including unenrolled preparers—to Circular 230 standards of practice. IRS implemented each recommendation through regulations issued in September 2010 and June 2011. The June 2011 regulations amended Circular 230 and established a new class of practitioners called “registered tax return preparers.” IRS intended for these new requirements to support tax professionals, increase confidence in the tax system, and increase taxpayer compliance.

GAO-06-563T.

According to IRS officials, approximately 84,148 competency exams were taken prior to the District Court’s decision. new testing and continuing professional education requirements. IRS appealed the order, but it was affirmed in February 2014 by the U.S. Court of Appeals for the District of Columbia Circuit. Figure 1 provides a summary timeline of IRS’s implementation of paid preparer requirements and legal proceedings. The President’s Fiscal Year 2015 budget, released in March 2014, included a proposal to explicitly provide the Secretary of the Treasury and IRS with the authority to regulate all paid preparers.

Although the District Court determined that IRS does not have the authority to regulate unenrolled preparers, the decision did not affect the requirement that all paid preparers obtain a Preparer Tax Identification Number (PTIN) and renew their PTIN annually. As of March 16, 2014, approximately 676,000 paid preparers have registered or renewed their PTINs. As shown in figure 2, the two largest categories of PTIN registrations and renewals are unenrolled preparers—55 percent—and CPAs—31 percent.

Four States Regulate Paid Preparers, but Requirements Vary

Currently, Oregon, Maryland, California, and New York regulate paid preparers. Both Oregon and California began to regulate paid preparers in the 1970s, while Maryland and New York’s programs were implemented more recently. Further, the programs themselves involve different types of requirements for paid preparers as illustrated in table 1.

In August 2008—prior to Maryland and New York implementing paid preparer requirements—we reported on state-level paid preparer requirements in California and Oregon. Specifically, we reported that both California and Oregon have requirements that paid preparers must meet before preparing returns; of the two states, Oregon has more stringent requirements.

According to our analysis of IRS tax year 2001 NRP data, Oregon returns were more likely to be accurate while California returns were less likely to be accurate compared to the rest of the country after controlling for other factors likely to affect accuracy. Specifically, in August 2008, we found that the odds that a return filed by an Oregon paid preparer was accurate were 72 percent higher than the odds for a comparable return filed by a paid preparer in the rest of the country.

Use of Paid Preparers Varied by Complexity of Tax Return, but Often Resulted in Larger Refunds

According to IRS’s SOI data, an estimated 81.2 million or 56 percent of approximately 145 million individual tax returns filed for tax year 2011 were completed by a paid preparer. Estimated use of paid preparers was fairly evenly distributed across income levels, and as table 2 shows, taxpayers with more complex returns used preparers the most. For example, preparers were more commonly used by taxpayers who filed the Form 1040 as opposed to the 1040EZ or 1040A and those claiming itemized deductions or the Earned Income Tax Credit (EITC).

Across all income levels taxpayers who used paid preparers had a higher median refund than those who prepared their own returns at statistically significant levels, as shown in table 3. Specifically, individual taxpayers who used a paid preparer had an estimated median tax refund across all adjusted gross income levels that was 36 percent greater than taxpayers who prepared their own return.

Limited Investigation and IRS Data Reveal Significant Errors in Returns Prepared by Paid Preparers

Taxpayers rely on paid preparers to provide them with accurate, complete, and fully compliant tax returns; however, tax returns prepared for us in the course of our investigation often varied widely from what we determined the returns should and should not include, sometimes with significant consequences. Many of the problems we identified would put preparers, taxpayers, or both at risk of IRS enforcement actions. The NRP’s review of tax returns from 2006 through 2009 also found many errors on returns prepared by paid preparers, and some of those errors were more common on paid prepared returns than on self-prepared returns.

Nineteen Site Visits Revealed Significant Paid Preparer Errors

Nearly all of the returns prepared for our undercover investigators were incorrect to some degree, and several of the preparers gave us incorrect tax advice, particularly when it came to reporting non-Form W-2 income and the EITC. Only 2 of 19 tax returns showed the correct refund amount. While some errors had fairly small tax consequences, others had very large consequences resulting in the overstatement of refunds from $654 to $3,718.

Our undercover investigators visited 19 randomly selected tax preparer offices—a non-generalizeable sample—to have taxes prepared. We developed two taxpayer scenarios based on common tax issues that we refer to as our “Waitress Scenario” and our “Mechanic Scenario.” Key characteristics of each scenario are summarized in table 4.

Errors in Tax Preparation Resulted in Inaccurate Refund Amounts

Refund amounts derived by the 19 preparers who prepared tax returns based on our two scenarios varied greatly. For our waitress scenario, the correct refund amount was $3,804, however, refund amounts on returns prepared for our undercover investigators ranged from $3,752 to $7,522. Similarly, the correct refund amount for the mechanic scenario was $2,351; however, refunds ranged from $2,351 to $5,632. Paid preparer errors generated during our 19 non-generalizeable visits resulted in refund amounts that varied from giving the taxpayer $52 less to $3,718 more than the correct amount. Of the 19 paid preparers we visited, 2 determined the correct refund amount: one correct tax return was prepared for the waitress scenario and one for the mechanic scenario. An additional 4 paid preparers calculated tax returns within $52 of the correct refund amount. On the remaining 13 tax returns—7 for the waitress scenario and 6 for the mechanic scenario—preparers overestimated the total refund by $100 or more. Figure 3 shows the amount of the refund over and under the correct refund amount.

In some instances, paid preparers made similar errors across multiple site visits. For example, on the waitress return paid preparers made two of the same errors: (1) not claiming the unreported cash tips and (2) claiming both children as eligible to receive the EITC. These errors resulted in clusters of overstated refunds. In four site visits, paid preparers not claiming unreported cash tips resulted in a refund amount overstated by $654. In three site visits, paid preparers made both errors, which resulted in a refund amount overstated by $3,718. In the mechanic scenario, paid preparers that did not include side income resulted in tax refunds that ranged from $2,677 to $3,281 above the correct refund amount.

Quality and Accuracy of Tax Preparation Varied Based on the Scenario and Specific Form or Line Number

A majority of the 19 paid preparers we visited made errors on common tax return issues; on some lines of the tax return most paid preparers were correct. Some of the most significant errors involved paid preparers (1) not reporting non-Form W-2 income, such as unreported cash tips, in 12 of 19 site visits; (2) claiming an ineligible child for the EITC in 3 of 10 site visits; and (3) not asking the required eligibility questions for the American Opportunity Tax Credit. Such errors could lead taxpayers to underpay their taxes and may expose them to IRS enforcement actions. By contrast, in some instances the majority of preparers took the right course of action. For example, 17 of 19 paid preparers completed the correct type of tax return and 18 of 19 preparers correctly determined whether to itemize or claim the standard deduction. Our results are summarized in figure 4.

Type of tax return. Paid preparers completed the correct type of tax return—the Form 1040—for 17 of 19 site visits. Two paid preparers incorrectly completed the Form 1040A for the waitress scenario. The Form 1040A should not have been used because the waitress received tip income that was not reported to her employer.

Dividend and capital gains income. Preparers recorded the income correctly on 8 of 9 returns. The mechanic received qualified and ordinary dividends, and capital gains from a mutual fund that were reinvested into the fund. This income was documented on a third party reporting form; the Form 1099-DIV. According to IRS guidance, a Form 1099-DIV must be filed for any person who receives dividends of $10 or more, including for funds that are reinvested.

Mechanic Scenario, Site Visit #1 One paid preparer who did not accurately record the investment income said that it was not necessary to include income that was reinvested in a mutual fund.

Total income. Of the 10 waitress returns prepared for us, 3 included the unreported cash tip income. However, only one of the three returns included the correct amount of tip income. Total income for the waitress scenario should include income documented on the Form W- 2, as well as the amount of unreported cash tip income offered by our investigator to the paid preparer during the site visit. The two returns that did not include the correct amount of tip income included lesser amounts.

Waitress Scenario, Site Visit #5 In response to the investigator mentioning her unreported cash tip income, one paid preparer told her that tips not included on the Form W-2 do not need to be reported.

Total income for the mechanic return should include non-Form W-2 business income—resulting from mechanic work and babysitting conducted outside of a formal employment arrangement—and income from ordinary dividends and capital gains. Of the 9 mechanic returns prepared for us, 4 returns included both the business income and the investment income. However, only 3 returns included the correct amounts of business and investment income.

Incorrectly reporting income often resulted in cascading errors on other lines of the tax return. Tax returns that did not include side income had errors in credits that are calculated based on income. For example, if a paid preparer did not report side income in the mechanic scenario, the resulting total income would make the mechanic eligible for the EITC when he otherwise would not be eligible. Similarly, because two paid preparers incorrectly chose not to include unreported tip income for the waitress, they selected the wrong type of tax return, the Form 1040A.

Mechanic Scenario, Site Visits #3 and #9 Two paid preparers demonstrated what the refund amount would be if the side income were reported compared to if it were not reported. Both preparers did not record the side income.

Itemized or standard deduction. All but one of the 19 returns correctly recorded the most advantageous deduction for the two scenarios. According to IRS guidance, taxpayers should itemize deductions when the amount of their deductible expenses is greater than the standard deduction amount. For the waitress scenario, the most advantageous deduction would be the standard deduction for head of household, and for the mechanic scenario, the itemized deductions were more advantageous. One paid preparer chose to use the standard deduction for the mechanic, even though it was approximately $3,000 less than the total amount of the itemized deductions we included in the scenario.

Child-care expenses. All 19 paid preparers did not record child-care expenses because neither the waitress nor mechanic was eligible to receive the credit. While none of the paid preparers recorded the credit, the reasons the preparers cited were often incorrect. According to IRS guidance, a taxpayer must attempt to collect the Social Security number of his or her child-care provider, but if unsuccessful, can report that fact to IRS and still claim the credit. For the waitress scenario, the reason that she was ineligible to claim the child-care expenses was that she did not attempt to get her child-care provider’s Social Security number. Upon learning that she did not have the Social Security number of the provider, several of the paid preparers did not enter her child care expenses on her return.

IRS guidance states that qualified child-care expenses only include amounts paid while the taxpayer worked or looked for work. The mechanic and his wife were not eligible for the credit because the child-care expenses were incurred for running errands, and not so that either parent could work. Again, many tax preparers said that the reason the credit could not be claimed was because the mechanic did not have the child-care provider’s Social Security number, not because he was otherwise ineligible.

Student loan interest. Eight of 10 paid preparers correctly included the deduction for student loan interest. The waitress’s Form 1098-E shows the interest the lender received from the taxpayer on qualified student loans. A taxpayer receives a Form 1098-E if student loan interest of $600 or more is paid during the year.

Sales tax deduction. Seven of 9 preparers recorded sales tax as a deduction on the mechanic’s tax return, however not all chose the most advantageous amount. According to IRS guidance, taxpayers who itemize deductions can choose whether to deduct local income taxes or sales taxes. Because the mechanic lived in a state that did not have income tax, sales tax should have been deducted. Of the 7 paid preparers that deducted sales taxes, only 2 recorded the amount that was most advantageous to the taxpayer. IRS provides an online calculator to help taxpayers estimate the amount of sales taxes they likely paid in a year. To determine this estimate, taxpayers input basic information such as ZIP code and annual income in the calculator. Five preparers chose amounts that were lower than the amount the calculator estimated.

Social Security and Medicare tax on unreported tips. Two of 10 paid preparers completed the Form 4137 and reported the amount of taxes owed on the tip income. Because the waitress received unreported cash tips, the amount of taxes owed on the unreported cash tip income should be calculated using the Form 4137. However, one of the preparers included a lesser amount of tip income when performing the calculation, resulting in a smaller amount of taxes owed. Another preparer reported the tip income by incorrectly completing a Schedule C, Profit or Loss from Business, and a Schedule SE for self-employment taxes.

Earned Income Tax Credit. The EITC on line 64a was another area where paid preparers made mistakes that resulted in a significant overstatement of the refund. Of the 10 returns prepared for the waitress, 3 reported two children on the Schedule EIC, instead of the one child who lived with the taxpayer in 2013 and was eligible for the EITC.

Waitress Scenario, Site Visit #4 One paid preparer questioned the investigator on the amount of time her older child lived with her. The investigator responded that the older child stayed with her on weekends. The paid preparer discussed the investigator’s response with the office manager and then stated that she can claim the child for the EITC if no one else does, which was not correct.

American Opportunity Tax Credit. All 9 paid preparers correctly chose the American Opportunity Tax Credit for the mechanic scenario. The mechanic had a 20-year-old son attending a community college and paid for both his tuition and books. According to IRS guidance, to be eligible for this credit, a student must meet certain requirements including full-time enrollment at least half the year and no felony drug offense convictions. Although we instructed the investigator to respond to paid preparer inquiries such that his son met these requirements, some paid preparers did not ask the required questions to determine eligibility.

Improper Conduct May Subject Preparers to Internal Revenue Code Penalties

All paid preparers are subject to certain requirements in the Internal Revenue Code (IRC) and may be subject to penalties for non- compliance. For example, the IRC imposes monetary penalties on paid preparers who understate a taxpayer’s tax liability due to willful or reckless conduct. As shown in figure 5, in 12 of 19 cases, paid preparers did not record additional side income not reported on Form W-2’s and may be subject to this penalty. The IRC also requires that paid preparers sign the tax return and furnish an identifying number. In 3 of 19 cases, preparers did not meet the signature requirement. In addition, 3 preparers used a PTIN that did not belong to them and one used a fake PTIN.

Additionally, 3 of 10 preparers in our study may be subject to a penalty for not meeting due diligence requirements when determining if both of the waitress’s children qualified for the EITC. When considering the EITC, paid preparers must meet four due diligence requirements. Generally, if paid preparers file EITC claims, they must (1) ask all the questions to get the information required on Form 8867, Paid Preparers’ Earned Income Credit Checklist; (2) compute the amount of the credit using the EITC worksheet from the Form 1040 instructions or a similar document; (3) ask additional questions when the information the client gives the preparer seems incorrect, inconsistent, or incomplete; and (4) keep a copy of Form 8867, the EITC worksheets, and other records used to compute the credit.

Because the returns we had prepared were not real returns and were not filed, penalties would not apply. However, we plan to refer the matters we encountered to IRS so that any appropriate follow-up actions can be taken.

Fees Charged for Tax Preparation Varied Widely Across Paid Preparer Site Visits

The fees charged for tax preparation services varied widely across the 19 visits, sometimes between offices affiliated with the same chain. Often, paid preparers either did not provide an estimate of the fees upfront or the estimate was less than the actual fees charged. In several instances, upon completion of the tax return, the preparer initially charged one fee, then offered a reduced amount. Figure 6 shows the fees charged by each of the 19 paid preparers we visited for each scenario. For the waitress scenario, the final fees charged for tax preparation ranged from $160 to $408. For the mechanic scenario, the final fees charged for tax preparation ranged from $300 to $587. For the two correct tax returns that were prepared, the final fee charged was $260 for the waitress scenario and $311 for the mechanic scenario. Some paid preparers provided receipts that listed total charges that were higher than the “discounted” amount ultimately charged. For example, one preparer estimated the cost of services to be $794, but then charged the taxpayer $300.

Paid preparers provided various reasons for the amount of the tax preparation fee, including, (1) the EITC form is the most expensive form to file, (2) the pricing and fees are at their peak from mid-January through February and then go down, and (3) there is a price difference depending if the tax return is completed in the morning or the evening.

IRS Data Suggest Errors on Paid Preparer Returns Were Similar to Those Generated During Our Site Visits

As in our limited investigation, our estimates from NRP data suggest that tax returns prepared by paid preparers contained a significant number of errors. As shown in table 5, returns prepared by a paid preparer showed a higher estimated error rate—60 percent—than returns prepared by the taxpayer—50 percent. Errors in this context changed either the tax due or the amount to be refunded. As noted before, it is important to remember that paid preparers are used more often on more complicated returns than on simpler ones, although we were unable to gauge the full extent to which this might be true. Furthermore, errors on a return prepared by a paid preparer do not necessarily mean the errors were the preparer’s fault; the taxpayer may be to blame. Preparers depend upon the information provided by the taxpayer.

In addition to different rates of errors on paid preparer filed returns and self-prepared returns, the amount taxpayers owed IRS also differed. Specifically, the estimated median amount owed to IRS was higher for paid preparer filed returns. For instance, as shown in table 6, it is estimated that taxpayers using a paid preparer owed a median of $354 to IRS, compared with $169 for taxpayers preparing their own return.

NRP estimates show that both individuals and paid preparers make errors on specific forms and lines of Form 1040, some of which we experienced in our undercover visits. Table 7 shows that in many instances, returns completed by a paid preparer are estimated to have a greater percentage of errors compared to self-prepared returns. For example, of returns prepared by a paid preparer, 51 percent have an error on the EITC line compared to 44 percent of self-prepared tax returns. In total, for five line items we analyzed, the difference in the percent of errors on returns prepared by a paid preparer was statistically greater than the percent of errors on self-prepared returns. These line items include (1) the itemized or standard deduction, (2) business income, (3) total income, (4) the EITC, and (5) the refund amount. Differences between the percent of returns with errors on the student loan interest deduction line, the unreported Social Security and Medicare tax on tips line, and the education credit line were not statistically significant when comparing returns done by a paid preparer to those that were self-prepared.

Conclusions

Over half of all taxpayers rely on the expertise of a paid preparer to provide advice and help them meet their tax obligations. IRS regards paid preparers as a critical link between taxpayers and the government. Consequently, paid preparers are in a position to have a significant impact on the federal government’s ability to collect revenue and minimize the estimated $385 billion tax gap. As of March 2014, 55 percent of paid tax preparers are unenrolled preparers, not regulated by IRS. Undoubtedly, many paid preparers do their best to provide their clients with tax returns that are both fully compliant with the tax law and cause them to neither overpay nor underpay their federal income taxes. However, IRS data, which more broadly track compliance, show preparers made serious errors, similar to the findings from our site visits. The higher level of accuracy of Oregon’s tax returns compared to the rest of the country suggests that a robust regulatory regime involving paid preparer registration, qualifying education, testing, and continuing education may help facilitate improved tax compliance. The courts determined that IRS does not have sufficient authority to regulate unenrolled preparers. In March 2014, the administration proposed that the Treasury and IRS be granted the explicit authority to regulate all paid preparers. Providing IRS with the necessary authority for increased oversight of the paid preparer community will help promote high-quality services from paid preparers, will improve voluntary compliance, and will foster taxpayer confidence in the fairness of the tax system.

Matter for Congressional Consideration

If Congress agrees that significant paid preparer errors exist, it should consider legislation granting IRS the authority to regulate paid tax preparers.

Chairman Wyden, Ranking Member Hatch, and Members of the Committee, this concludes my statement. I would be pleased to respond to any questions that you may have.

Contacts and Acknowledgments

For questions about this statement, please contact James R. McTigue, Jr. at (202) 512-9110 (mctiguej@gao.gov). Individuals making key contributions to this testimony include: Wayne A. McElrath, Director; Libby Mixon, Assistant Director; Gary Bianchi, Assistant Director; Amy Bowser; Sara Daleski; Mary Diop; Rob Graves; Barbara Lewis; Steven Putansu; Ramon Rodriguez; Erinn L. Sauer; and Julie L. Spetz.

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