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IRS Regulation of Return Preparers: April 15 Edition

Posted on Apr. 15, 2014

April 15 is an appropriate day to flag the issue of regulating return preparers. Last week the Senate Finance Committee held a hearing entitled Protecting Taxpayers from Incompetent and Unethical Return Preparers. Witnesses included Commissioner Koskinen, National Taxpayer Advocate Olson, a practitioner from Oregon (one of four states to regulate unlicensed preparers), Block CEO Bill Cobb, consumer rights advocate Chi Chi Wu and others. A link to video of the testimony and all of the witnesses’ written statements can be found here.

There are some good articles summarizing the hearing and the witnesses’ statements. (see for example last week’s article in Accounting Today). There is also robust public debate on this topic; for example the excellent op-ed by a law student from NYU who succinctly summarized some of the main points that advocates of additional regulation have made. That piece is entitled Rein in Shady Preparers(registration required). A good representation of the opposition to regulation is last week’s written testimony of Dan Alban (the lead attorney who successfully argued the Loving case), who is an articulate advocate. I have discussed my views on the importance of regulating preparers in prior posts.

The arguments regarding preparer regulation include the following: the proposals are anti-competitive and will drive up taxpayer costs, IRS already has enough tools to tackle the problem of incompetent or unscrupulous preparers, the process leading up to the IRS’s decision to impose the requirements was corrupted by corporate interests that would benefit from additional barriers to entry, and the real focus should be on cleaning up and simplifying the tax system.

I will not address all of these objections (and others) but make a few points below.

The rallying cry is tax simplification. It would likely drive down errors and reduce the need to use commercial preparers. Such a drastic streamlining of the code is unlikely. Thus we continue to see public policy choices represented in the code through credits, deductions, and other preferential treatment of economic decisions.

Refundable credits bring to the fore many views on tax simplification and the role of the tax code in developing social policy. The biggest refundable credit and the one that gets the most attention when it comes to errors is the earned income tax credit (EITC). Yet as I discussed in a post last month and as IRS research reveals, the largest dollar source of errors in EITC claims, commercial or self-prepared, relates to the residence of children. Yes there are some challenging and complex issues on that point (e.g., temporary absences) but legal complexity is not usually a characteristic of the residence issue.   Likewise the underreporting of Schedule C income is not fundamentally an issue of complexity. The largest components of individual tax gap stem from the limited information the government has about the source of the errors and the high costs that the IRS faces in detecting those errors through traditional tools of enforcement. It is those areas where nontraditional measures that increase visibility and accountability of preparers and taxpayers are vital tools necessary to maintain the confidence in the fairness of our tax system.

I do not mean to suggest that structural reform would not have an impact on the tax gap. Splitting the EITC up to account for its work and child characteristics may drive down the opportunity and incentives for taxpayers to misstate facts, as would potentially increasing the amount and availability of the childless EITC even without wholesale credit reform. Why might increasing the childless credit influence overclaim rates on the EITC overall? If a noncustodial parent with earned income was entitled to receive some meaningful EITC even without the presence of children, his or her incentive to improperly claim a child as a qualifying child decreases. The current EITC penalizes working non-custodial parents who may support families or spend significant time with children. Under the current EITC those adults are entitled to little or no benefits in many situations, although they may be able to claim the dependency exemption and child tax credit, thus highlighting the role of the preparer in developing the taxpayer’s facts and understanding the appropriate tax treatment.

Likewise, the individual underreporting tax gap is based on a series of differing problems that varies by taxpayer and by issues with respect to the same taxpayer.  Like the “family credits,” understanding and accurately reporting self-employment income are areas which would benefit from accuracy in paid preparer fact development and understanding.

Preparer testing and education are meant to be part of the IRS’s tool-kit, but that alone should not be the sole determinant of a wholly accurate return. A tax system will always need the ability to detect and sanction those who cross the line; testing and education are insufficient.

The IRS has many tools to influence compliance, and there are other measures that may be less costly that may also increase visibility and accountability of preparers and taxpayers. In particular, as Dan Alban has emphasized, the IRS’s uniform preparer registration requirements (undisturbed by Loving) provide an opportunity for IRS to understand preparers and communicate with preparers who may be taking aggressive positions. It is shocking how little the IRS even knew about preparers before this simple but key reform proposal was implemented a few years ago. Likewise, enhanced due diligence is really just getting started for EITC preparers, and recent tax reform proposals have called for expanding due diligence for other credits.  In his written testimony last week Block CEO Bill Cobb proposed juicing up taxpayer self-disclosure requirements for issues where preparers have heightened disclosure requirements (such as the EITC). This may reduce the incentive for taxpayers to rely on ghost preparers who are completely invisible to the system and encourage taxpayers who self-prepare to honestly report on their returns.

The additional costs associated with testing and education are a red herring and deflect the societal need to ensure accurate, honest tax returns.  The costs that are borne by the preparers and passed on to taxpayers have to be compared to the overall costs borne by the public at large when such a high percentage of commercially-prepared returns has errors. That is especially important given IRS research that suggests there are higher error rates among unlicensed return preparers as compared to other preparers. Further, to the extent that small preparers are less able to benefit from economies of scale and would likely be more directly impacted by testing and education costs, any program could provide waivers or differing fees depending on preparer size or complexity of the returns the preparer may be authorized to prepare for example. However it is important not to confuse complexity with the number of schedules.  A low-income taxpayer’s return may include several schedules to support a large refund, including Schedule EIC, and schedules necessary to claim other credits, such as other family status credits and education credits. Charging by the form should not dictate a higher cost which may be borne disproportionately by lower income taxpayers. The discussion surrounding complexity and costs I think can benefit from a more nuanced appreciation of the differences between legal and factual complexity.  I will pick this topic up in a future post.

On the cost side of the ledger few advocates point to the taxpayer costs associated after the fact compliance efforts. Those costs include the challenges of responding to an audit and/or dealing with collection following the audit of an improper return—easy for many readers of this blog but a potentially major obstacle for others. Responding to an EITC audit where the paid preparer did not complete the preparer due diligence form accurately, or honestly, is rich with costs to the taxpayer – missed work, retaining an attorney, requesting assistance from others to document the audit response, just to name a few. For those who owe money to the IRS due to the receipt of an improper refund, the stress of collection notices and the fear of the bills can lead to other problems with tax administration. The growth in retail establishments peddling offers in compromise and other help with the IRS, while good for the infomercial industry, creates another opportunity for exploiting unsophisticated taxpayers.

As a parting thought, the policy issues surrounding the IRS and the Administration’s request for Congress to pass legislation authorizing the IRS to impose testing and education requirements present an opportunity for informed and reasoned discussion on tax administration. It is easy to rail against the tax gap and high overclaim rates but the IRS’s task of reducing errors on any issue that is not characterized by information reporting and withholding is difficult. IRS in its judgment believes that it could do a better job administering the tax laws and working with preparers if Congress gave it the power that the DC Court said it did not have absent explicit legislative authority. Congress should give the IRS the tools it needs to do its job.  If it does give IRS those tools, the burden should be on the IRS to report on the costs and benefits of its additional powers. That would allow for further monitoring and evaluation based on facts.

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