Despite the rapid growth in electronic filing, many CPA firms are reluctant to take part in the program. The authors give a report card on the program and its participants to date and provide advice to those who haven't joined yet.

In 1985 an IRS research study showed that over 20% of all tax returns were prepared by computer. These returns, already in magnetic form, were printed and mailed to the IRS and re-keyed into the IRS' database. The only winner in this redundant, error-prone, and costly process was the U.S. Postal Service. As a result, in 1986 the IRS tested the concept of electronic filing in a pilot program with five tax preparation firms and 25,000 refund-eligible returns. The program has grown dramatically ever since. In 1989, over 1 million personal tax returns were filed, albeit in the limited areas where electronic filing was permitted. In 1990, electronic filing was available in all fifty states, and over 3,000,000 returns were filed electronically. In 1991, approximately 7,500,000 returns were electronically filed. The number of electronic filings grew 44% this year with 10,800,000 returns filed as of April 17th, 1992. The IRS anticipates that approximately 15,000,000 returns will be filed electronically in 1993. Electronic filing is by far the most successful program the IRS ever implemented.

THE IRS GOALS

Electronic filing is no longer an option in the eyes of IRS planners. The IRS's direct labor costs for processing an electronic return are only four cents, compared to 40-50 cents for paper returns. The IRS error rate is only 3% for electronic returns, compared to 16% for manual returns. Electronic filing is a necessity if the IRS is to control costs, maintain effectiveness, and meet its overall automation objectives.

WHO HAS ADOPTED

Non-CPA tax preparers have embraced electronic filing more quickly and completely than the CPA community. Many of these are high-volume tax preparers who see electronic filing as an important feature they must make available to their clients to remain competitive. Many CPAs, particularly those with high-volume practices, feel electronic filing is an important service, but do not view it as vital to their competitive position. CPAs in smaller practices consisting of high net worth individuals are more critical and view electronic filing as impractical for the type of tax returns they do, particularly since there are limitations on returns that can be electronically filed. They do not believe that their clients really need or want the service and therefore question the need to expend the resources to get involved. Despite these criticisms, the popularity of electronic filing continues to grow, and it is becoming more practical in the process.

There are limits as to which returns qualify for electronic filing. Electronic filing can handle easy to moderately complex returns. More complex returns, ones with more than nine rental properties or over three businesses, do not currently qualify for electronic filing. Realistically, electronic filing still isn't for everyone.

The jury is still out on the subject of balance due returns. In 1992 only half of 1% of returns filed electronically were balance due returns. Many practitioners surveyed said they cannot imagine clients paying a fee to transmit a return with an amount due. On the other hand, some feel there is a comfort benefit in the IRS' guarantee of acceptance or rejection notification within 48 hours of receipt. Even with a balance due, the taxpayer does not have to remit until April 15. The IRS hopes to offer in the near future credit card payment capability for balance due returns.

HOW TO GET STARTED

You must first register with the IRS by filing Form 8633, which identifies what role you plan to play--originator or transmitter--and is the basis for assignment of an identification number or EFIN. You may not participate until officially notified of acceptance. However, acceptance does not mean you must provide the service this year. For complete information, contact a software vendor or request Publication 1345 from the IRS, which includes application forms and details. You should also read IRS Rev. Proc. 91-69 concerning obligations of participants in the program. IRS-sponsored electronic filing seminars are a tremendous free resource as well.

TRANSMITTERS AND COST

Electronic filing requires an investment in hardware and software. Your tax software provider likely has a number of options you can choose from. Most local and regional CPA firms use the electronic filing options offered with their tax software but use a service bureau to transmit the return. CPAs not using in-house tax software use a service bureau or another surrogate service to both create and transmit the electronic return. For last season, approximately 89% of the 55,000 IRS- accepted electronic filing participants used third party transmitters. The reason: the expense and additional required technology does not make direct transmitting cost effective for low-volume filers (those doing less than 300 electronic returns). Among other things, a more sophisticated modem is required to communicate with IRS service centers.

Software vendors offer transmission services as part of a fully integrated menu of services. They offer a variety of packages that are subject to a wide range of pricing techniques. One company requires a $250 purchase of software plus a $250 deposit toward the processing of returns at $7.95 per return. Another company offers a three-tiered pricing mechanism that includes the cost of the additional software. A deposit of $100 is worked off against a per-return cost of $9.95. You must process at least ten returns or lose the balance of your deposit. Alternatively, a deposit of $495 features a per-return cost of $4.95. Another package requires a $995 deposit against a $1.95 per return cost.

PROFITABILITY OF SERVICE

For electronic filing, preparers' charges range from $15 for a simple federal return to $35 where a state return is included. H & R Block charges $25 if they prepare the return, and this may well be the standard. Since these amounts are sufficient to more than cover direct costs, the ultimate profitability for this service will depend on the volume of returns handled.

So how profitable can electronic filing be?

One franchise tax preparer in the Midwest is finding that electronic filing is a highly profitable service. The company vice president reported that electronic filing generated nearly $93,000 for participating offices. The executive noted that only a few short years ago roughly one out of ten clients were asking for electronic filing. Last year, it was approximately one out of every three clients.

H & R Block had a 34.7% increase this year, with electronically filed returns accounting for 60% of their business. They have reached over one billion dollars in revenue for the 1992 tax season with electronic filing a major contributor.

Twenty percent of all returns filed by high-volume preparers were electronically filed. One tax software service's statistics show that out of 16,000 CPA clients, 3,000 opted for some form of electronic filing option and 100,000 tax returns were electronically filed by these practitioners. At that rate, the average CPA firm with 500 tax returns has an average of 30 returns filed electronically. But profits, large or small, should not be the motivational force for CPAs.

OTHER FACTORS

So why should any small practitioner with limited resources opt to provide electronic filing services? Necessity. The IRS projects that by 1988 more than 50% of all returns will be filed electronically. To achieve this goal, the IRS is currently working on several major enhancements that will enable over 95% of all individual returns to be filed electronically. Their expanded program plans include:

* Widespread marketing of a "File now and pay by April 15 program."

* Credit card legislation that would allow payment of tax due by credit card.

* Elimination of the last piece of paper in the process--Form 8453, starting with an "electronic signature" test pilot program.

* Filing certain 1040EZ returns by telephone, given successful testing during the 1992 season.

There are hidden benefits to electronic filing. Both the CPA and the IRS can clearly operate more efficiently, save paper, and reduce errors. Probably the most significant benefit for CPAs is the error feedback that is transmitted to senders. The IRS has extensive edit routines that pick up inconsistencies in tax returns prior to acceptance. Electronic filing can reveal an error in the tax return before the taxpayer learns about it from the IRS. For example, suppose you forgot to enter all the numbers of your client's social security number. By filing electronically and getting an error report beforehand, it is less likely your client will receive a correction notice from the IRS. Despite all the quality control procedures you may have at your firm, this additional safety net is worth the investment of electronic filing.

REPORT CARD

So how can we grade the players in the electronic filing game thus far?

IRS Success at Starting and Maintaining the Program: B

The IRS has committed itself to this process. Even the IRS's goal of 10 million electronic form returns by the 1992 tax season has been surpassed by more than 2 million. The 1992 returns included 1.3 million filed under the 1040-PC format which permits the filing of a computer generated one-page return. With the introduction of new applications such as joint state filings, corporate, partnership, and estate return filings, participation is sure to increase dramatically. One potential for improvement is the ability to access data about estimated payments, prior year credits, and prior year tax amounts. Currently, the IRS is working diligently to protect privacy and maintain security of the information while technologically streamlining procedures.

Taxpayer Acceptance: B

More and more taxpayers are asking for electronic filing, particularly those due refunds. Instead of waiting eight to ten weeks for a refund, electronic filing enables a refund to be sent in two to three weeks. Many taxpayers speed the process further by taking advantage of Refund Anticipation Loans. They borrow the amount of the refund less applicable fees, and the loan is repaid when the IRS sends the refund directly to the lending institution.

CPA Acceptance: C

Most CPAs are still undecided, but for them electronic filing appears inevitable. The IRS may require high-volume prepares to file electronically much the same as it created magnetic tape requirements for high-volume filers of Forms 1099 and W-2.

Volume Tax Preparer's Acceptance: A

The high-volume preparers have jumped at the opportunities to sell and promote electronic filers. Their success is well known. A survey of high-volume, non-electronic filing conducted last tax season by Best Programs, a provider of electronic filing software, indicated that 46% of those surveyed were considering electronic filing as a necessity of business and 56% felt they would attract more clients by offering electronic filing services. Nearly 20% admitted losing clients who wanted the option of quick refunds offered by electronic filing.

State Acceptance: C

The IRS and 15 states are testing the feasibility of joint electronic filing of federal and state tax returns. The IRS gives each state the ability to obtain its separate tax return data from the IRS computer complex so that taxpayers do not have to make separate transmission of the state return. In essence the IRS is offering states a conduit service.

Initial testing began in 1991. For tax returns filed in 1992, South Carolina offered the program statewide, while Kansas, Maine, New York, North Carolina, West Virginia, and Wisconsin were limited to test areas. In 1993, Kansas, North Carolina, and South Carolina will offer electronic filing. Kansas, South Carolina, West Virginia, and Wisconsin will begin to accept balance due returns as well as direct deposit of refunds. Indiana, Kentucky, Louisiana, Mississippi, Missouri, New Mexico, Oklahoma, and Utah will join in the electronic filing network. The one drawback at this stage is that the returns must be refund-only even though the IRS now accepts balance due returns nationwide. Total state acceptance is slow but is rapidly improving.

STAYING COMPETITIVE

The local practitioner must become familiar with electronic filing to stay competitive much the same as he or she had to become PC literate 10 years ago. While there may be good reasons to not offer the service, there are better reasons for getting involved. Practitioners may find their clients do not want or need the service, or the service, as currently offered by the IRS, is limited and troublesome. But that is only temporary. As more and more taxpayers seek out electronic filing services, there will be greater opportunities for practitioners to increase their business. Of those surveyed, 60% stated that about half their clients receive refunds. Electronic filing not only generates an extra service fee from clients, but also is an effective way of attracting new clients.

IRS efforts, through programs for electronically transmitting information--corporate, partnership, and other types of returns--are likely to result in ever increasing numbers of businesses and sophisticated individual taxpayers demanding electronic filing services. One striking conclusion from this mid-term report is that electronic processing may offer enhanced quality and efficiency in the tax preparation process. The greater efficiency afforded by the process could be instrumental in avoiding those mistakes that disturb and alienate clients. As vendors make it more cost effective for even low- volume filers to jump on the bandwagon, CPA's will find it more attractive to offer their clients the most up-to-date quality services.

Patrick R. Colabella, CPA, teaches accounting at St. John's University. He is a member of the AICPA and the NYSSCPA and is presently chairman of the Education in Colleges and Universities Committee. He also practices public accounting in his own firm.

Mary D. Maury, CPA, teaches at St. John's University. She is a frequent contributor to accounting journals, including The CPA Journal.

James Petersen is President of Best Programs, a provider of PC software for accounting, tax, and business applications. Petersen founded Best in 1982.