Preparer regulations and home-cooked tax returns

Iowa CPA Joe Kristan worries that increased preparer regulations proposed by the IRS will cause higher prices and says:

One consequence of higher prices will be that fewer people will use preparers. It's still legal to do your own return. It's hard to see how that will improve the finished product.

We regulate restaurants for health code reasons, and perhaps that regulation causes restaurants to have higher prices.

It's still legal to do your own home-cooking.

That doesn't change the fact that it's still a good idea to regulate restaurants for health and safety codes.

I'm not a fan of all government regulations (for example, the idea that you need to have a license to braid hair seems a bit ridiculous!), but there are clearly cases where it's warranted.

Tax preparers have access to a vast amount of sensitive and confidential taxpayer data. Tax preparers have the power to move vast amounts of money from the US Treasury into people's bank accounts on a systematic and large scale. Tax preparers also have the power to create vast amounts of havoc in their clients' lives.

That calls for regulation, in my book.

The public has a right to know that someone is checking the scales and fuel pumps at grocery stores and gas stations; the public has a right to know that someone is checking that restaurant kitchens are not overrun with vermin; the public has a right to know that someone is checking to make sure that tax preparers are not systematically defrauding the US Treasury. The public also has a right to know that someone is checking to make sure that tax preparers are not selling a product that can endanger their financial health.

Consider the taxpayer in the video below. It certainly sounds to me as though she would have been better off doing her own return than turning it over to the paid preparer that she said she patronized.



What I don't understand, however, is why this particular firm is apparently still in business two years after this episode aired. They are even offering a franchise service to other wanna-be tax preparers who want training and a turn-key opportunity to follow in their footsteps.

And they have a Facebook page. Two of their photos show a happy taxpayer holding a refund check and an unhappy taxpayer holding his head in distress. The caption on the first photo reads "HE E-FILE [sic] HIS TAX RETURN PROFESSIONALLY..." and the caption on the second photo reads "HE TRIED TO DO HIS TAX RETURN BY HIMSELF AND MADE MISTAKES!"

It's true. Taxpayers do make mistakes when they do their own returns. But so do paid preparers. The average taxpayer probably makes more mistakes than the average paid preparer, just as the average home cook probably makes more sanitation mistakes than the average restaurant chef.

But the worst paid preparers who systematically prepare quantities of inaccurate returns should be weeded out of the system, just the way snake-oil salesmen calling themselves physicians, unsanitary restaurant operators, and vendors using dishonest weights and measures have been weeded out.

As for more taxpayers doing their own returns, that's already happening, even without the regulations. The statistics show that more people are going the do-it-yourself route, perhaps because of the economy.

Personally, I think it's a good thing for more people to take ownership of their financial information. Preparing their own tax returns could be an opportunity for people to take stock of their financial position in an intelligent and thoughtful manner.

Congress could go a long way in that direction by designing a smarter and simpler tax code that would not push so many ordinary taxpayers with relatively simple financial lives into wasting so much time, effort, and/or money on preparing their tax returns.

new reality TV show?

Here's a delightful article in the San Francisco Chronicle about a Nobel laureate physicist from UC-Berkeley who was willing to go on the TV show "Are you smarter than a Fifth Grader," where he won a million dollars competing against fifth graders.

As my students are taking their VITA certification exams this week, I got the idea that maybe House Ways and Means Chairman Rangel and Treasury Secretary Geithner should be asked to appear on a TV show called "Are you smarter than a VITA volunteer?"

Although error rates in nationwide samples of all types of preparers (including VITA) are unacceptably high, I know some VITA volunteers who could certainly give them a run for the money on their knowledge of basic tax law that applies to ordinary Americans.

I rarely watch TV, but I think this show would make compelling viewing.

I will say this: I will be holding my VITA students to much higher standards than Chairman Rangel and Secretary Geithner have met.

National Tax Bee: further thoughts

While the tax gap is a serious problem, and the complexity of US tax law places huge burdens on all Americans, Americans have a well-deserved reputation as some of the most law-abiding taxpayers in the world. Surveys show that most Americans actually want to comply with the tax law, and many take enormous time, trouble, and expense to do so.

Last year, an exchange student told me that her parents back home in another country do not need to file tax returns, because, as she put it, "The government just knows everything about you, and they just take the money away before you ever get it."

In some countries, cheating the government out of taxes is actually something of a national sport.

During World War II, most Americans took great pride in complying with tax law, which was relatively new for them. Before World War II, only a very small percentage of Americans paid income taxes. As the saying goes, during World War II, the income tax went from a "class tax" (on the wealth) to a "mass tax" (on almost everybody.)

Perhaps a National Tax Bee could celebrate and promote the fact that American taxpayers are actually among the most law-abiding in the world.

It's also important to promote the role of the many competent and conscientious tax preparers who help those taxpayers deal with the compliance burdens our tax law imposes.

We hear about the scofflaws and the incompetent, but it's really important to recognize the many honest taxpayers and the professionals who are doing their best to help them comply with our country's tax laws.

ESPN take note: a National Tax Bee?

The popular stereotype of a tax professional paints them as bland and boring, robotic and devoid of personality. Reading tax pro blogs has certainly convinced me otherwise.

A quintessential example of a colorful (sometimes to the point of flamboyance!) character is Robert D Flach, who writes the Wandering Tax Pro blog. Robert's blog gives fascinating glimpses into his professional life as an unenrolled tax preparer who has been preparing tax returns in New Jersey since the early 1970s. Based on what I can discern from his blog posts, he seems exceptionally conscientious, scrupulously careful, and well-versed in tax law. It's also clear that he takes pains to stay up to date with the ever-changing tax law, as his latest post includes notes he took during his attendance at a recent continuing ed seminar for tax preparers. (As an unenrolled preparer, no law compels him to take this training, but it's clear that he embraces such opportunities whole-heartedly--he's clearly no "seat-warmer." Based on his blog posts, I would guess that his class participation contributes a lot to the liveliness of the sessions and helps keep the other preparers awake.)

His use of the occasional expletive in his blog is a bit jarring--his language sometimes sounds more like that of a sailor than a tax professional, but otherwise, his blog posts suggest that he serves his clients very well, minimizing their tax burdens while staying completely within the law.

He clearly takes pride in the tax returns he prepares for his clients, regarding them as works of art. He writes them out in meticulous longhand, since he eschews the use of tax software. I suspect he may be in a class by himself in that respect--I've never met or heard of any other tax pros who don't use software.

Although he refuses to use software, he apparently does like to watch TV (and complains a lot about reality TV shows.) I watch very little TV myself, aside from my two annual rituals (the National Spelling Bee in late spring and the Times Square ball at midnight on New Year's Eve), but recently I did catch a fascinating episode of a show called "Are you smarter than a fifth grader?" in which a Nobel Laureate physicist wound up winning a million dollars and the right to say "I am smarter than a fifth grader."

All of this has given me a great idea for highlighting the bizarreness of the tax code: ESPN should televise a National Tax Bee, just as they televise the National Spelling Bee. Robert would make a great contestant on such a show (though they might have to bleep out the occasional expletive.)

The Bee could present little minitax scenarios and the contestants would take turns figuring out the answers. Just as the National Spelling Bee doesn't allow spellers to use computerized spell-check, the National Tax Bee wouldn't allow preparers to use software. The rules should allow them to use the tax forms, tax instructions, Pub 17, and copies of the tax code for reference.

Just as the National Spelling Bee doesn't ask contestants to spell out whole essays, the questions would be relatively short and self-contained focusing on particular aspects of tax situations (such as, "Who gets to claim this kid?" or "What is the filing status?" or "Is this allowable as an itemized deduction?" etc.)

There are some details to work out. The tax code and regulations are much more convoluted and less readable than the Webster's Third New International Dictionary, and they also have an order of magnitude more pages than the dictionary. So the judging panel would have to be pretty resourceful in dealing with contestant challenges to the official "correct" answers. I can imagine some ways to handle this. Contestants who want to submit challenges could submit them in writing, to be referred to a panel of tax law professor judges in an isolation booth, so that they would not know the identity of the contestants whose challenges they are evaluating.

Just like the National Spelling Bee, the early round questions would start out with reasonably commonplace but challenging tax situations and then they'd get more and more bizarre and obscure with succeeding rounds.

Here's a contestant lineup that would make for an interesting show:

Robert D Flach, Tax Girl Kelly Erb, The Tax Lawyer Peter Pappas

HR Block, Jackson Hewitt, and Liberty Tax could be invited to send their top tax preparers

VITA and AARP could be invited to send their top tax preparers

The IRS could enter a few expert employees from different departments (TAC, SPEC, audit, NTA all come to mind as possibilities)

The American Bar Association and CPA professional societies could be invited to send their top tax lawyers and CPAs

Then we could have some celebrity contestants: There are many interesting possibilities in Congress--I'd put my money on Barney Frank over Charles Rangel, any day. Larry Summers vs. Tim Geithner would be an interesting match up--that would be a lot closer, but my bet would go on Larry. Maybe the CEOs of the big chains also.

Who else would you suggest for this show? Feel free to leave your suggestions in the comments.

And what about the judging panel? The tax law professors would be the clear choices for that--and some of them would be at least as colorful as the contestants.

As for color and play-by-play commentary, I'd love to see National Taxpayer Advocate Nina Olson in the anchor role, along with Alice Rivlin and Economist Mom as well. Nina could talk about the hardships faced by American taxpayers in trying to comply with the code, while the other two commentators could talk about the cost of all those exotic loopholes for the favored few in terms of the burden they inflict on the rest of us. It would be a great chance to talk about how tax reform could improve our economy.

It could be a great way to educate the American public about tax law. Imagine everything the public could learn from watching a show like this:

1) How to comply with basic tax law (from the early round questions)

2) Some good questions to ask your preparer to see if he knows his own stuff (from the middle round questions)

3) The ridiculous complexity of tax law and the crying need for tax reform and simplification. (from the final round questions)

There could also be student editions of the show, perhaps with different divisions: middle school, high school, college, professional schools.

ESPN, are you listening? (Hey, Noah Webster is in my family tree, and as the mother of two former National Spelling Bee contestants, I'd be happy to volunteer my services as a consultant in developing the show.)

This could be a huge opportunity for television to do some real good for a change.

Role of Paid Preparers in Tax Compliance: New Evidence

The Leviner-Richison study contributes some fascinating new evidence on tax compliance by taxpayers who use different types of preparers. Some of their results present quite a contrast to the previous literature in the subject, which I discussed in my last post.

Leviner and Richison's new work analyzes a random cross-sections of 1999 tax returns claiming EITC that had been selected to study noncompliance with the Earned Income Tax Credit (EITC) rules. They initially divided those returns into nine different categories based on the type of preparer: (1) self-prepared, (2) CPA preparer, (3) attorney preparer, (4) Enrolled Agent, (5) HR Block/Jackson Hewitt (the two big national chains), (6) Other Professional Tax Preparer, (7) Friend/Relative, (8) IRS/VITA/TCE (volunteer free tax prep and IRS taxpayer assistance), and (9) Other.

The big chains (#5) and Other professional preparer (#6) accounted for 56% of the returns in the sample. Very few returns in the study sample were prepared by CPAs and attorneys that the authors decided to combine those categories for their analysis. That's not too surprising, since EITC recipients are low-income taxpayers and very few attorneys and CPAs specialize in serving that clientele, aside from those who volunteer in VITA.

Here's how they summarize their results:

As illustrated in Table 1 below, our analysis reveals that CPA/Attorney, HR Block/Jackson Hewitt, and IRS/VITA/TCE staff have the lowest percentage of returns with change (either positive or negative) to EITC when the original amount claimed on the returns is compared to that concluded by the IRS after audits and reviews....

"Change" is IRS-speak for finding an error rate in an audit. So a high change rate means a high error rate. They found both overclaim and underclaim errors, but, not too surprisingly, the overclaim error rate was about an order of magnitude greater than the underclaim error rate. That is, when the IRS found an error, it was far more likely to be that the taxpayer's return had claimed too much tax refund rather than too little refund.

An important note to keep in mind: the rules for claiming "qualifying children" on a tax return were quite different in 1999 than they are today. The rules are still complicated, confusing, and subject to abuse today, but this was arguably even more true of the rules that applied in 1999.

That said, this is a REALLY discouraging error rate. Bear in mind that these returns were a RANDOM representative set of returns filed in 1999.

The authors have additional cautionary notes to bear in mind in interpreting this data:

An examination of the Adjusted Gross Income line (AGI, Table 2) reveals a nearly 50 percent rate of returns with change for CPAs/Attorneys, and over 60 percent for Enrolled Agents. It is possible that the financial circumstances EITC claimants have are complex enough to confuse even the most trained of preparers. Paid preparers usage is believed to be more common among taxpayers with complicated returns which may go some way toward explaining errors on returns filed by preparers (as opposed to taxpayers filing for themselves) generally. This might be particularly the case with regards to taxpayers engaging the most trained and experienced preparers such as those who are CPAs and Attorneys. Even so, errors made on paid prepared returns do not necessarily mean that these errors are the result of the preparer’s, as opposed to taxpayer’s, misconduct.

In other words, it's important to bear in mind the correlation vs. causality problem here. It's entirely possible that the higher error rate of Enrolled Agents vs. unenrolled preparers may reflect the greater complexity of the returns they prepare rather than a lesser degree of competence or conscientious adherence to the law.

They also looked at patterns of error in AGI reported by different types of preparers, summarized here:

The types of preparers to exhibit the highest rate of change in claimed AGI are: Other Professional Tax Preparer, Other Preparer, and CPA/Attorney, (in that order). HR Block/Jackson Hewitt and IRS/VITA/TCE have almost half that rate of change and are the most accurate compared with other preparer types.

Again, we need to keep in mind the previous cautionary note about correlation vs. causality, because the types of taxpayers who patronize different types of preparers are not necessarily the same.

This study was intended as exploratory rather than conclusive, but it certainly provides some interesting data for consideration.

Role of Paid Preparers in Tax Compliance: Literature Review

TaxProf Paul Caron posted a link to an interesting new paper available on SSRN,
The Role Paid Preparers Play in Taxpayer Compliance in the United States: An Empirical Investigation with Policy Implications

Here's a fascinating excerpt from their literature review:

Using 1979 Taxpayer Compliance Measurement Program (TCMP) database, Erard (1993) found that noncompliance was greater on paid, than self, prepared returns, with the highest predicted mean level of noncompliance occurring on CPA or lawyer-prepared returns. If a taxpayer’s preparation mode changed from self to using a CPA or lawyer, noncompliance increased by a factor of about 4.5! In contrast, the noncompliance of a taxpayer switching from self to some other preparer increased by only 15 percent.

More recently, the IRS reported a higher error rate on paid (56 percent)—as compared with self—prepared (47 percent) returns. This disparity in error rates translated to different dollar amounts taxpayers owed after audit. For Tax Year 2001 taxpayers using a paid preparer were liable for a median of $363 after audit, while those who self-prepared owed a median of $185 per return.

The authors of the study are Sagit Leviner, a law professor at Tel Aviv University, and Kyle Richison, an IRS researcher. (IRS Office of Research, Analysis, and Statistics) have posted The Role Paid Preparers Play in Taxpayer Compliance in the United States: An Empirical Investigation with Policy Implications

After making the observation above, they observe the possible negative externality effects from spreading "infectious" negative attitudes towards tax compliance. In other words, when tax pros encourage their clients to violate tax law, their clients may spread those attitudes to others in casual discussions.

As an important aside: the evidence cited above from the old TCMP study is especially interesting because the TCMP data was based on a random selection of returns for audits. In other words, TCMP audits are not subject to sample selection bias.

This is all quite interesting. I will need to go look at the original sources the authors cite as their sources for the passages above. One of the sources may be an IRS internal research study not available to the public, however.

Here are the footnoted sources for the passages above:

Brian Erard, Taxation With Representation: An Analysis of the Role of Tax Practitioners in Tax Compliance, 52(2) JOURNAL OF PUBLIC ECONOMICS 163 (1993).

Id; see also Internal Revenue Service, Survey of Tax Practitioners and Advisers (1987); Ayres et al. (1989), supra note 11. But cf. Andrew D. Cuccia, The Effects of Increased Sanctions on Paid Tax Preparers: Integrating Economic and Psychological Factors, 16(1) THE JOURNAL OF THE AMERICAN TAXATION ASSOCIATION 41 (1994); Richars G. Broody and John J. Masselli, Tax Preparers: Whose Team Are They On?, 41 THE NATIONAL PUBLIC ACCOUNTANT 18 (1996).

National Research Program (2001)

This is just their literature review of prior work done by others. In my next post, I'll go on to discuss the results of their new contribution to the literature.

WSJ: Tax Prep Becomes a Disposable Luxury

This Smart Money column in today's Wall Street Journal asserts that H&R Block's woes are due to more people going to the "do-it-yourself" mode of tax prep.

The firm has suffered from dwindling demand during the downturn. Its 13,000 retail offices across the country prepared 5.7% fewer tax returns in this year’s tax season, as more customers either filed themselves or just didn’t file because of unemployment. H&R Block’s online services and TaxCut software, which increased filed returns by 21%, mitigated those losses.

Jackson Hewitt CEO talks about the tax prep market

The Seeking Alpha website has a fascinating transcript of Jackson-Hewitt recent conference phone call discussing their firm's performance with investors.

Here's Harry Buckley, CEO of Jackson-Hewitt, speaking to investors and prospective investors in his firm in a call earlier this month:

Another issue of note is our inability to compete and file a high percentage of tax returns when we have control of the client in our office. For a variety of reasons that we must get our hands around, a large number of clients who enter our offices begin a transaction and then do not complete a return, or complete a return and then don't have us electronically file it. This is what we call holes and voids and it is a significant problem that needs to be rectified....

In looking at the entire industry, if we look at the number of returns that were filed last year, and certainly we were down over 500,000 and Block was down over 600,000, and yet the total returns filed electronically were only down 27,000. I think it's indicative from that that there is a growing market out there for independents.

My observations:

Interesting to note that the market share of the big two has fallen in the past year.

Mr. Buckley's use of language reveals an interesting view of his firm's relationship to clients. In the excerpt above, he used the phrase: "when we have control of the client in our office." The investors were apparently not bothered by his use of such language. I wonder how Jackson-Hewitt clients would feel if they heard the company CEO talking about them that way?

Unlike Mr. Buckley, as a VITA site coordinator, I have never viewed our site as having "control of our clients" when they come in to our site.

They seek our assistance, and we provide it as long as their return fits within the scope of our training and certification, and as long as they are willing and able to provide us with all the documents and information we need to prepare an accurate return. Occasionally, we do not feel comfortable doing a particular return, either because it is too complex, or because the client is unwilling or unable to provide all the information needed for an accurate return. We are quite willing to turn away such business, and try to screen it out on the phone ahead of time, whenever possible.

For example, a few taxpayers who own modest two-family homes occasionally turn up at our VITA site. They live in one apartment and rent out the other one. VITA training and certification, even at the "Advanced" level, does not include Schedule E for rental income, probably because of the complexities of depreciation rules. So we tell those taxpayers that we will be unable to do their return and they need to consult a tax professional with greater expertise than we can offer.

Another example is that a few clients ask us to prepare their return before they have received all their W-2's in the mail. We have to tell them that we can't do their return until they have all their documents. Most of our taxpayers understand this requirement, and they wait patiently until they have all the documents needed.

A very few of them complain that other tax preparers are willing to file returns in January with just a "final paystub." We tell them that we are IRS-trained and certified, and we operate strictly within the law. If the taxpayer doesn't want to comply with the law, it's his prerogative to go elsewhere--and face the consequences.

Because we are a volunteer site providing free tax assistance, we are able to prioritize QUALITY over quantity. We have plenty of taxpayers who are willing to provide us with all the information needed for an accurate return, so we have no problem with turning away the occasional taxpayer who doesn't want to provide the information we believe we need for an accurate return.

Of course, commercial tax preparers do need to worry about quantity as well as quality, and it's hard for commercial tax preparers who try to "play it by the book" to lose business to those who don't.

A commercial tax preparer who turns away business from taxpayers who want to file before they receive their W-2's is going to lose business (and profits) to unscrupulous preparers.

Here's more from Mr. Buckley's conference call to investors on that issue, specifically addressing the "pay-stub filing" issue.

Sloan Bohlen - Goldman Sachs

On the tighter IRS standards, could you wager a guess as to what impact that might have on what kind of pay-stub filing we saw last year and how that could be incrementally beneficial this year?

Harry W. Buckley

I don't think they will address that. It has been brought to their attention. Last year during tax season it was brought to the IRS's attention. They did close down a few. But the numbers are just so high out there for them to take an active stance and go after them, tax season would be over.

Stock analyst outlook for H&R Block

Excerpt from a Seeking Alpha website description of H&R Block stock prospects (emphasis mine):

Reuters reported on September 2 that the IRS is reportedly considering options like competency tests and registration, as well as fees, in an effort to improve the accuracy of paid tax preparers; in several government reports, the paid preparers had high error rates, even doing worse than volunteer preparers. In a letter dated August 31, H&R Block said it backs legislation that would improve training and ethics in the industry. Analysts believe the company could benefit from regulation if smaller competitors that have fewer available resources are unable to comply.

Two big publicly held franchise chains dominate the paid tax prep industry in the country: H&R Block(stock symbol: HRB) and Jackson-Hewitt(JTX).

Those two firms haven't been doing so well lately.

Yesterday, Block held its annual shareholder meeting and its CEO faced the music, explaining the company's 22% drop in its stock price over the past 12 months and its plans to recover and rebuild the company.

Jackson-Hewitt stock, has done even worse, falling about 70% over the past year.

For comparison, during the same period, the overall market, as measured by the S&P fell around 14%.

Both companies have betas around 0.9, which means that they would ordinarily be expected to outperform the market during downturns, not to underperform it.

Correlation vs. causality: tax pros and audit probability and LOVE

Tax Practitioner Credentials and the Incidence of IRS Audit Adjustments

2003, Accounting Horizons

John Hasseldine, Peggy A Hite

Abstract

A random selection of Internal Revenue Service office audits from October 1997 to July 1998, the type of audit that concerns most taxpayers, is analyzed. Taxpayers engage paid preparers in order to avoid this type of audit and to avoid any resulting tax adjustments. Whether there are more audit adjustments and penalty assessments on tax returns with paid-preparer assistance than on tax returns without paid-preparer assistance is examined. By comparing the frequency of adjustments on IRS office audits, it is concluded that there are significantly fewer tax adjustments on paid-preparer returns than on self-prepared returns. Moreover, CPA-prepared returns resulted in fewer audit adjustments than non CPA-prepared returns. The study included 2,253 audit cases; 71% of the audited taxpayers prepared their own tax return, 19% hired a CPA, and 10% hired a non-CPA. Most adjustments come from deduction errors, and CPA-assisted returns have significantly lower likelihood of having a deduction adjustment.

Given that most paid preparers are not CPAs, a naive interpretation of the data above could lead to an erroneous conclusion, to wit: hiring a CPA to prepare your tax return "causes" a higher likelihood of IRS audit than hiring a non-CPA to prepare it.

An alternative explanation could be that the subset of taxpayers whose finances are sufficiently complicated as to make them likely to attract the interest of the IRS are also more likely to hire a CPA than they are to hire a non-CPA.

Since the study also found that IRS audits in the sample turned up fewer errors on CPA-prepared returns than on non-CPA-prepared returns, choosing a CPA might well have been a very good decision on their part.

In a study such as this one, there are always many unobserved variables which could be a source of what econometricians refer to as LOVE ("Left Out Variable Error.")

The sample of taxpayers selected for office audit is clearly not a random representative cross-section of taxpayers. Taxpayers who prepare their own tax returns are a minority of taxpayers, but they constituted 71% of those audited in the study sample. It's an interesting question as to whether preparing your own tax return raises the probability of audit, after statistically controlling for the complexity and other attributes of the return.

Tax software and barriers to entry: are tax pros more like physicians or more like hair braiders?

Trish McIntire (Our Taxing Times) makes an important observation: computer software has significantly lowered barriers to entry in the paid tax prep industry:

As tax software has developed, home computer products and online filing have made it easier for the DIYer [do-it-yourselfer] to prepare and electronically file a return. This has given rise to two problems. The first is the taxpayer who did his own return by hand and then switched to a program and doesn't check the results. Joe Doe has been preparing his own return for years by hand and discovers one of the boxes. Before when he ran into something he didn't understand, he would grab the instructions, Pub 17 or call the IRS to find out about his issue. With the box, if he can find something like his issue, he is less likely to research and more likely to rely on the software handling it correctly. These don't worry me since they are more an IRS problem, in fact, I get many new clients from this group. The group that worries me is the DIYer, who tries to bring in a little extra money preparing returns. The boxes make it easy and too many people are tempted to do something they can not do by hand.

Economists like to analyze different kinds of industries by thinking about barriers to entry in those markets.

For example, there are high barriers to entry in the physician market in all states. You need to spend many years in college, medical school, residency, and there are many obstacles including organic chemistry, MCATs, and licensing exams. Physicians who want to go into private practice face additional barriers because they have to come up with up-front money to pay for equipping an office, hiring office staff (who are knowledgeable about the ins and outs of billing insurance companies, among other things!), malpractice premiums, etc., etc. There are also requirements for continuing education.

In fact, even if you want to go into the hair-braiding business, many states impose barriers to entry. The state of Virginia, for example, requires wanne-be paid hair braiders to complete an approved training program involving 170 hours of instruction in hair-braiding among other things.

A. In order to receive a license as a hair braider, an applicant must meet the following qualifications:

1. The applicant shall be in good standing as a licensed hair braider in every jurisdiction where licensed. The applicant shall disclose to the board at the time of application for licensure any disciplinary action taken in another jurisdiction in connection with the applicant's practice as a cosmetologist or hair braider. The applicant shall disclose to the board at the time of application for licensure whether he has been previously licensed in Virginia as a cosmetologist or hair braider.

2. The applicant shall disclose his physical address. A post office box is not acceptable.

3. The applicant shall sign, as part of the application, a statement certifying that the applicant has read and understands the Virginia hair braiding license laws and the board’s hair braiding regulations.

4. In accordance with § 54.1-204 of the Code of Virginia, the applicant shall not have been convicted in any jurisdiction of a misdemeanor or felony which directly relates to the profession of cosmetology or hair braiding. The board shall have the authority to determine, based upon all the information available, including the applicant’s record of prior convictions, if the applicant is unfit or unsuited to engage in the profession of hair braiding. The board will decide each case by taking into account the totality of the circumstances. Any plea of nolo contendere shall be considered a conviction for the purposes of this section. The applicant shall provide a certified copy of a final order, decree or case decision by a court with the lawful authority to issue such order, decree or case decision, and such copy shall be admissible as prima facie evidence of such conviction. This record shall be forwarded by the applicant to the board within 10 days after all appeal rights have expired.

5. The applicant shall provide evidence satisfactory to the board that the applicant has passed the board-approved examination, administered either by the board or by independent examiners.

After the applicant has complied with all of the foregoing requirements, taken the 170-hour hair braiding training course, passed the board certification exam, and paid a $70 licensing fee, he or she is duly licensed to hang out a shingle as a "board-certified hair braider." Only then is s/he legally allowed to practice as a paid hair braider in Virginia.

My own state, New York, poses even more extensive requirements for wanne be professional hair braiders: 300 hours of approved training. A braider with a Virginia hair-braiding license can't skip the extra hours required in New York unless she can show 5 years experience as an out-of-state hairing braiding pro.

Most economists think some sort of legal barriers to entry in the physician market are a good idea, because the risk of bad medical care may be hard for consumers to observe in advance. There's a strong "information asymmetry" argument in favor of licensing physicians.

On the other hand, most economists think that the risk of a bad braiding job is low enough that state licensing requirements for "board-certified hair braiders" create economic inefficiency. Whether such requirements are actually enforceable as a practical matter, however, is another question altogether. Many hair braiders operate very informally, working out of their own apartments or making housecalls. As a practical matter, I would guess that there may be quite a bit of "unlicensed paid hair braiding" going on in Virginia and New York, licensing requirements or no.

What about professional tax preparers?

Right now, there are very low barriers to entry in tax prep industry. As I've mentioned before, in 48 states anyone (even an illiterate and innumerate convicted criminal) can go into the tax prep business. No need to show any qualifications, no need even to register before hanging out one's shingle.

As Trish's post makes clear, in almost all states, anyone with an inexpensive laptop and out-of-the-box software can go door-to-door making housecalls doing paid tax prep--and possibly fool unsuspecting and hapless clients into thinking that he knows what he's doing. Thanks to inexpensive boxed software, it's easy for a well-meaning but quite incompetent person to appear to be a knowledgeable tax pro.

The downside of a bad braid job may be laughable and any damage should be temporary, readily apparent, and easily reversible.

The downside of a bad tax job is not so funny, not always apparent, and the damage is not temporary or easily reversible.

Is licensing tax preparers a practical answer, however? As a practical matter, it may be very hard for the IRS to enforce such rules, just as it's hard for states like Virginia and New York to enforce rules against unlicensed hair braiders.

Tax preparer objections to testing--and my responses

The Wandering Tax Pro (TWTP) has raised a number of objections to requirements that commercial tax preparers should have to pass a licensing test. His objections are in bold type below. My responses follow in regular type.

(1) Making all tax preparers take an annual, or even semi-annual (if re-registration is every two years) proficiency test to maintain their “license” is ridiculous and excessive. No other similar federal financial “credential” requires annual testing.

Volunteer Income Tax Assistance (VITA) certification is a federal financial credential that requires annual testing.

In fact, the IRS is emphatic that even an attorney or CPA is required to take and pass the test annually if s/he wants to assist taxpayers at a VITA site. The IRS does not consider even enrolled practitioner status a sufficient credential to prepare tax returns at a VITA site, unless that enrolled practitioner also passes the VITA tests each and every year.

The National Taxpayer Advocate, Nina Olson, has testified to Congress that the VITA certification process is a modest starting point that indicates that commercial preparer testing is practical.

(2) What good is an open book, or “open software”, test as proof of competence? All it proves is that one knows where to look in the book. I agree that a tax preparer does not have to memorize the Tax Code to be competent, and part of one’s competency is knowing where to look for information (and we all rely heavily on workbooks like QUICKFINDER HANDBOOK during the season) - but if the test is going to be open book why bother. If EAs do not have an open book test for the enrollment exam then neither should LTPs.

College students can tell you that open book exams can be MUCH harder than closed book exams. As a professor, I know it's possible to make very hard questions for an open book exam. Open book does not necessarily equal easy!

No test is perfect, and I can certainly see that both the Enrolled Agent (EA) exams and the VITA exams have considerable room for improvement. However, I think the VITA tests are probably a better starting point as a model for the unenrolled preparer exam, because the VITA tests focus on the areas that cause most of the problems that the IRS actually sees in the overwhelming majority of returns (i.e., incorrect application of the rules on filing status, claiming dependents, most common types of deductions and credits, treatment of different types of retirement income, etc.)

The released questions from old EA exams appear to be all multiple-choice questions with very simple scenarios that isolate one particular tax issue. They also focus on many details of tax law that most rank and file unenrolled preparers rarely or never see. All that most tax preparers need to know about the generation-skipping tax provisions in estate tax law, for example, is that they should refer any taxpayer with an estate potentially large enough to be subject to taxation to consult an attorney specializing in estate planning.

By contrast to the EA exam, which has very short taxpayer scenarios, some of the VITA exam questions require the test-taker to complete an entire tax return based on a reasonably extensive taxpayer scenario that resembles the kinds of tax situations they will most commonly encounter. Other questions require the test-taker to "quality review" and find all the mistakes in an already-prepared return. Unlike the EA exam released questions, not all the VITA questions are multiple-choice. Some require specific numeric answers.

Neither test is perfect, but I think the VITA test is a better model for rank and file unenrolled preparers than the EA test.

(3) Just because I have the knowledge, training and experience to pass a proficiency test does not mean that I should embrace with open arms the financial and other inconveniences of having to study for and take one.

I can certainly understand why you would not "embrace" such a test. Most people don't especially like tests, even on subjects in which they may excel, but they regard them as a necessary evil. (I happen to be one of those people who actually likes most tests, though even I will concede I didn't especially like taking the driving test. I'm personally not looking forward to the day when the government decides that older people--even those with unblemished driving records like mine--need to periodically retake the driving test. I passed mine the first time around, with flying colors--and even got a score high enough to be a driving instructor! But I took it in California, where they don't require parallel parking, so I know I'll be nervous if they ever make me take a test that does require parallel parking! So I do sympathize!)

As for the financial costs and the inconveniences, yes there would be costs and inconveniences, but the cost could be much less than the cost of CPE credits.

As for the studying time, a good certification test shouldn't require you to study anything you don't already need to review in order to prepare accurate tax returns for your clients.

In my opinion, a good test for commercial preparers should be based on the kind of work that tax preparers do every day, just as the VITA tests already are. Basically, you would be given several pages describing a taxpayer scenario, including copies of his documents and a list of other facts about the taxpayer's situation, and you would use those facts to prepare a tax return, and then answer questions based on the numbers in the return you just prepared. There would be different components of the test, requiring you to do several different types of returns of varying degrees of difficulty, but nothing ridiculously arcane or out of the ordinary.

After 38 years of continued unblemished practice I do not intend to “start from scratch” and prove that I know what I have been doing for almost 4 decades.

In an ideal world, I agree that an experienced preparer with an unblemished record should not have to start entirely from scratch. It would be more efficient if the IRS could give such preparers at least some "partial credit" that might reduce the amount of time devoted to monitoring them.

Unfortunately, from what I understand of the IRS preparer databases, it may not be easy for the IRS to identify a preparer's track record, because preparers may use multiple preparer numbers. It's relatively easy for the DMV to check your driving record, even across multiple states, but not so easy for the IRS to track a preparer's record. Given the confused state of the 22 sometimes inconsistent IRS preparer databases, the IRS has conceded that it isn't even sure how many paid preparers there were last year--it might be anywhere from half a million to over a million. I suspect that it would cost the IRS a good deal more to track down all audit records associated with a given preparer than it would cost to administer and score an exam.

Any scheme of preparer regulation clearly has to do a better job of authenticating who prepared a given return.

A practical system that could make life easier for experienced preparers could work as follows: pre-test/CPE/post-test. Experienced preparers could have the option of taking a relatively short but hard pre-test. If they do well on it (as I expect most competent experience practitioners would), then that could reduce the number of CPE hours they are required to take, and those who passed the pre-test would also be excused from the post-test.

(4) I still think that it would be literally impossible to properly register and test over 1 Million tax preparers (I include CPAs and attorneys who want to prepare 1040s) in the period of May 1 through November 15 (the only true opportunity to properly conduct registration and licensure) of the first year such legislation takes place. Even if the test is administered by an outside contractor the IRS OPR still has to process the results as part of the licensure process.

Millions of high school students take the college entrance exams every year. The ETS and ACT electronically transmit those results to colleges within a few weeks after the exam. Why should it take the IRS any longer to process an electronic file containing test score results than to process the electronic file containing the barcode attendance figures stating the number of hours of seat-time the preparer put in at continuing professional education (CPE) sessions? It will likely need to outsource much of this work, whether we are talking about testing or CPE, but it certainly doesn't seem to me that it takes any longer to process test reports than CPE reports.

And, if you're concerned about costs, the cost of a paper-based test is considerably cheaper than CPE credits. (SAT costs $45, but that includes scoring the hand-written essay component. ACT test, without an essay, costs $32.) How many hours of CPE credit will $32 buy?

(5) If registration and licensure of all tax preparers is to be successful it will require the support and cooperation of all tax professionals.

No system will attract "the support and cooperation of all tax professionals," since there are clearly incompetent and dishonest tax professionals who have no desire to mend their ways.

Excessive testing requirements and invasive background checks do not inspire cooperation.

I personally don't find the VITA tests at all excessive. I'll concede they have room for improvement, but I actually rather enjoy the challenge of taking them, so I guess you could say that the VITA tests do inspire my cooperation.

The background checks don't bother me either. It seems only fair that the IRS should check out the background of tax preparers, since taxpayers must turn over so much sensitive information to their preparers: names, addresses, SSNs, dates of birth, documents that include bank and brokerage account numbers, and perhaps soon health insurance information as well. The possibilities for identity theft are very real.

I will gladly support and cooperate with the process as long as there is a “grandfather” procedure

As for grandfathering, I don't mind taking the exact same tests that new VITA volunteers take each year. It keeps me on my toes, as far as staying up to date with the latest changes in the law, and making sure that my brain is still sharp. I actually enjoy taking the test as soon as it becomes available in late November each year.

As an experienced preparer, it takes me relatively little time to take the test. Of course, it takes new preparers much longer to take the test (as it should), and some of them wind up having to study some more and take the re-test (again, as they should.)

and all individuals who want to prepare 1040s for a fee (CPAs and attorneys included) are included in the testing (unless grandfathered) and CPE requirements.

As I mentioned above, anyone who wants to be a VITA volunteer, including career IRS employees and enrolled practitioners such as attorneys, CPAs, and EAs, is already required to take the exact same certification tests that regular folks do. In my experience, the enrolled practitioners who volunteer with VITA are typically very knowledgeable and experienced, and do not find the tests to be especially burdensome.

I guess we must just agree to disagree.

I guess so! At least on some things!

30% of preparers in NY "secret shopper" visits "horribly fraudulent"

Today's Albany Times Union has a profile on William Comiskey, the Deputy Commissioner for Enforcement in the New York State Tax Department.

Mr. Comiskey comes across an energetic ironman--in his spare time, he has been training in the steep foothills near his home in Rensselaer County for a 500-mile bicycle race across the state. He also runs, swims, and plays soccer.

According to the article, he's got wisdom and experience as well as energy: He plays soccer on an "over-40" team but said he's "contemplating an over-50 team. Playing in a 40 year-old body is very different from playing as a 57 year-old."

He's also had a lot of experience in law enforcement:

He was appointed Deputy Commissioner of Tax Enforcement in March 2007 during the Spitzer administration, but has spent most of his career working for government in various enforcement capacities. Immediately after graduating from Fordham University School of Law, Comiskey clerked for New York Court of Appeals Judge Hugh R. Jones. He worked as an assistant district attorney in Manhattan and as Chief Assistant District Attorney in Rensselaer County, spent 10 years with the state's Organized Crime Task Force, and served as chief prosecutor for New York's physician disciplinary board at the Department of Health. He prosecuted Medicaid fraud and served as bureau chief in criminal prosecutions in the Attorney General's office under Eliot Spitzer before moving to Tax and Finance.

Mr. Comiskey sounds like a very determined guy, someone that honest taxpayers and tax preparers are happy to have on their side. Here's how he described his department's aggressive program of using undercover secret shoppers to ferret out dishonest preparers:

"Part of enforcement now is a lot of undercover work and we have a lot of interesting toys for capturing voices when people aren't quite aware they're being recorded. We have button-hole cameras and it has been really and tremendously revealing. This year, we've done a little project on tax preparers. We go out pretending to be tax payers ... we've done it at 170 different tax preparers. Fifty-one of them have prepared bad returns that are just horribly fraudulent. I have some transcripts ... here's one: a tax preparer describes how he's gonna do a 'ho-hum, no muss, no fuss, simple [expletive] return that's gonna get through the system' and he'll never get audited and never get caught. He underreports income then for two years of about $80,000. That he knows. Do you think he knew what he was doing? He was selling our investigator as a taxpayer, 'I know how to cheat without getting caught.' ... We've arrested about 20 this year so far. And there's lots more in the wings."

51/170 is 30%. I don't think that means 30% of all tax preparers are horribly fraudulent--it's likely that the NYS Tax Department is being smart in targetting its secret shopper visits primarily on those tax prep businesses that show suspicious patterns in the returns they've submitted. Mr. Comiskey comes across like a guy who knows how to pick his battles--whether it's which soccer team to play on, or which preparers to visit.

The few professional preparers I've had the pleasure to meet in person have struck me as scrupulously honest, and I believe they would welcome a secret shopper visit. That's probably why they are unlikely to get one. They're also happy that the state tax department is working on putting the bad guys out of business.

Mr. Comiskey clearly has his eyes on the real prize: the deterrence effect. In the response to the reporter's question, "What's the goal?"

"We recovered $2 billion last year and we expect a similar rate this year. That money is the small dollars. The big dollars come from the deterrent effect. ... I see people in three groups. You have the group of people who will always do the right thing, because that's how they are wired. Then you have a much larger group, who do the right thing because of the consequences if they are caught. Then you have the small group of people who break the rules. Chasing dollars is what you have to do. What we're trying to do is move the little group so you can sway them into voluntary compliance."

"Ultimately, the goal is to level the playing field so that the honest ones aren't chumps."

Criminal charges and penalties for unscrupulous tax preparers

The Tax Lawyer posts some heartening news about criminal crackdowns on fraudulent tax preparers here. He comments:

The IRS’s lack of a tax preparer monitoring regime is catnip to con-men and they are taking full advantage of it.

As I pointed out in an earlier post, in theory, the IRS does monitor tax preparers who e-file, which are the majority of returns these days, but apparently it doesn't have the resources to do it very well.

The Tax Lawyer also links to arguments against greater preparer regulation by Joe Kristan, who says that such regulations will drive non-compliant preparers underground.

The reality is that some non-compliant preparers apparently already operate underground. If there are paid preparers who are willing to fabricate fraudulent and fictitious deductions and credits on their clients' returns, then why should we expect that they will put their own real names and identification numbers on the return to make it easy for the IRS to monitor them?

It's easy enough for a fraudulent preparer to steal the identification number of another preparer, after all. It's on the copy of every return a legitimate preparer has ever prepared. So clients who come in to an unscrupulous preparer with copies of prior year returns prepared by a legitimate preparer automatically give the evil new preparer access to the legitimate preparer's identifying information.

There are important practical and technological issues the IRS needs to address to deal with this problem. Ultimately, maybe preparers need to provide biometric data (high-tech fingerprints or retina scans) or at least secret PINs not revealed to others when they file returns. Although some might say that collection of biometric data is an invasion of the preparer's privacy, anyone applying for an EFIN (Electronic Filing Identification Number) as an electronic return originator already needs to submit his fingerprints to the IRS.

An EFIN is effectively a license to electronically move large amounts of money from the government's bank accounts into other people's bank accounts (or, in some cases, into the preparer's bank account.) And it all happens very quickly. With the emphasis on e-filing and direct deposit of refunds, the IRS has very little time to scrutinize returns before moving the money.

Why it's hard to count the number of tax preparers out there

Here are some fascinating excerpts from a DOJ tax complaint filed earlier this month about a preparer named Derrick Jackson, also known as "Glenn Dent," who filed returns under multiple DBA business names, using preparer IDs that didn't actually belong to him. (In one case, he used an SSN in the "paid preparer ID field" that belonged to a person who had died two decades ago. I guess "Dead preparers tell no tales." In another case, he used an EIN that belonged to an entirely unrelated franchise where he had never worked.)

8. From 2002 through 2004, Jackson prepared at least 288 federal income tax returns for others, using the name Derrick Jackson and the business name International Tax and Accounting Services. In 2005, he prepared at least 149 tax returns using the same business name and his social security number. And in 2006, he prepared at least 76 federal income tax returns for others under the alias Glenn Dent and the business name Tax Wisdom.

9. To disguise his true identity, Jackson sometimes used the alias Glenn Dent (d/b/a Tax Wisdom) when he prepared tax returns. When he prepared these returns, Jackson used a social security number which belonged to a person who died in 1977.

10. The electronic identification number (EIN) that Jackson used for his business Tax Wisdom, and listed on tax returns he prepared, does not exist. The EIN that Jackson fraudulently used to file these returns belonged to a Jackson Hewitt Tax Service franchisee that was not affiliated with the defendant.

The rest of the complaint goes on to detail the many bogus deductions and credits the preparer procured for the customers of his tax prep business.

But just from the paragraphs I've quoted above, you can see why the IRS would say it has a hard time counting up how many preparers, or knowing exactly who prepared a return.

It's disturbingly easy for a preparer to write down another preparer's tax ID number in place of his own. Many clients routinely bring their old tax returns from previous years when they visit a new tax preparer. All the information a preparer needs to steal is right on the client's copy of his old tax return from previous years.

Any IRS proposals to regulate tax preparers will need to deal with the issue of identity theft among preparers. Theft of preparing identification numbers obtained from former clients (unwittingly!) or from former employees of legitimate tax preparers.

All of this is only made harder because there's an alphabet soup of preparer ID numbers that paid preparers use on their tax returns, even when they are trying to comply. Some use their Social Security numbers (SSNs), some use their Employer Identification Numbers (EINs), some use their EFINs (Electronic Filer Identification Number), and some use PTINs (Preparer Tax Identification Numbers.) And the IRS has 22 different databases to try to keep track of it all.

Here's what the AICPA says:

“The IRS currently is not able to track, monitor or control preparers’ activities and compliance, or even determine the total number of paid tax return preparers,” said TIGTA Inspector General J. Russell George in a statement. “As a result, the IRS currently is not capable of ensuring that paid preparers adhere to professional standards and follow the law.”

TIGTA found that tax preparers are using multiple ID numbers, making it difficult to keep track of them. Even when the IRS does have tracking data, it may not be accurate. Using a statistical sample of 139 tax preparers, TIGTA found that multiple identifying numbers were used by 93 of them. The names of the 139 preparers in various systems were inconsistent 45 percent of the time. There were inconsistencies in 24 percent of the preparers’ street addresses listed in the various systems, while telephone numbers varied 40 percent of the time. In 10 instances, IRS records showed the preparers were attorneys, although TIGTA’s research showed that only two of them were members of their state bar association. Seven preparers were listed as being both attorneys and CPAs, but TIGTA could verify that only one of them held both designations.

What does a preparer have to do to face jail time?

Earlier I explained that it's hard for the DOJ and IRS to shut down egregiously fraudulent tax preparers who operate large-scale operations filing hundreds and thousands of bogus tax returns over many years.

It can take years just to get an injunction. It takes vast quantities of professional staff hours for the IRS and the DOJ to build a case for that injunction, so understandably they focus their limited enforcement resources on the very worst of the worst preparers.

And, at the end of all that work, what happens to the preparers the DOJ goes after for large-scale fraudulent preparation of bogus returns with fabricated deductions?

More often than not, it seems to be just an injunction.

Injunctions are civil actions. No jail time. No fine. Just a court order telling you that you must stay out of the tax prep business.

The cases against the preparers that resulted in injunctions were so outrageous that I wondered why the DOJ had only requested an injunction, rather than taken them to criminal court to face jail and large fines.

The apparent answer is that criminal cases are even more time-consuming to build than civil cases.

I started to wonder: What does a preparer have to do to get sent to jail?

Based on the pattern of DOJ results, the answer seems to be: a preparer has to do a LOT more than just fabricate deductions to go to jail.

Here's the story about one preparer who was recently convicted by a jury of and faces sentencing

WASHINGTON, June 12 /PRNewswire-USNewswire/ -- Following a four-day trial and less than an hour of deliberations, a federal jury today convicted tax return preparer, Marcel J. Toto-Ngosso, of Silver Spring, Md., of 17 counts of preparing false tax returns in connection with a scheme to generate fraudulent tax refunds for client-taxpayers, the Justice Department and Internal Revenue Service (IRS) announced.

According to the indictment and evidence introduced during trial, Toto-Ngosso ran a tax preparation business out of his home, located on East Shaw Avenue in Silver Spring. Toto-Ngosso prepared false tax returns for clients for tax years 2001 through 2006 which claimed numerous fraudulent deductions including false dependents, inflated charitable contributions, fraudulent un-reimbursed employee expenses and other false and fraudulent deductions to which Toto-Ngosso knew his clients were not entitled.

Evidence was also introduced that Toto-Ngosso purchased the names and Social Security numbers of individuals, which he later sold to his clients for $500 to $800 per dependent. Toto-Ngosso used these names and Social Security numbers on the false tax returns in order to secure larger refunds for his clients.

At trial, the government introduced evidence that after Toto-Ngosso learned he was under investigation by the IRS, he instructed his clients to lie about the information that he reported on their tax returns.

U.S. District Judge Roger W. Titus scheduled sentencing for Sept. 21, 2009. Toto-Ngosso was detained pending sentencing. He faces a maximum of three years in prison and a $250,000 fine for each count of conviction.

So, apparently, the DOJ threw the book at this preparer for not only preparing fraudulent returns but also for systematically involving other people in active fraud, by buying and selling SSNs and by instructing his clients to lie to the IRS.

Putting the bad tax preparers out of business is hard!

Under current law, it apparently takes a LOT for the government to make successful case that shuts down a tax preparer.

The Department of Justice (DOJ) announced on July 17 that it has obtained injunctions against 410 tax preparers in the last decade. These means that those 410 preparers are forbidden to operate tax prep businesses.

However, as far as federal law is concerned, anyone else besides those 410 preparers specifically enjoined by court order are legally within their rights to hang out their shingle as "professional tax preparers" of US income tax returns. The government estimates that somewhere between half a million and a million paid preparers operated in 2008, most of them unlicensed and unregulated.

Looking at the DOJ complaints is eye-opening. Even when a tax preparer has engaged in a large-scale pattern of systemic fraud, involving thousands of tax returns and millions of dollars in fraudulent refunds, it takes years for the IRS and DOJ to shut them down.

The right to be an unlicensed tax preparer apparently has a lot of legal protections under current law.

The right of taxpayers to be protected from the systemic fraud practiced by unlicensed preparers has much less protection under current law.

No matter who prepares our own tax return, all taxpayers suffer from the systemic fraud practiced by tax preparers, the most egregious of whom appear to come from the vast ranks of the unenrolled commercial preparers.

The E in E-file doesn't necessarily mean Ethical!

If you see the IRS e-file logo at your tax preparer, it means--IN THEORY--that the owners and chief officers of that tax prep business have passed muster with the IRS e-file provider application process, which includes a "suitability background check." That includes an FBI criminal records check, a credit report check, a check to make sure that the preparers' own personal tax record is clean, and a check for any previous violation of e-file non-compliance.

Once a preparer passes muster as an authorized e-file provider, he is entitled to display the logo above and to e-file returns. If the IRS later finds a pattern of unethical behavior, they can yank his e-file provider privileges.

So, IN THEORY, the sign above should provide some assurances that the IRS has found the tax prep business operators to be "suitable" and that they have not had their e-file privileges revoked for illegal tax preparation practices.

IN PRACTICE, the reality can be very different, as this December 2008 US Department of Justice (DOJ) Complaint shows. According to the DOJ, a husband/wife/mother-in-law team have operated a small family tax prep business out of their home since at least 2003. The business was originally founded by the father-in-law at least a dozen years ago. They operated under at least ten different D/B/A (doing business as) names, and several different EFINs (Electronic Filing Identification Numbers.)

Over the years, the IRS says it found suspicious patterns of fabricated deductions and credits on the thousands of returns e-filed by the small family-operated business. The IRS revoked the company's EFIN, but the business just applied for new ones--and apparently got them. In fact the IRS isn't sure it has actually found all the returns prepared by the business, because it's possible they also used other EFINs the IRS hasn't been able to track down yet. (This DOJ complaint provides a good illustration of why the IRS really can't be sure how many tax preparers are operating in any given year. A recently released government study suggested the best guess is somewhere between half a million and a million paid preparers in 2008.)

Eventually, the IRS essentially threw up its hands and decided that revoking EFINs was not enough to shut the business down. The Commissioner of the IRS asked the DOJ to file a complaint asking a federal judge to issue an injunction forcing the husband/wife/mother-in-law all to shut down their business entirely. The injunction was granted in February 2009, but meanwhile thousands of tax returns filed over the previous six years have created problems for the taxpayers who used the service, and who might have been reassured by the "IRS Authorized E-file Provider" logo the business was able to display.

I highly recommend reading the entire DOJ complaint, but here are some enlightening excerpts.

5. Chalamar Muhammad is a tax return preparer who, since at least 2003, has prepared fraudulent federal income tax returns that report inflated or false deductions and inelude false corroborating documentation, in order to receive higher tax refunds for customers. The returns elaim inflated or fabricated charitable deductions, education deductions and credits, mortgage interest paid, business expenses, real estate taxes paid, dependent exemptions, and capital losses.

6. Chalamar is neither a licensed Certified Public Accountant nor a lawyer. She stated to the IRS that she has had no training in tax preparation and elaims to call ~ IRS 1-800 number whenever she has a tax question. Chalamar did not file her own individual tax returns for 2001, 2002,2003, and 2004 until August 2005.

7. Chalamar has been a principal and/or owner of the Muhammads' tax preparation business since at least 2003. Beginning in 2003, she exercised control over the business' finances, paid herself a salary from the business' funds, and filed an application for an Electronic Filing Identification Number (EFIN) - which is nceded to elcctronically filc income tax returns through the IRS's E-File program - with the Internal Revenue Service in which she identified herself as the Responsible Offcial and Vice President of the company. She obtained an EFIN in January 2004, which the Muhammads' business used to electronically file fraudulent tax returns
with the IRS for the 2003 and 2004 tax years.

The business, which operated out of the Muhammed's home, was apparently started up by Chalamar's father at least a dozen years earlier, though the IRS does not have any record of his EFIN, if any. In 2005, Chalamar's husband Curtis Muhammed applied for an EFIN, and in 2007, her mother Doranna Muhammed applied for an EFIN.

As the complaint above noted, Chalamar did not file her own personal tax returns from 2002 through 2004, even though she clearly had lots of revenue from all the people who paid her to do their tax returns.

She did, however, prepare a timely 2002 tax return for her husband Curtis. The return she prepared for Curtis gave his filing status as "Head of Household." In a subsequent tax audit of that return, however, the two of them didn't agree on whether they had actually been married that year or not. Curtis said they were already married in 2002. Chalamar testified that they were not yet married in 2002, but she also testified in Tax Court in 2006 that she could not actually "remember the date" of their marriage.

According to the IRS, the tax returns prepared by the business for their clients weren't any more accurate than the return Chalamar prepared for her husband. The following paragraph from the DOJ complaint suggests some practices that may have contributed to their inaccuracy:

16. The Muhammads' customers typically drop off their tax return information at the defendants' office without speaking with any particular employee. The returns are prepared without the customer present, and the customer is not contacted with questions that would allow the tax return preparer to determine whethcr the customer is eligible for certain deductions and credits frequently claimed on the Muhammads' customers' returns. Either Chalamar or another person contacts the customer when his or her tax return is completed. The tax return preparer does not typically review the completed tax returns with the customer.

How many tax returns did they prepare? The IRS isn't sure, but it's at least thousands.

17. The Muhammads' business has prepared and electronically-filed at least 2,633 federal income tax returns since and including the 2003 tax year.

18. The total of 2,633 electronically-filed returns likely does not represent the true volume of the Muhammads' tax preparation activities. This figure does not include amended returns, returns the Muhammads' business has filed using an EFIN that the IRS has not identified, returns the Muhammads' business filed in paper form with no preparer identification information reported.

19. The total size of Muhammads' customer base is not known due to the fact that Chalamar has failed to provide the IRS with a complete customer list. On multiple occasions in 2006 and 2007, the IRS issued requests to Chalamar Muhammad seeking, among other items, a list of customers that have used the Muhammads' tax preparation business. In November 2008, the IRS issued a letter requesting the information pursuant to I.R.C. § 6 i 07(b). Chalamar responded with an incomplete list of only 50 returns prepared and filed for the 2006 and 2007 tax years.

20. Chalamar Muhammad prepared the majority of the returns that have been electronically filed with the lRS. Yet less than 1% of the 2,633 electronically-filed returns identify a paid tax return preparer as required by law.

By the time of the DOJ complaint, the IRS had already completed audits of hundreds of their customers. Depending on the year in question, error rates ran as high as 90% or more and the IRS has already found additional tax owing of over $2 million, an average of over $2,000 per return. The DOJ estimates that the business prepared fraudulent returns costing the US Treaury over $7 million in revenue. And there may be many more returns that the IRS will never be able to track down, because the business did not always bother to identify themselves on the returns they prepared for their customers.

The DOJ complaint suggests that some of claimed deductions were flagrant fabrications. For example, some returns prepared by the Muhammads listed fictitious donations to churches that did not even exist.

The good news: in March of this year, the Federal Court granted them the injunction the DOJ and IRS sought against at least two members of the family: Chalamar and Curtis Muhammad have now been permanently enjoined from participating in the tax business. They did not appear in court to defend themselves against the injunction request, so the judgment against them was entered by default.

However, Chalamar's mother, Doranna, was apparently not easy to track down in order to serve papers against her. At the time the injunction was granted against Chalamar and Curtis, the government reported that the case against her "remained pending."

So, as far as I can tell, the court has not yet granted an injunction that would forbid Doranna from preparing taxes. I would HOPE that her EFIN has been revoked, but apparently she would not be doing anything illegal by preparing paper tax return or giving tax advice to paying clients, or from e-filing under the EFIN of yet another family member or friend the IRS hasn't yet identified.

So at least until the process server finds her, Doranna is apparently at liberty to continue to hang out her shingle as a tax preparer.

Caveat taxpayer!

Musical chairs and revolving doors in the tax prep business

A few interesting observations:

There's been some fascinating "musical chairs/revolving doors" among the tax prep franchise chains and important government positions.

1) H&R Block's former Chairman and CEO, Mark Ernst, is now Deputy Commissioner of the IRS in charge of operations.

2) Richard Breeden, who took over as Chairman of H&R Block from Mark Ernst in 2007, is a shareholder activist and former head of the SEC. Breeden gained control of Block by waging a successful proxy fight, criticizing Block's previous management for their involvement in the subprime mortgage market, which he estimated had cost Block $4.5 billion in profits over the previous two years.

3) Jackson Hewitt got a new President and CEO last month, Harry Buckley, who had previously been President and CEO of H&R Block. Interesting coincidence: Jackson-Hewitt announced this appointment on June 4, the same day the IRS announced its plans to investigate ways to regulate preparers.

4) A former H&R Block employee, John Hewitt, originally founded Jackson Hewitt and later also launched Liberty Tax, the third biggest national franchise. Liberty Tax is privately held and is much smaller than the two market leaders, but it has a high degree of visibility due to its "guerilla marketing" tactics of paying people to stand out in the street dressed in Statue of Liberty and Uncle Sam costumes to flag down potential customers.

The big chains WANT to be regulated

Apparently, the big tax prep franchise chains WANT to be regulated.

The stock markets also apparently believe regulation will increase profits for the big chains. They're putting their money where their mouths are.

H&R Block (stock symbol HRB) and Jackson Hewitt (JTX) are the "big players" in the commercial tax preparation business. Both companies voiced strong support when the IRS announced in early June that it was investigating ways to regulate all paid tax preparers.

The stock market certainly thinks that Block and Hewitt stand to gain from the IRS move to regulate paid preparers. Block stock rose 19% in June, while Jackson Hewitt rose 58%, even though the overall stock market was largely unchanged in June. The effect for Hewitt was especially marked, with a huge spike in price and volume immediately following the IRS announcement.