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Quality in Free and Commercial Tax Preparation

Quality in Free and Commercial Tax Preparation

Results from the 2006 Tax Season

Prepared by Amy Brown for the Annie E. Casey Foundation

June, 2006

Introduction

The Annie E. Casey Foundation launched the National Tax Assistance for Working Families Campaign (NTA) in January 2003 as a way to expand the impact of local Earned Income Tax Credit (EITC) outreach and free tax preparation projects.  Forty-one campaigns participated in 2005, filing more than 150,000 tax returns and bringing over $200 million in federal and state tax refunds to low-income working families. 

In 2005, the Foundation supported a review of tax returns prepared by the campaigns, as a first attempt to gather and analyze comprehensive data on quality at free tax preparation sites.  This year, a second round of reviews included both returns prepared at free tax preparation sites and a smaller number of commercially-prepared returns.  The goal was to gather additional data on campaign accuracy as well as to gain insight into the comparative quality of returns prepared for a fee by individual tax preparers and tax preparation firms.

A comprehensive report, Quality in EITC Campaigns: Results from the 2006 Tax Season (AECF, 2006), discusses in detail the results for free tax sites.  It is based on reviews of 191 tax returns at 16 free tax preparation sites from eight NTA campaigns.  At each site, returns were reviewed after tax preparation was complete but before the filer left the site.  This allowed the reviews to not only look at the tax returns themselves but also examine all documents and ask questions of the filers.  The reviews covered all aspects of each federal tax return, including: personal data; dependency and exemptions; income, deductions and adjustments; schedules, worksheets and attachments; tax credits; and e-filing and direct deposit.

This paper presents results from both the free tax sites and a second set of reviews – 15 tax returns that were completed by commercial preparers.  Despite the small number of paid returns reviewed, this analysis provides important comparative data that can help put the free tax site results in perspective.  The returns were all prepared in the New York metropolitan area for tax filers who were affiliated with 1199SEIU, a local healthcare workers’ union (filers were either members of 1199, or family or friends of members).  The filers were the first 15 people to respond to an advertisement offering a free double-check of their taxes.

The 15 returns represent a diverse sample of paid tax preparers, including large national chains, mom-and-pop businesses and individuals.  The filers fell into the same income range as those served by the free tax preparation sites and generally resembled those tax filers in terms of both demographics and the complexity of their tax returns.  In order to facilitate comparison of the results, the paid return reviews used a parallel methodology to the reviews of free tax returns: the completed return and all related documentation were examined with the tax filer present to provide information and answer questions.  In addition, information was collected on the fees charged for return preparation.

The results presented here also add to the information learned from other recent studies of accuracy in commercial tax preparation.  Most importantly, a 2006 study by the Government Accountability Office (GAO) sent “secret shoppers” to have returns prepared at 19 commercial firms in a large metropolitan area.•  As will be described below, the results of this study largely corroborate the GAO’s findings, strengthening the value of each.

•United States General Accountability Office.  Paid Tax Return Preparers: In a Limited Study, Chain Preparers Made Serious Errors.  2006.  GAO-06-563T.

Part I:  Major Findings

1. Mistakes were fairly common in all tax returns, but returns by free tax sites had far fewer mistakes than those by commercial tax preparers.

41% of all free returns had at least one mistake, somewhat fewer than in 2005 and significantly less than the 73% of paid returns with a mistake.  Furthermore, the paid preparers had more than twice as many mistakes per return as the worst-performing free site studied.

2.  Free tax returns also had far fewer of the most serious mistakes – those that changed the refund amount – than commercially prepared returns. 

19% of free returns, and 67% of paid returns, contained the most serious mistakes – those that changed the refund amount.  For free sites, the mistakes were roughly split between ones which increased and decreased the refund; for commercial preparers, the mistakes were more likely to give the filer a larger refund than he or she was due. 

3.  Mistakes by paid preparers had a greater dollar value than those made by free tax sites, and a more significant cost to the U.S. Treasury. 

Returns that overstated the refund did so by an average of $746 in free sites and $857 for paid preparers.  Those with too-low refunds cost the tax filer an average of $426 in free sites and $530 for paid preparers.  For all 191 free tax returns, the total cost of mistakes was a net $3,101 in over-claimed tax refunds – or an average of $16.24 per return.  For paid preparers, the total cost was $2,165, or $144.33 per return.

4.  More complicated returns were more likely to contain mistakes. 

Complexity appears to be a factor in mistakes for both free and commercial preparers, but yet again, much more so for the paid preparers.  These include returns with a filing status other than single, and those with additional schedules.

5.  Filers who used commercial preparers paid an average of $114. 

Cost ranged from low of $40 to a high of $325.  Individual preparers tended to charge the least, with both small businesses and national chains charging the most.   Only sometimes did there appear to be a relationship between the complexity of the return – for example, the need to file additional schedules – and the price of tax preparation

Part II:  Detailed Findings

This report uses the data collected from reviews of both free and paid tax returns to address the following questions:

• How common are mistakes?
• How serious are mistakes?
• What is the dollar value of mistakes?
• What types of mistakes are made?
• Does the complexity of returns matter?
• How much did filers pay for commercial tax preparation?

1.  How Common are Mistakes?

The most basic question addressed by this analysis involves the frequency of mistakes in returns prepared by free tax sites and commercial tax preparers.  Tax preparation is a complex process, involving potentially hundreds of decision points, each of which offers the potential for error.  This review focused on both data entry and application of tax law in key areas relevant to low-income tax returns.

Table 1: Frequency of Mistakes

As seen in Table 1, returns prepared by free tax sites were far less likely to contain mistakes, and also had far fewer mistakes, than commercially prepared returns.  Overall, 41% of returns prepared at free tax sites had at least one mistake and the typical return contained 0.6 mistakes.  The number of mistakes per return at the eight free sites ranged from 0.4 to 1.1 mistakes per return.  In comparison, 73% of returns prepared for a fee had at least one mistake and the typical return had 2.3 mistakes – more than twice the number at the worst-performing free site. 

2.  How Serious are Mistakes?

The number of mistakes does not tell the whole story, however.  A mistake could be anything from a misspelled name to the claiming of a child who does not qualify as a dependent.  The mistakes identified in this review were divided into three categories, based on the seriousness of their consequences:

a.  Mistakes with no consequence for the return.  Most commonly,   these occur on returns where the filer has no tax liability, and therefore a mistake does not affect the refund due.

b.  Mistakes that will likely delay receipt of a tax refund by the filer.    Most commonly, delays result from mistakes that cause an e-filed return to be initially rejected by the IRS (such as a mismatch in a last name or Social Security number).

c.  Mistakes that change the return’s bottom line.  These are the most serious mistakes, and include both mistakes that result in higher refunds (or lower the tax due), and those resulting in lower refunds (or increased amount due).

Table 2: Consequences of Mistakes

Many of the mistakes made by both free tax sites and commercial preparers had no consequence for the return.  However, the reviews still found a significant number of mistakes with delayed and incorrect refunds.  For both types of preparers, 13% of returns had mistakes that would likely delay receipt of the tax refund.  Delayed refunds can cause serious problems for low-income filers who need to pay bills and other obligations.

Table 3: Mistakes in Refund Amount

Free tax sites performed far better than commercial preparers when it came to the bottom line of returns.  Paid returns were far more likely to change the refund amount, and especially, to give the filer a higher refund than they should have received.  Only 19% of free returns had an incorrect refund, compared with 67% of paid returns.  For free sites, the mistakes were roughly split between ones which increased and decreased the refund.  For commercial preparers, the mistakes were more likely to give the filer a larger refund than he or she was due.  In many cases, the mistakes seemed purposefully designed to inflate the tax refund – yet at the same time, preparers were making other mistakes that cost their customers money.

3.  What is the Dollar Value of Mistakes?

The dollar value of incorrect refunds varied widely for each group of returns.  The largest mistakes at free sites were approximately $2,800 above and $2850 below the correct amount.  At commercial preparers, the largest mistakes were approximately $1,800 above and $1500 below.

As seen in Table 4, overall, returns with a higher-than-appropriate refund overstated the refund by an average of $746 in free sites and $857 for paid preparers.  Those with too-low refunds cost the tax filer an average of $426 in free sites and $530 for paid preparers.  When the difference in number of high and low refunds is taken into account, the average value of all mistakes was $91 in free sites and $241 for paid preparers.

Table 4: Cost of Mistakes•

For all 191 free tax returns, the total cost of mistakes to the U.S. Treasury (assuming mistakes are not caught and corrected) was a net $3,101 in over-claimed tax refunds – or an average of $16.24 per return.  For paid preparers, the total cost was $2,165, or $144.33 per return.

•Some returns had mistakes that both lowered and raised the refund; only the net change is considered here.  Also, please note that the amounts in the third column do not equal the sum of the first two because the calculations have different denominators (i.e. the number of returns in each category).

4.  What Types of Mistakes are Made?

Free sites and commercial preparers also differed in the types of mistakes that were made.  Table 5 looks at the percent of all mistakes that occurred in each area of return preparation.  As the chart illustrates, mistakes at free tax sites were more likely to be in data entry and return basics (filing status, personal exemptions and dependency).  The mistakes made by commercial preparers, meanwhile, were more concentrated in income, adjustments and tax credits. 

In particular, paid returns frequently failed to include all income and incorrectly itemized deductions.  Paid preparers were far more likely to try to itemize than the free sites (some of which turn away filers who want to itemize), but – as seen in Table 6, below – made mistakes in every itemized return.  The preparers often seemed to view itemizing as a mechanism for increasing the tax refund – whether or not it was actually appropriate.  In fact, the many of the mistakes seemed to be purposeful attempts to invent or exaggerate deductions – generally without the full understanding of the tax filer.

Table 5: Mistakes, by Type

Commercial preparers also made mistakes in a high percentage of returns with low-income tax credits.  As with free sites, the Retirement Savings Credit presented problems.  Commercial preparers seemed less likely than free sites to ask filers about child care expenses in order to determine eligibility for that credit.

5.  Does the complexity of returns matter?

Complexity of the returns appears to be a factor in mistakes made by both free and commercial tax preparers, but yet again, much more so for the paid preparers.  For example, the difference in percent of returns with mistakes for single filers and others (head of household or married) was 24 percentage points for free sites and 50 percentage points for paid preparers.  Similarly, both types of preparers had more mistakes in returns with additional schedules, but 100% of the returns with schedules by paid preparers had mistakes.

Table 6: Mistakes, by Complexity of Returns

6.  How Much did Filers Pay for Commercial Tax Preparation?

The 15 filers paid an average of $114 for tax preparation.  Cost ranged from low of $40 (paid by four filers) to a high of $325.  Individual preparers tended to charge the least, with both small businesses and national chains charging the most.  By and large, the fees seemed to have no rationale aside from the willingness of filers to pay.  Only sometimes was there a relationship between the complexity of the return – for example, the need to file additional schedules – and the price of tax preparation.

Part IV: Conclusion

The information presented in this report provides perhaps the first data directly comparing quality at free tax sites and commercial tax preparers.  Furthermore, by including a cross-section of real returns, and looking at not only the total number of mistakes but also the types of mistakes and the severity of mistakes, the study provides much more nuanced information about tax return quality than has been previously available. 

Overall, the results of the study reinforce the importance of quality assurance in tax preparation generally.  Neither type of preparer achieved the level of quality that tax filers have a right to expect from trained volunteers or professionals.  Having said that, the study strongly suggests that quality is a greater concern for customers of commercial tax preparers than those who visit free tax preparation sites. 

As noted earlier, a 2006 report by the Government Accountability Office (GAO) presents results from a review of paid tax preparers that involved “secret shopper” visits to 19 commercial firms in a large metropolitan area.   That report found serious problems: every return had some mistake, and only two of the 19 returns had the correct refund amount.  Both the frequency and types of mistakes corroborate the findings presented here.  Together, they make a compelling case for increased scrutiny of commercial tax preparers. 

The results of both the free and paid return reviews also reflect the difficulty that even trained preparers face when attempting to apply a complicated and constantly changing tax code to individual situations, each of which is unique in its own way.  Simplification of the tax code would likely help alleviate a large portion of the errors found by both this study and the GAO report.

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