How a proposed IRS tool could disrupt the billion-dollar tax prep industry

The IRS is preparing to test a first-of-its-kind online tool that would allow taxpayers to file federal returns to the agency for free, with a pilot version of the program coming as early as next year, according to the service.

Why it matters: A direct e-file system could reshape how millions of Americans do their taxes, experts say, while potentially disrupting the multi-billion-dollar tax preparation industry, which has resisted such a system for decades.

• The announcement "marks the beginning of a sea change in the IRS as the agency transforms how Americans interact with the tax system," Amanda Renteria, CEO of the non-profit and non-partisan advocacy group Code for America, said in a statement.
• She said she believes the "announcement is a significant step toward revolutionizing access to the tax system so that it is easier and more equitable."
• The direct-file proposal would also be akin to public tax-filing systems offered by dozens of other developed countries.

Catch up quick: The 2022 Inflation Reduction Act ordered the IRS to assess the feasibility of creating and running a voluntary government-run electronic filing system, and the service did so in a report to Congress earlier this week.

• The George W. Bush administration had proposed a direct-file system in the early 2000s, but it was fiercely opposed by for-profit tax prep businesses — including Intuit, the parent company of TurboTax — which launched a lobbying campaign against it, ProPublica reported.
• As a compromise, Intuit and other commercial tax prep companies agreed to offer millions of low-income taxpayers free online federal filing through the Free File program.
• However, since the program was launched in 2003, both TurboTax and H&R Block — the two largest participants — have left, putting the program's future in jeopardy.

What they're saying: Intuit said in a statement that the IRS' latest proposal "is a solution in search of a problem, and that solution will unnecessarily cost taxpayers billions of dollars."

• It said the government-run system also has an inherent conflict of interest, in which the IRS serves as the tax collector and tax preparer.
• "The study ignores the harm a government-run system will have on vulnerable taxpayers and the true costs to taxpayers," Intuit said. "The costs estimated in the study to build, operate, and maintain are laughable."

Yes but: Renteria, the Code for America CEO, said a "free and simple direct file service will ensure that more families in America receive the tax benefits they are eligible for."

• Researchers for Code for America, which aims to make it easier for people to access government services, created their own version of a direct-file prototype earlier this year.
• A government e-filing system also wouldn't eliminate private tax software alternatives.

By the numbers: The IRS estimated in this week's report that setting up and operating its own filing system would cost between $64 million and $249 million annually, depending on how many people use it and the scope of covered tax situations.

• The report included the results of previous studies, one of which found that 72% of surveyed taxpayers said they would be either "very interested" or "somewhat interested" in a direct-file tool.

• However, in another study, 60% of respondents said they would stick with their current commercial software if the IRS system could not prepare or file state returns — meaning it would need to "collaborate with entities [...] who prepare state tax returns to ensure they could receive the information."
• 47% survey respondents also said it was "very important" that the tool include forms with sections already filled in by the IRS with information reported by third parties, such as employers — a technique already used by dozens of countries.

The big picture: On average, according to IRS estimates, most taxpayers spend around eight hours and lose $140 each year for filing their taxes, which they are required by law to do.

• A 2022 survey by researchers at Harvard and the University of California, San Francisco, had similar findings, with the median worker paying $100 annually to do their taxes.
• Meanwhile, Intuit reported $666 million in Turbo Tax-linked revenue for the first six months of fiscal year 2023, a 25% increase from the same time period last fiscal year.
• H&R Block, which prepared 20.5 million U.S. tax returns in 2022, reported a net income of $553.7 million in fiscal year 2022.

Of note: In 2022, Intuit agreed to pay $141 million to settle a claim from all 50 states and the District of Columbia that it deceived nearly 4.4 million Americans between tax years 2016 through 2018 into paying for tax services that should have been free.

Go deeper: Tax refunds are lower, and that means less spending money