Paid tax preparers, used car dealers, refund anticipation loans, and the earned income tax credit: the need to regulate tax return preparers and provide more free alternatives.

• Author: Cords, Danshera

INTRODUCTION

In 2004, almost 60 percent of all taxpayers used paid preparers to complete their tax returns, (1) which means tens of millions of taxpayers paid to determine their tax liability. (2) The percentage of taxpayers using paid preparers increased to about 73 percent for taxpayers claiming the Earned Income Tax Credit ("EITC") in 2006. (3) The cost to taxpayers of using paid return preparers is significant.

In 2000, taxpayers spent about $14.7 billion on tax return preparation. (4) Because most taxpayers use paid tax preparers there should be some means by which to ensure that tax preparation services are of high quality. (5) Currently, many return preparers are unlicensed and unregulated.

Many taxpayers likely would be surprised to learn that this is a largely unregulated industry in which car dealers, appliance stores, travel agents, contractors, furniture stores, and massage parlors in most states have just as much right to prepare tax returns as those trained to prepare tax returns: certified public accountants ("CPAs"), lawyers, enrolled agents, (6) and volunteer income tax preparers. Many unlicensed preparers not only prepare returns, but also offer ancillary services and financial products including electronic filing, refund anticipation loans ("RALs"), refund anticipation checks ("RACs"), and check cashing services for the unbanked, which are regulated by the Treasury. However, adding those services to a paid return preparer's menu of available services does not significantly increase the amount of regulation or oversight. (7)

As many as half of all paid preparers are not CPAs, lawyers, or enrolled agents. (8) These unlicensed, unregulated preparers are referred to as unenrolled preparers. The primary oversight of unenrolled return preparers is imposed by state consumer protection laws, except in the few states that impose licensing and regulation on return preparers. (9) Unfortunately, many consumers do not realize that their tax preparer is neither licensed nor subject to professional regulation.

Recent legislative and regulatory proposals (10) and government reports (11) recommend changes to the way that paid return preparers are treated, the ability of tax preparers to share taxpayer information with lenders for purposes of facilitating RALs, and the benefits of additional free tax preparation resources. Each of these recommendations has merit, but alone will not resolve the problems faced by taxpayers relying on paid preparers, especially taxpayers who also rely on the EITC. A combination of increased training and regulation of paid preparers, increased taxpayer education, and the provision of increased free tax preparation services would provide the most benefit to taxpayers, especially those in the middle-and low-income groups who need the most assistance.

The frequent use of paid preparers by low-income taxpayers, coupled with lax oversight of tax preparers beyond that provided by state consumer protection laws, results in a potentially lost opportunity to oversee those in the best position to help ensure compliance with the largest federal anti-poverty program, the EITC.

More data is needed regarding the information that return preparers provide and the incentives that the return preparers actually have to encourage compliant or noncompliant taxpayer behavior. (12) In addition, some return preparers are not primarily in the business of return preparation, but offer that service as an ancillary to their primary business, which may be selling cars, appliances, travel, furniture, liquor, or any other good or service. The offers of tax return preparation and RALs are used as a means to ensure that low-income clientele can afford to purchase the seller's goods or services. Because much of the profit from these services comes from EITC recipients, tax dollars intended to help low-income taxpayers escape poverty are being transferred to paid preparers and away from taxpayers in need. The inherent potential for abuse suggests the need for greater oversight. (13) Paid tax preparers are not the only option available to taxpayers who need help completing their tax returns.

Research indicates that paid preparers do not always explain lower cost alternatives, explain the alternatives well, or fully explain all of the costs associated with the return and ancillary financial products and services, including RALs. (14) Taxpayers use paid preparers for a variety of reasons, including their failure to understand the tax laws and the hope that a paid tax preparer will help them obtain a larger or faster refund. (15) In addition, many middle- and low-income taxpayers do not realize that there are free alternatives to paid preparers. (16) Although most taxpayers understand that RALs are loans, many low-income taxpayers need their refunds quickly, and those who fail to understand the nature of the transaction may believe, based on advertising slogans like "money now" (17) or "rapid refund," (18) that the ancillary services marketed by paid preparers will result in their receiving their refund more quickly. (19)

Because many in Congress believe that fraud is rampant in the EITC, significant resources are devoted to reduce EITC noncompliance and harsh sanctions are imposed on taxpayers discovered to have erroneously or fraudulently claimed the EITC. (20) Resources that have been devoted to auditing EITC recipients exceed the number of dollars that are at stake, when considered in relation to their share of the tax gap. (21)

This Article advocates increased regulation of tax return preparers and disclosure. More complete disclosures would reduce the number of RALs and thereby reduce the resources that must be allocated to EITC compliance, which will help improve both tax compliance and the situation of low-income taxpayers. This Article argues that consistent regulation of paid preparers and greater oversight of RALs, coupled with increased simplification of the EITC, should reduce EITC noncompliance. This Article concludes that rather than devoting additional resources to EITC enforcement, the government should direct more resources to providing greater oversight of return preparers and increase education about and availability of free return preparation alternatives. Redirecting resources in this way might have a greater effect on accurate tax reporting, a better result than collecting very small sums from low-income individuals--whose noncompliance may be a result in many cases of taxpayers' failure to understand very complex rules.

Part I of this Article will discuss the EITC generally, including eligibility for the credit, receipt of the credit, noncompliance, and use of the credit. Part II will discuss paid preparers, their regulation and training, and the quality of the returns that they provide to taxpayers. Part III will discuss the relationship between paid return preparers and low-income taxpayers, including the incentives and conflicts facing each, as well as various proposals to increase preparer oversight. Part IV will discuss the current oversight of the EITC, changes that could be made, and the impact that each of these has on the tax gap.

The next section will discuss the EITC generally.

1. EARNED INCOME TAX CREDIT

   1. Generally

      When adopted in 1975 as a one-year credit, (22) the EITC was intended to give social security and self-employment taxes back to low-income wage earners and self-employed persons. (23) When the EITC was made permanent in 1978, (24) the credit was expanded with the addition of an advanced payment option that allowed recipients to receive a portion of the credit ratably throughout the year. (25) Unlike most tax credits, from its inception, the EITC has been a refundable credit, allowing recipients to receive a refund to the extent that the credit exceeds the recipient's tax liability. (26)

      The EITC has never been simple to calculate, because it is based on income and the presence of qualifying children. Initially, the IRS calculated the EITC for taxpayers who had not claimed the credit and then notified and paid the credit to eligible taxpayers. (27) In 1992, after the IRS determined that 600,000 eligible taxpayers had failed to claim the EITC, the IRS recalculated these taxpayers' tax liability (28) and sent refunds consistent with its calculations. Later analysis showed that the IRS incorrectly awarded the EITC to about 270,000 of those taxpayers. (29) That the IRS could incorrectly determine that so many taxpayers were eligible for the EITC helps to illustrate the challenges that taxpayers face in determining their own EITC eligibility.

      Over the past thirty years, the EITC program has experienced several major changes that have dramatically increased the size of the program, increasing its importance as a component of the federal government's anti-poverty program, and attempting to improve the program's compliance rate. (30) In 2002, the EITC lifted more than five million people out of poverty, over half of whom were children. (31) Without the EITC, approximately 60 percent of its recipients would continue to live below the poverty line. (32)

      The primary beneficiaries of the EITC are single-earner households, whether married couples with one wage earner or single parents, with two qualifying children; families with more children do not receive additional benefits. (33) Families with more or less than two qualifying children may be eligible for the EITC, but because of the income phaseouts, the credit amount is less likely to be adequate to increase the family income above the poverty line. (34) Moreover, even with recent changes, the EITC has a marriage penalty and the income level at which the phaseouts begin is not doubled for married couples. (35)

      The EITC is very cost efficient compared to many other direct benefit programs. Although estimates of the program's administrative costs vary, its implementation by the U.S. Treasury is generally estimated to...