Use of free tax filing software drops significantly

Decrease followed agreement limiting the service to 70 percent of tax filers, auditors find.

Use of the Internal Revenue Service's free electronic tax filing offering dropped substantially following the introduction of new eligibility restrictions, according to an audit report released Friday.

The decrease in use could keep the agency from meeting its congressionally-mandated goal of having 80 percent of all federal tax returns filed electronically by the end of 2007, the 45-page Treasury Inspector General for Tax Administration report said. In 2006 about 66 percent of taxpayers filed electronically.

"It is imperative that the IRS carefully examine the reasons this free service is not being used by more taxpayers," Treasury Inspector General J. Russell George said. "The IRS must review its marketing strategy to better target taxpayers who file paper returns even though they are eligible for this program."

The service, dubbed the Free File Program, allows people to prepare and file their income tax returns electronically and free of charge. The software is available on the IRS Web site and is provided by a consortium of tax software companies known as the Free File Alliance.

When the program started in 2003, the alliance agreed to offer free services to at least 60 percent of individual taxpayers. In 2005, some vendors offered the free software to all interested individual filers. But in October of that year, the alliance amended its agreement so that no more than 70 percent of individual taxpayers would qualify, based on adjusted gross income. For returns filed in 2006, for instance, taxpayers had to have adjusted gross incomes of $50,000 or less to qualify.

In 2005, a record 5.12 million taxpayers used the free program. But participation fell to 3.9 million, or 3 percent of all individual tax returns, in 2006. The drop coincided with the introduction of the new income restrictions.

The report did find that 24 percent of the users of the free file program in 2006, or 819,000 taxpayers, were first-time filers.

Despite the fact that no further adjustments were made in 2007, auditors found that as of April 14, only 3.3 million taxpayers filed returns using the free service.

The audit also found that the IRS failed to fully document oversight reviews of companies participating in the Free File Alliance. Alliance members incorrectly included the Free File indicator on approximately 37,000 returns from taxpayers who actually paid tax companies to prepare and file their returns, the IG found. The program software also did not always accurately compute taxes due.

In response to the report, Richard Morgante, commissioner of the IRS' wage and investment division, said the agency would develop a plan to evaluate and promote the Free File program. He also said the agency would expand marketing efforts by directing promotional materials to taxpayers who are eligible to use the software, but have filed their returns on paper. He agreed to establish a process to assess the accuracy of the Free File indicator early in the filing season.

Morgante did not agree with the auditor's recommendation to establish a process to test the accuracy of the software used in the program before the filing season. He said doing so would present a monumental challenge, due to the complexity of tax law.

Representatives of the Free File Alliance did not respond to requests for comment on the report.