IRS continues to pay millions to process paper tax returns

Agency should invest in scanning technology to convert documents to an electronic format, and mandate e-filing by tax preparers, IG reports.

The Internal Revenue Service could save money by requiring all tax preparers to file forms electronically and by using scanning technology to convert paper returns into an electronic format, according to a watchdog report released on Wednesday.

Nearly 43 percent of individual income tax returns filed in 2008 -- or 66.4 million -- were paper, costing the IRS $190.6 million in processing fees, according to a report released by the Treasury Department's inspector general for tax administration. The cost of processing a single paper-filed tax return is $2.87, compared to $0.35 for an e-filed return.

The 1998 IRS Restructuring and Reform Act required the IRS to treat paperless filing as the preferred method of submitting returns and set a goal of having at least 80 percent of all returns filed electronically. But a separate law prohibits the IRS from requiring e-filing of individual income tax returns.

The IRS should pursue a federal mandate for paid preparers to e-file individual income tax returns, the IG said. Such a change in the law would result in an increase of 26.9 percent in e-filings and reduce IRS paper tax return processing costs by $66.6 million annually, according to the report.

"Most paid preparers who filed paper tax returns actually used an electronic tax software preparation package and 70 percent also e-filed at least one tax return, which indicates a familiarity with the electronic preparation and e-filing process," the IG said. "However, while paid preparers are willing to e-file returns, some taxpayers are reluctant to do so."

Information on paper tax returns must be entered into computers manually by IRS employees. This process requires the agency to employ more than 5,000 data transcribers during peak processing.

"Without a modernized paper submission processing system that converts paper tax returns into an electronic format, the IRS will continue to have to use its labor-intensive, error-prone and costly system to process paper-filed tax returns," the IG stated. Mistakes during manual transcription require "costly rework in order to ensure returns are correctly processed and cause no harm to taxpayers," the report noted. Historically, error rates are less than 2.5 percent for e-filed tax returns, versus more than 25 percent for paper-filed ones.

The IRS initiated efforts to modernize processing of paper returns in 1988, 2003, 2004 and 2007, but canceled them due to cost overruns and failure to request or secure funding. The latest effort -- known as the Modernized Submission Processing concept -- was to include a system for automating the extraction of paper tax return information. It was estimated to cost $66.2 million for development, and $10.7 million annually for operation and maintenance. Though IRS senior executives ranked the effort as one of the top modernization priorities for the fiscal 2010 investment portfolio, they ultimately did not request any funding, and the project is no longer listed as one of the agency's priorities for fiscal 2010 or 2011.

The IG recommended that IRS update the Modernized Submission Processing concept to include scanning technology that would provide the IRS with an option to convert paper-filed tax returns into an electronic format, "thereby reducing processing costs associated with paper-filed tax returns." Such technologies already have a track record of success in a number of states, according to the report.

The IRS agreed with the IG's recommendation to pursue scanning technology by the end of 2012, but noted budget constraints. The agency also agreed with the recommendation to mandate e-filing of tax returns by paid preparers, pointing to a proposal that would require tax preparers who file more than 100 returns in a calendar year to submit them electronically. The proposal -- included in President Obama's fiscal 2010 budget request and under consideration by the Treasury Department -- would be effective for tax returns due after Dec. 31, 2010, according to the report.