This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: cutting out the middleman.

On May 16, the IRS released a report on the feasibility of an IRS-run free return filing system. While there have been options to prepare taxes for free for several years, the Free File program was run by a group of tax preparation companies. Some of these companies had come under scrutiny in recent years for directing eligible taxpayers to paid services.

So is this new program a good alternative? Here to talk more about this is Tax Notes senior reporter Jonathan Curry.

Jonathan, welcome back to the podcast.

Jonathan Curry: Hi again, Dave.

David D. Stewart: So to start off, could you tell us some background on what Free File is?

Jonathan Curry: Yeah, I'd be happy to. The Free File program is an over-two-decades-long, public/private partnership between the IRS and what's called the Free File Alliance, those companies that you referred to that prepare tax returns.

That started with the IRS Restructuring Reform Act of 1998, 25 years ago. That law set a goal for the IRS to have 80 percent of taxpayers file electronically by 2007. And the IRS decided that the best way to do that was to enlist the help of the private sector, which all sounds good on paper because that frees up the IRS to do other things. They don't have to worry about developing their own system, maintaining it, overseeing it. They can just kind of hand that off to someone else. In practice, I think most would say it's been disappointing at best. Some people have stronger words to say than that.

The use of the Free File program peaked in 2005, and it's really only just muddled along ever since then. The program took a nosedive after a series of ProPublica articles back in 2019, which you alluded to earlier, that showed how these Free File member companies were intentionally steering taxpayers away from free services and towards paid products instead. Last year, Intuit, which owns TurboTax, agreed to pay out a $141 million settlement over the claims that it scammed users with claims of "free, free, free."

So in practice, only about 2 to 3 percent of the taxpayers who are otherwise eligible for Free File, as in that they meet these income limitations, are actually using it. In that context, the IRS has spent the last couple months studying whether it should throw its hat into the ring and set up a free filing system of its own. They'll let taxpayers file their returns directly with the IRS instead of going around through an intermediary to file their taxes. This is commonly referred to as direct file because you're filing directly with the IRS.

This idea does have some very vocal supporters in Congress, Senator Elizabeth Warren chief among them, I would suppose, and Treasury Secretary Janet Yellen last year at a congressional hearing said that the IRS was going to do this, it's just a matter of timing and funding.

Fast-forward a few months after her statement there, the IRS gets $80 billion as part of the Inflation Reduction Act, and within that $80 billion big, massive chunk of change, there's a small little provision that gave the IRS $15 million to study the question of what it would take for the IRS to do this.

David D. Stewart: What did the IRS have to say in its report?

Jonathan Curry: Yeah, so that report came out [May 16] and there was a lot in there about taxpayer attitudes towards it. They surveyed taxpayers. They also developed what they call a prototype, a functioning prototype of what a direct-file system would look like to a taxpayer. It was limited functionality, but it led someone to actually see it, if you were to click through the menus and prepare your taxes that way.

It also explored the pros and cons from an administrative perspective, what it would require from the IRS, the different stakeholders that would be involved, like state tax administrators and things like that. It didn't really come to any sort of neat and tidy conclusion, though. It just sort of just explained the different aspects of what would be involved here.

David D. Stewart: Now I understand you recently talked to a guest about this. Could you tell us who you talked to?

Jonathan Curry: Yeah, sure. I talked to David Kautter. He's a former acting IRS commissioner. He is a former Treasury assistant secretary for tax policy. Currently, he's at RSM and he's also a member of our board of directors here at Tax Analysts. And like I said, he's a former IRS commissioner. He's someone that would know what this would take from an inside perspective, and I think that's a pretty valuable perspective to have here.

David D. Stewart: What sort of issues did you get into?

Jonathan Curry: Well, we started with his impressions of the report, and I don't want to spoil too much, you'll have to listen for that, but I'll just say upfront, he's a little bit disappointed with what he saw there. There's a lot of unanswered questions in his mind, especially as someone who'd be thinking about what it would take for this to actually unfold.

He has a lot of concerns over the practicality of the IRS getting into the direct-file game, whether it really is going to be this boon to taxpayers that advocates hope for, if there's a gap between reality and the ideal here, and also some of the obstacles the IRS is going to need to overcome.

In particular, one of the issues we're really going to talk about a lot is the challenge of state tax return filing, which you might be wondering, who cares about that? We're talking about the IRS. Well, taxpayers. I don't know about you, but when I file my taxes, I file my state and federal at the same time. And for the IRS to be doing that for you, suddenly makes this into a bigger program than the IRS might want to get into.

David D. Stewart: Well, all right, let's go to the interview.

Jonathan Curry: I'm sitting here with former IRS Commissioner Dave Kautter, former Treasury assistant secretary for tax policy, longtime fixture in the tax community. Dave, welcome to the podcast.

David Kautter: Thank you, Jonathan. It's nice to be here.

Jonathan Curry: Let's jump right in. The IRS released its long, I guess, much-ballyhooed, long-anticipated report on the feasibility of a direct-file program. Basically, the IRS allowing taxpayers to file directly with them instead of going through an intermediary like TurboTax and whatnot. The report came out last week and I'm curious, did this answer every question you had about what the system might look like or are there a few unanswered questions there for you?

David Kautter: The short answer is no. The report's helpful in some areas and not helpful at all in other areas. Many questions are unanswered in the report. In fact, I'd probably say there are more unanswered questions than there are answered questions.

But in my mind, the three most significant unanswered questions in the report are first, which taxpayers would be able to use direct file and when? In other words, what types of income could be reported, will there be limits on the amount of income that could be reported? What types of activity could be allowable? In other words, on the right types of activity question, there are tens of millions of taxpayers who are relatively low-income, who are independent contractors, the so-called gig workers — will they be allowed to participate in the direct-file program? So the first big unanswered question is, who and what types of income?

Second is, what will the user interface look like? Will it be easy to understand and use?

And third, and this is a point which I think is understated consistently in the report, is what about state tax returns? There are 43 states that impose some sort of individual income tax, 41 impose taxes on wages, one imposes a tax only on interest and dividend income, one only imposes a tax on capital gains. But that is a significant question that the report acknowledges, but I think dramatically understates the significance of.

Jonathan Curry: There was a MITRE [Corp.] study that came out just before this report was released that was examining taxpayer attitudes towards a hypothetical IRS direct-file system, and they offered a couple different scenarios. But one of the key takeaways was that state tax filing, the ability to file your state taxes simultaneously with the federal, was basically the big defining factor between whether people were more likely to want to switch to an IRS-run system versus sticking with whatever they've used previously.

David Kautter: I think that's exactly right. The ability to only enter data once is significant for taxpayers. If under this system that's being proposed, taxpayers had the option to file for free with the federal government directly with the IRS, and then they had to take the same data, go to a commercial software preparation program, enter the same data in, and pay to file the state return, the attractiveness of the direct-file program goes down dramatically.

Jonathan Curry: Do you have any sense of how difficult it would be for the IRS to make that function possible, to make it a simultaneous filing [of] state and federal?

David Kautter: What's interesting about the report to me is it talks about working with state administrators and that's always important, but I can't imagine 43 states are going to develop a direct-file program for taxpayers. And so there's going to have to be an effort here to resolve this problem one way or another, or I just don't think the IRS direct-file program is going to be very successful at all.

Jonathan Curry: My colleague, Lauren Loricchio, wrote a story, too, after this report came out. She spoke with the head of the FTA — which I think it's the Federation of Tax Administrators, it's for state tax administrators — and the head of that said that they look forward to hearing from the IRS, but at this point, that collaboration has not yet started, which is perhaps a bit surpris[ing] given that the report describes an effort to launch a pilot program in 2024. So perhaps state filing might not be on tap for at least the initial pilot.

David Kautter: Exactly. There are only two ways to get this done that I can see, right? The states build direct-file programs or the IRS builds 43 programs. Every state's tax laws are somewhat different; some are dramatically different from other states. And so building a federal direct-file program is one thing. Building 43 state direct-file programs is [a] completely different magnitude, and the report acknowledges the importance of being able to file on a consolidated basis, but it just doesn't deal with it directly. And I think that is one of the most significant issues, for the reasons I stated earlier.

Jonathan Curry: Can you do me a favor and describe, in a sense, the best- and worst-case scenario? So you're basically saying, the best arguments for the supporters of this, the best arguments from critics of this. What's the best thing that could come from this and what's the worst way this could explode and fall apart?

David Kautter: Sure. Well, let me focus on this from a policy point of view and administrative point of view. I think the best case is the IRS builds an effective, focused prototype that's easy to use, secure, and popular. The prototype is piloted next filing season, and the prototype is then expanded, best case.

Worst case, IRS diverts resources from other significant technology priorities, ends up with a prototype that's expensive, doesn't work very well, and is not widely used, and then discarded. So those are the two extremes to me.

Jonathan Curry: Sure. OK. Fair enough. What do you think it would take for something like this to succeed?

David Kautter: Sure. I think there are three core elements, Jonathan. First, a user-friendly interface that's easy to understand and use. Second, there has to be high-quality, responsive customer service. Questions — no matter how simple, no matter how straightforward the software is — there're going to be questions. And if those questions can't be answered, taxpayers are going to quickly abandon the system. And third, state tax return capability, reentering data and paying to file the state return when you've just filed a federal return for free, I think is a significant issue.

Jonathan Curry: What about some of the practical, or I guess you call them operational, challenges for the IRS? We talked about the need to collaborate with state tax administrators, but this would also cost money. Would the IRS need to get more funding for this? What do you sort of see?

David Kautter: Sure. The funds are important. I think the single most important operational obstacle is mindset. Currently, the IRS does not provide the level of proactive support that this sort of a system would need. So in other words, right now the IRS does a pretty good job of generating publications, and last year did a very good job of answering the phone.

A direct-file system changes the mindset. To me it's sort of like the difference between sitting behind a cash register and having customers walk up and pay for a product, as opposed to a sales representative who has to go out and make sales calls and actually convince people to use the product. And so it is this mindset which needs to change, and you see it not just in the government or the IRS, you see it in private industry all the time. People who are their whole career, reactive, are asked to be proactive, build something that people really want, as opposed to something people are forced to do.

And it is a completely different mindset and it adds an entirely new dimension. You have to be more proactive, you have to be more customer-oriented. And I don't want to say it's the complete opposite, because the IRS engages in outreach and is concerned about taxpayers understanding the tax law. So it's not a complete shift, but it's a significant shift.

And sure, the money's important, and sure, the software has to be written in a user-friendly fashion, and you need customer support, but it's this viewing the taxpaying public and their compliance activity in a proactive fashion as opposed to a reactive fashion that I think is the biggest operational obstacle here.

Jonathan Curry: It's interesting, we were talking about with the prototype that they tested, they tested a functional prototype of what this would look like, and it was morphed so that people could see what this looks like. They tested, I think, with only about 14 people, according to the report, but nevertheless, they tested it and they said the feedback to that was actually surprisingly good.

People responded saying, they're like, "Oh, this actually is better than I anticipated the IRS would come up with." So it seemed like it might have been more perhaps user-friendly that you might otherwise envision a state government, federal agency, coming up with something.

David Kautter: It's hard to interpret exactly what that means. I had a friend who used to say, "Just because you end up on third base doesn't mean you hit a triple. You might have been born there." And I think in a case like this, you worry that the bar is so low, that people expected it to be such a miserable experience, that when it wasn't, they said, "Well, this is pretty good."

Again, it's hard to tell from the wording in the report, but I wondered whether the bar was so modestly low that it was easy for the people who were part of the 14 who got to use this piloted software thought it was better than they expected.

Jonathan Curry: Now, you were talking about how one of the advantages the private sector has is they need to go out and get people to want their product, whereas the IRS might just be simply like, "Here's a product, use it if you want it."

Is the allure of free, because the IRS, as I understand, they envision this being a free service, is that going to be enough to get people to switch their return filing provider of choice from say, TurboTax, to the IRS?

David Kautter: I think free will be enough for some taxpayers, but it's hard to tell how many. The state return issue, I'll bring up again. It's a huge issue. Even though it's free, to then turn around, have to reenter the data and pay to file the state tax return, I think will disappoint many people who might otherwise use the IRS direct-file.

Jonathan Curry: And then how does the issue of the IRS developing and running this direct-file program sit with Congress right now? Does it fit neatly within a partisan box or is there some crossover there? Where do you sort of see that?

David Kautter: Right now I think it's in the formative stage. It's not clear where most members of Congress stand on this at the moment. So far, the discussion has taken on a partisan aspect to it, which is not healthy if you want a free and open and full consideration of whether this direct-file approach makes sense. I think the hope of turning around the early opposition that some in Congress have expressed will depend on a successful rollout of a prototype next year.

I think if the prototype goes very well and people feel that the data they're given is objective and that the user response has been favorable, that will go a long way toward turning around some of the resistance.
But if people feel they're being spun and they don't feel they've gotten a straightforward story with respect to the user experience, I think it'll get dramatically worse.

Jonathan Curry: Along those lines, Commissioner [Daniel] Werfel has been in the hot seat actually lately after it was revealed in the report that the IRS was already developing a pilot program to test this out or to try it out in 2024. The view is that the IRS should have waited for the results of this report, debated it in Congress, waited for some sort of authorizing, "Go forth and do this," rather than plunging ahead.

You're a former IRS commissioner, so you're well suited to know what it's like to sit in that seat. I hate to make you be the backseat driver to a current commissioner, but I am curious to know, do you think this might have been a misstep, could have been handled differently?

David Kautter: Well, I think it's very unfortunate that the administration moved forward in the way that it has. I think direct filing with the IRS is an issue that deserves full and open consideration if it's going to have any chance of bipartisan support.

Instead, the process followed so far, specifically building and modeling a prototype and making plans to launch a direct-file program next year before the report was ever finalized and delivered, has the appearance that the study was perfunctory, that the surveys and the reports were irrelevant to the decision to move forward, and that the federal government wasted $15 million on a report that was irrelevant to the decision-making process.

It's unclear to me who drove this process, but in my experience, this is not how the IRS tends to operate. So my guess is that this process was driven elsewhere in the administration, but I do not have firsthand knowledge of how this process—

Jonathan Curry: You're not currently in the commissioner's seat.

David Kautter: I am not.

Jonathan Curry: OK, understood. Well, let's talk about costs. The study was $15 million for this. The report says the estimated cost of developing and running this, the annual cost is between $64 million and about $250 million per year, depending on a whole range of factors. And even that wide-ranging estimate is subject to significant uncertainty according to the report.

Also in Washington, everyone likes to talk about cost in 10-year increments, [so] $64 million or $250 million turns into $640 million to a $2.5 million price tag in our typical way of thinking about the cost of things. First question on that, does that price tag seem realistic?

David Kautter: I think the greatest understatement in the entire report is its statement about "considerable uncertainty" around the development cost. At one point in my career, I was responsible for the tax technology budget of a Big Four accounting firm. Experience tells me that it is virtually impossible to anticipate all the problems involved in a project of this magnitude.

I think the costs are substantially understated for at least three reasons. First, the IRS has no experience in this area. Second, the IRS doesn't have the capacity to build something like this right now. So this initiative is going to require the IRS to hire people with the right skills or outsource the development or a combination of the two. And third is the issue we've talked about earlier in this podcast, which is the state tax capability.

I don't know how IRS proposes to solve that problem, but when the report says there's considerable uncertainty, I would say that's understated dramatically.

Jonathan Curry: The price tag estimate that we talked about, the $64 million and $250 million, is based off an estimate where, again, probably considerable uncertainty, but they talk about servicing about between 5 million and 25 million taxpayers.

The Free File program, the Free File Alliance, where the private sector is supposed to be providing free return preparation for low-income taxpayers, only had about 4 million users for tax year 2020. What does something like this do to the tax preparation industry? Is this the apocalyptic end of TurboTax, Intuit, and all the above?

David Kautter: Well, I think private industry is going to be just fine in this area, especially in the short term. And the reasons I say that are, brand loyalty is a compelling motivation for many consumers, including with respect to tax software. There is a certain comfort that comes with using the same software year after year. You become familiar with it, you become comfortable with the questions. Third, I'd say ease of already having last year's data in a system makes life simpler. You can compare last year to this year.

Concerns about the IRS being the preparer, reviewer, and the enforcer are going to discourage some taxpayers from using the program. And I think some will use the IRS software, I'm sure of that, but I don't think the tax preparation software industry has much to worry about, especially in the short term.

Jonathan Curry: And again, I'm going to use this metaphor, I'm beating it to death here. You wore the commissioner's hat for a time, you've been in the office there. Do you think the IRS wants to be doing this? Now to some extent, perhaps it doesn't matter what they want to do, they do what they're told to do by Congress, Treasury, and so forth. But within the building, is there a sort of eagerness to go in this direction?

David Kautter: I don't know where the current commissioner and administration stand on this at the moment, but I would say the IRS has a long list of technology priorities. In 2019, they issued a modernization report which listed dozens and dozens of programs that they needed to improve or develop in order to serve taxpayers effectively.

It is hard to believe that all of a sudden, direct file has catapulted from not on that list at all, to No. 1 on the list. So I think that the IRS has done a really good job of identifying what it needs to do to improve user experience with the IRS.

It's in the process of trying to build some of that software with the infusion of cash from the Inflation Reduction Act. They have the funds to accomplish that, but direct file was not something when I was in the acting commissioner job that was high on our list.

The commercial software vendors have good products, they work well. Data got into the system effectively, the IRS had an effective operating partnership with those software vendors. And so IRS was inclined, at least when I was there, to focus on areas [which] needed support, where you could substantially improve the taxpayer experience, and this was not one of them.

It seems to me in part, this is being driven by a desire to help taxpayers save money by being able to file. And there is something irrational about a tax system where the federal government wants you to file electronically and won't allow you to file directly with them electronically, where you have to go through a software vendor.

So I understand the arguments and I understand the irrationality of it. I just have a hard time believing that this is top of the career folks' list at the IRS when it comes to technology initiatives.

Jonathan Curry: And I think the IRS report itself, as well as the independent evaluation included in the IRS's report by New America and their external people helping them out with that, they both came to the conclusion that if this is to succeed, it's going to require leadership, IRS leadership, to really commit to this. I think you talked about this earlier, a half-hearted attempt to just like, "Here's a direct-file thing. You can use it if you want." It's not going to get off the ground well.

David Kautter: This is going to take a sustained, focused effort to convince taxpayers to use the new software, the direct-file system. As you pointed out, Jonathan, earlier, we've got a Free File system now where taxpayers can file for free their federal return.

There are around 70 million taxpayers who are eligible for Free File and about 3 percent of those taxpayers use that system. Why a dramatic number of taxpayers, in excess of the 3 percent, would all of a sudden decide to use a direct-file system that the IRS has come up with instead of the commercial software that's available for free, is not clear to me.

So I think the only way this becomes widespread is the system is easy to use. There's plenty of customer support. The IRS advocates actively that taxpayers can benefit from using this system, that it is for free. And I think that's the only chance this system has of prospering going forward. And I can't help but mention, again, you've got to solve the state tax return problem, I think, or this will always be just a shadow of what it could possibly be.

Jonathan Curry: All right. Well, Dave, thank you so much for being here. It's been a pleasure talking with you about Free File.

David Kautter: Jonathan, thanks for inviting me. It's an interesting topic and it's going to be interesting see to see how it evolves.

David D. Stewart: And now, coming attractions. Each week we highlight new and interesting commentary in our magazines. Joining me now is Acquisitions and Engagement Editor in Chief Paige Jones. Paige, what will you have for us?

Paige Jones: Thanks, Dave. In Tax Notes Federal, four tax pros explain how multinationals based in the U.S. owe the IRS as much as $1 trillion from violating a 2009 regulation. They explore how the IRS can recover those funds. Marie Sapirie examines the section 6418 credit transfer provision and how the IRS might verify and audit taxpayers who use it.

In Tax Notes State, Morgan Scarborough examines how the Republican Party's worsening relationship with big businesses has affected tax policymaking. Robert Wood examines California tax disputes and outlines a few tips to help negotiate the process and traps that practitioners may face.

In Tax Notes International, six KPMG practitioners examine how transfer pricing considerations may be triggered by the increased focus on the development of electric vehicles. Three NovioTax professionals explain the importance of proper transfer pricing strategy documentation in the intercompany transfer of assets.

In Featured Analysis, Ryan Finley explains that section 42's drafting problems would require major revisions to solve. He offers some suggestions for how to do it.

And finally, on the Opinions page, Robert Goulder asked whether the GOP's tax pledge has any life left in light of the Limit, Save, and Grow Act of 2023.

David D. Stewart: That's it for this week. You can follow me online @TaxStew, that's S-T-E-W, and be sure to follow @TaxNotes for all things tax. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or a review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.

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