IRS E-File: A History

 

FS-2011-10, June 2011

Within 25 years, the mere trickle of 25,000 electronically filled individual tax returns has turned into a torrent of more than 100 million a year and led to a permanent change in the way Americans file their taxes.

And it started with one IRS employee having to manually turn on a modem every time tax returns were e-filed, a dedicated research and project office staff and an admittedly awkward use of the distinctive “Mission Impossible” theme.

The IRS e-file surpassed a landmark: 1 billion individual Form 1040 tax returns received and processed safely and securely. IRS Commissioner Doug Shulman has called IRS e-file one of the federal government’s most successful modernization programs.

IRS e-file has come a long way from the 25,000 returns submitted by five tax preparers in 1986.

In the 1980s, efficient tax collection was becoming more difficult because of the complex, time-consuming and error-prone process of converting paper returns and information documents into a form that could be processed by machine. Even the mere storage of paper tax and information returns was becoming costly as more and more space was needed for the burgeoning reams of required paper forms and documents.

Even as tax practitioners were starting to use computers to prepare clients taxes, the IRS still forced them to print and mail returns because of the processing system.
Enter IRS e-file. The initial idea sprang from the IRS Research Division, which ran tests to prove the technical feasibility of Electronic Filing System (EFS), a concept it believed would simply the processing method.

In 1986, a pilot program was launched to test the costs and benefits of EFS and to gauge acceptance by preparers and taxpayers. Only five tax preparers in three metropolitan areas – Cincinnati, Raleigh-Durham and Phoenix – agreed to participate. Then, the system could only process returns that were due refunds.

“The processing system at that time consisted of a Mitron and a Zilog, which most people have never heard of,” recalled retired IRS employee Leonard Holt, who served as a branch manager in the e-file project office. The tax preparer would call a designated number at the Cincinnati Service Center and an IRS employee would plug the phone into the Mitron, which Holt described as a modem with a tape drive.

When the transmission was finished, the IRS employee would transfer the tape to the Zilog, a super mini-computer, which would massage the data into files that the IRS’ Unisys System could process.

To send the acknowledgement, the IRS employee would have to telephone the tax preparer who would plug the phone into his own modem and reverse the transmission process.

Still, the “electronic” process seemed promising. Holt and former IRS employee Mike Jackman, discussing e-file one day after work, sketched the IRS e-file process onto a napkin along with the creation of an e-File Project Office and the equipment needed to move the concept from beyond the research stage.

Mercedes del Toro, also now retired, became a part of the e-file project office team because she had training in COBOL, a computer programming language. She developed the specifications for the Form 1065 for partnerships and Form 1041 for trusts which also were being e-filed along with the Form 1040.

“My first day on the job started by leafing through the many Internal Revenue Manual pages on my cluttered desk,” recalls del Toro. After lunch, she told her boss the job would take six months; her boss said she had one month. “Thank God for overtime, coffee, good health, sense of humor and a wonderful team.” It wasn’t pretty, but the job was done on time.

In 1987, 66 preparers from seven cities participated and filed 78,000 tax returns. That year, electronic Direct Deposit was added to put the refunds directly in the bank accounts.

By 1988, the IRS moved to an IBM Series I processing system, the 16-bit minicomputer, which finally eliminated the need for an IRS employee to plug the phone into a modem. And tax preparers were starting to become curious.

IRS National Account Manager Aaron Welch was in the IRS’ Baltimore District in 1988 and recalls when officials from headquarters had to explain to tax preparers what e-file was all about because few other IRS employees understood it.

“We had about 12,000 e-file returns in Baltimore District that first year. That included all of Maryland and Washington, D.C. The second year we had about 60,000, and everybody celebrated. This year, taxpayers in Maryland and D.C. e-filed over 2 million federal returns," Welch said.

Once e-file became operational almost the entire project office was conscripted into marketing the new product to tax preparers.

Laurie Barrett, who now works for IRS Portal Business Management, recalls traveling around Colorado trying to convince tax preparers to make the investment into modems and join electronic filing. A promotional video featured the distinctive theme from “Mission Impossible” and Greg Morris, who played electronic expert Barney Collier in the hit television show, was the video spokesman promoting e-file. In the beginning, the theme song brought laughs from the audience, recalled Barrett, who served as an IRS district e-file coordinator when the program started.

Eileen McCrady, former chief, systems development branch and later marketing branch chief, remembers: “Tax preparers were not buying any of it. Most people figured it was a plot to capture additional information for audits.” Actually, e-filed returns are so accurate that it decreases the chances of hearing from the IRS. In the early days, the number of participating tax preparers was so small that McCrady kept a list, ironically on paper, in her desk. Even at the IRS the use of computers was limited and McCrady often shared one computer with six colleagues.

In 1990, IRS e-file became operational nationwide and 4.2 million returns were filed electronically.

From the beginning, IRS e-file received a tremendous boost when two major tax preparation firms, H&R Block and Jackson-Hewitt, agreed to give it a try. More tax professionals became willing to give it a chance.

And, the e-file seminars eventually became the IRS Tax Forums which now annually draw more than 20,000 tax preparers who learn about the latest tax changes and other IRS activities as well as e-file.

IRS e-file has proven to be a win-win for all involved. Taxpayers get faster refunds, in as few as 10 days if they use direct deposit. Or, they get payment options to file now and pay later. An e-filed return is far more accurate. It has an error rate of 1 percent compared to 20 percent for a paper return.

The IRS currently is phasing in its Modernized e-File (MeF) system, the next generation of electronic filing. MeF means acknowledgements will be sent within minutes as opposed to 48 hours. If a return is rejected, a more detailed message will allow taxpayers to quickly correct errors and resend the return.

MeF uses a transactional based platform that allows individual returns to be transmitted to the IRS. Legacy e-file is based on batch processing that required many returns to be sent at once several times a day.

MeF and the Customer Account Data Engine (CADE), which will replace the IRS master file tapes, will provide the foundation for the future electronic transactions by taxpayers and by tax preparers, eventually providing real-time access to accounts and speeding refunds to a matter of a few days instead of a few weeks.

Now, e-file no longer is the exception; it’s the norm.

E-FILE HISTORICAL TIMELINE

1986: Initial filing season pilot with 5 tax preparers in 3 cities; 25,000 returns filed. The program could only accept simple returns that were due a refund.

1987: Pilot expanded to 7 cities; 78,000 returns filed. Direct Deposit was added as a benefit.

1988: Pilot expanded to 16 IRS districts; 583,000 returns filed. The Form 1065 (partnerships) and Form 1041 (trusts) are added to the e-file list.

1989: Pilot expands to 36 states; 1.1 million returns filed.

1990: E-File expands nationwide; 4.2 million returns filed.

1992: Telefile pilot debuts for 1040-EZ filers to e-file via telephone. The IRS begins to accept individual tax returns where tax is owed and checks can be mailed via paper voucher.

1998: Congress passes IRS RRA 98 containing a provision setting a goal of an 80 percent e-file rate for “all federal tax and information returns.”

1999: Electronic payments through credit cards or direct debit introduced; IRS pilots alternative programs to allow taxpayers to sign returns electronically instead of mailing a signature form.

2002: IRS allows taxpayers to sign e-file returns using a Personal Identification Number (PIN) which made the e-file process entirely paperless.

2003: Free File debuts; IRS partners with Free File Alliance, a consortium of tax software companies, to make free tax preparation software and free e-file available to most individual tax payers. In a major step for businesses, e-file is expanded to the quarterly Form 941 for employment taxes and the annual Form 944 for small businesses.

2004: Modernized e-File (MeF), the next generation of IRS e-file, makes its debut, accepting business and information returns such as the Forms 1120, 1120-S and 990 series.

2005: E-filed returns cross the 50 percent threshold; 68.4 million returns filed. Telefile ends after years of declining use as users migrated to tax software and e-file..
2006: MeF becomes mandatory for businesses and exempt organizations with assets of $50 million or more.

2007: MeF threshold for businesses and exempt organizations lowered to assets of $10 million or more.

2009: Congress passes a provision requiring tax preparers who file more than 10 individual tax returns to file electronically; IRS phases in the requirement, setting the threshold at 100 or more for 2011 and 11 or more for 2012.

2010: MeF begins a roll out for the Form 1040 series and 23 related forms which will take three or more years to make all the related forms available; IRS stops mailing paper Form 1040 packages.

2011: E-filed returns cross the 100 million threshold in one filing season; cumulative total exceeded 1 billion returns. Approximately three out of every four individual tax returns were filed electronically.

Tax Challenges of Business Income

 

FS-2008-20, April 2008

WASHINGTON—Internal Revenue Service research indicates that understated business income contributes significantly to the tax gap, with the majority understated by small businesses.

To assist small business and self-employed taxpayers better understand their reporting obligations, this fact sheet addresses the issue of income and how to determine gross income.

Business Income, Gross Receipts or Sales

If there is a connection between any income received and a business, the income is business income. A connection exists if it is clear that the payment of income would not have been made if the business did not exist and operate.

Small business owners and self-employed taxpayers must report on their tax returns all income received from their businesses unless specifically excluded by law. In most cases, business income will be in the form of cash, checks and credit card charges.

But business income can be in other forms, such as property or services. There are many forms, including: bartering, real estate rents, personal property rents, interest and dividend income, canceled debt, promissory notes, lost income payments, damages, economic injury payments, as well as kickbacks.

All income earned is taxable. Directing payment of income to a third party does not remove the reporting and payment requirements for small businesses and self-employed taxpayers.

Cost of Goods Sold

Some businesses may make or buy goods to sell. If so, these businesses may deduct the cost of goods sold (COGS) from their gross receipts. To determine these costs, the value of inventory at the beginning and end of the year must be calculated.

There are several factors that go into determining COGS, including: inventory at the beginning of the year; purchases less cost of items withdrawn for personal use; labor costs (generally applies to manufacturing and mining operations); materials and supplies (generally a manufacturing cost); other costs (generally applies to manufacturing and mining operations); and inventory at the end of the year.

Inventory, net purchases, cost of labor, materials and supplies, and other costs are added together. Inventory at the end of the year is subtracted from this total to determine COGS.

Gross Income

To calculate gross income, first determine net receipts (gross receipts minus returns and allowances) and minus the cost of goods sold. Returns and allowances include cash or credit refunds made to customers, rebates and other allowances off the actual sales price. Then add any other income, including fuel tax credits. Gross income must be determined first before deducting business expenses.

Tools to Use

There are tools available to assist small business owners and the self-employed track and report income such as the use of: a formal set of books and records with strong; accounting/financial computer software; and separate bank accounts for business and personal income and expenses.

Small businesses and self-employed taxpayers greatly benefit by accurately recording and reporting all income. Insufficient recordkeeping could cause income to be over-reported and too much tax paid or too little income reported and too little tax paid.

The Small Business and Self-Employed One-Stop Resource is a Web based tool. It contains a wealth of information to educate business owners and the self-employed on their unique tax filing and reporting obligations.

Another Web based tool is the Online Learning and Educational Products section of IRS.gov which allows business owners to view a streaming video of an IRS Small Business Workshop, order the Small Business Workshop on DVD, take an IRS course, or complete an online, self-directed version of a workshop taught live around the country.

These tools can help to more accurately determine income and expenses as well. There are benefits beyond accurate income and expense reporting to be gained. Formalized financial records will help small businesses when it is time to apply for loans or efforts to obtain capital for expansion.

Links:
• Publication 334, Tax Guide for Small Business
• Publication 583, Starting a Business and Keeping Records

Wage Compensation for S Corporation Officers

FS-2008-25, August 2008

Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code. When corporate officers perform services for the corporation, and receive or are entitled to receive payments, their compensation is generally considered wages.  Subchapter S corporations should treat payments for services to officers as wages and not as distributions of cash and property or loans to shareholders.

S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.  Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes.  S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

This fact sheet clarifies information that small business taxpayers should understand regarding the tax law for corporate officers who perform services.

Who’s an employee of the corporation?

Generally, an officer of a corporation is an employee of the corporation.  The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages. Courts have consistently held that S corporation officer/shareholders who provide more than minor services to their corporation and receive or are entitled to receive payment are employees whose compensation is subject to federal employment taxes.

The Treasury Regulations provide an exception for an officer of a corporation who does not perform any services or performs only minor services and who neither receives nor is entitled to receive, directly or indirectly, any remuneration. Such an officer would not be considered an employee.

What's a Reasonable Salary?

The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state "Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation."

The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly.  However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.

There are no specific guidelines for reasonable compensation in the Code or the Regulations. The various courts that have ruled on this issue have based their determinations on the facts and circumstances of each case.

Some factors considered by the courts in determining reasonable compensation:

• Training and experience

• Duties and responsibilities

• Time and effort devoted to the business

• Dividend history

• Payments to non-shareholder employees

• Timing and manner of paying bonuses to key people

• What comparable businesses pay for similar services

• Compensation agreements

• The use of a formula to determine compensation

Medical Insurance Premiums treated as wages.

The health and accident insurance premiums paid on behalf of the greater than 2 percent S corporation shareholder-employee are deductible by the S corporation as fringe benefits and are reportable as wages for income tax withholding purposes on the shareholder-employee’s Form W-2. They are not subject to Social Security or Medicare (FICA) or Unemployment (FUTA) taxes. Therefore, this additional compensation is included in Box 1 (Wages) of the Form W-2, Wage and Tax Statement, issued to the shareholder, but would not be included in Boxes 3 or 5 of Form W-2.

A 2-percent shareholder-employee is eligible for an AGI deduction for amounts paid during the year for medical care premiums if the medical care coverage is established by the S corporation.   Previously, “established by the S corporation” meant that the medical care coverage had to be in the name of the S corporation.

In Notice 2008-1, the IRS stated that if the medical coverage plan is in the name of the 2percent shareholder and not in the name of the S corporation, a medical care plan can be considered to be established by the S corporation if: the S corporation either paid or reimbursed the 2percent shareholder for the premiums and reported the premium payment or reimbursement as wages on the 2percent shareholder’s Form W-2.

Payments of the health and accident insurance premiums on behalf of the shareholder may be further identified in Box 14 (Other) of the Form W-2.
Schedule K-1 (Form 1120S) and Form 1099 should not be used as an alternative to the Form W-2 to report this additional compensation.