When free tax filing really isn't free

What's the catch? Is it safe?

by Tony Novak, CPA, MBA, MT     January 20, 2015

You've likely noticed the flood of advertisements of "free" online tax filing that flood media this time of year. The advertisements apparently avoid legal problems that he service may not actually be free by saying "Get started for free" but too many users are misled by other language that leads them to believe that the entire filing service is free. This year the advertising theme among the major players is "mine is more free than your free offer". Many of these users apparently do not know until the end of process - after they've invested more than an hour setting up an account, authorizing the use of their private information and entering all of their income details - that the service they expected is not really free.

In general, online consumer software companies that offer a no cost entry level service do a good job of communicating the true costs and limitations of that offer. But that seems to not be true of tax filing companies. Free online tax service can be a great thing. But not telling consumers up front that they do not qualify for the free service until after they've given up private information just stinks.

History of freefile

About half of American tax filers prepare their own tax return while half use professional preparers. Over the past 25 years the federal government has developed and promoted a project called "Freefile" to encourage and develop free online tax filing services for lower income filers. Like all government programs, e-file program had rules and seemingly arbitrary limitations. Currently the limit is $60,000 to qualify for free online filing of federal income taxes. State taxes may or may not be included in the free filing offer depending on your state. Freefile also limits the type and number of in-app sales that the service provider could offer.

Over the past few years tax software companies largely abandoned the limitations of government program - at least as far as their advertising goes - to develop their own independent "free" online filing systems that are not part of the government-supported e-file system. Today tax software companies make a significant portion of their profits from the sale of optional "add-on" ancillary services like bank services to speed up availability of tax refund money. The sales of these add-on services focus primarily on lower-income tax filers.

Online tax filing offers clear savings and advantages to consumers. Errors are significantly reduced, refunds are faster, data is retained from year to year to make subsequent filings even faster. There is no software to file and almost any Internet-connected device can be used to access the service.

Limitations of free filing

To be clear, some online tax filing is really free and represents a great consumer value. It's just that finding clear description of the limitations of each free filing service for each provider is not as easy as it should be. These limitations are no longer strictly controlled by the government but rather by the promotional programs of each commercial tax software company. These limitations vary from one provider to another. For example, Turbo Tax states that it limits its free service to first time filers, students and those who do not have children, a house or investments. 1040.com offers 1040EZ returns and extensions for free. It is difficult for taxpayers to know which category they fall into before selecting an online tax filing service. The advertising strategy of the 8-10 largest firms in this online tax preparation marketplace can be summarized as using the term "free" to lure customers onto their site and then up-sell some service on the back end when the return is ready to be filed.

Risks

Tax filing is significantly more complicated than ever before (see my article "Tax preparers should be scared"). CPAs and professional tax preparers spend hundreds of hours each year learning to deal with the tax filing system. I've spent more than a hundred hours myself over the past few months doing practice returns and comparing the results to a database to look for patterns of errors and problem areas. We know that even among trained professionals, the variance of tax return results and the resulting amount of tax liability can be substantial. When combined with the statistics on automated tax compliance enforcement and automatic penalty assessment, it is easy to reach a conclusion that self-filing is a high risk of liability on audit.

The likelihood that an untrained tax filer could log on to a filing system and then accurately complete and file their own tax return - especially if it involves any complicating factors - is slim. Successful self-preparation of a typical tax return is no more likely than success in repairing our own automobile engine. We need to be clear that some can but most cannot.

Use of private information

Consumers do not seem to be clear on the issue of use of their personal information for the sale of other supplemental products. While free online tax services do require users to read the fine print and sign the privacy and use acknowledgement, it seems likely that consumers do not recognize the substantial difference between this authorization and, for example, a Facebook user privacy policy.

Some predict that soon all types of tax and accounting software will be free to individual and small business users because the use of the information is more valuable than the cost of the software. That strikes me as a scary thought.

Personal support for tax filers

There are likely to be more questions and problems with filing this year than at any time in recent memory. IRS says that support will be limited or unavailable this year. The IRS Commissioner and the Taxpayer Advocate Office predict that less than half of taxpayer telephone calls will be answered this season and then only after a 30 minute wait. Free tax services do not offer personal support. Small private online tax filing practices like mine offer free support to online filers but frankly, I have no way to monitor and control the cost of that support so that means that I have to handle it on a case-by-case basis.

In past years the IRS offered personal services of community-based volunteers to help more than a half million low income taxpayers file their tax returns at no cost. This year the program has been dismantled due to lack of funding.

At its best, low cost online filing enables some providers like 1040.com share revenue with tax advisers like me allowing me to focus on offering tax advice on demand and audit support for an individual who is otherwise capable of preparing their own simple tax return. I also praise 1040.com for clearly communicating the limits of the free filing offer and making it clear that most users pay a simple low fee for the service. This is an example of how technology can sometimes brings the best of both worlds to improve consumer experience.

The bottom line

Direct online filing of self-serve tax returns is a great thing for individual filers with modest income and simple tax returns. We need to do a better job of communicating that many tax filing services for average 1040 filers are not actually completely free and that the typical taxpayer should actually expect to pay a small fee in return for the real benefits of these complete online filing systems, including ancillary services. It would be naïve to think that a taxpayer with a more complex tax return could save either time or money by doing it themselves.

2014 Tax Filing Resources

General:

Income tax filing by mobile phone

Tax services flyer

Tax services post card

The easiest way to file your income tax return

Planning:

10 Things you need to know about this year's taxes

Don't be treated as a 2nd class taxpayer

How to send documents to an online tax preparer

Tax planning made easy

When free online filing really isn't free

Pricing:

2015 National average tax preparer fees

Tax service pricing for CPA-prepared returns

1040.com online filing pricing

How to get free CPA help with online tax filing