IRS Wants State Help With New Tax Return E-Filing Pilot Amid Privacy Concerns
IRS Wants State Help With New Tax Return E-Filing Pilot Amid Privacy Concerns

By Tom Ozimek

The Internal Revenue Service (IRS) is asking states for assistance with test-driving a new electronic free-file tax return system that will help the tax agency decide whether to press ahead with a more permanent program that could include support for filing both federal and state tax returns.

The IRS in May announced plans to carry out a limited test pilot in 2024 for what is shaping up to be a free IRS-run electronic tax filing system, commonly known as “Direct File.”

The agency released a report to Congress that said most taxpayers are interested in such a program and that the IRS is technically capable of delivering a Direct File program.

“The IRS review looked at the potential operational and administrative requirements of such a system. Ultimately, the results show there is taxpayer interest in an optional Direct file program and such a program is technically feasible. Any path forward should start with a limited pilot to assess operational factors,” IRS Commissioner Danny Werfel said in a statement in May, adding that the agency looks forward to working with various stakeholders on the project.

Data cited in the IRS’ “Direct File” report to Congress showed that taxpayers would be more interested in such a program if it included support for filing state tax returns.

As the agency’s stakeholder engagement and technical work on the program have progressed since May, the IRS is now calling on states to work with the agency on next year’s pilot.

“Over the next several weeks, we will finalize our plans for state tax integration and pilot strategy so that we can focus on the technical aspects involved in testing a potential new filing option for taxpayers and state tax administrators,” Mr. Werfel said in a July 26 letter (pdf) to the heads of the Federation of Tax Administrators (FTA), which serves state tax collection agencies, in part through intergovernmental and interstate coordination.

Mr. Werfel said in the letter that the IRS is especially interested in input from states and the FTA on the “challenges they may face when integrating with a Direct File pilot, be they technological, policy-driven, or other concerns.”

“We welcome involvement from all states that are interested in taking part in the 2024 pilot,” Mr. Werfel wrote, asking states to express interest in participating in next year’s test drive by the beginning of September 2023.

Problems to Address

Experts say that a number of issues need to be resolved before a state tax filing component can be incorporated in Direct File, including around ensuring security of taxpayer data.

“There are a range of questions here for the IRS to consider, including paramount security of taxpayer data and requirements of 6103 taxpayer privacy protection,” according to Natasha Sarin, a former counselor to Treasury Secretary Janet Yellen and deputy assistant secretary for economic policy in the Treasury Department, as cited by Nextgov/FCW.

An analysis from an independent third party on the feasibility of the Direct File system, which was included in the IRS’ report to Congress, was carried out by New America and professor Ariel Kleiman, an associate professor of law at Loyola Law School, Los Angeles.

Mr. Kleiman and New America wrote in its analysis that, for the new system to be successful, it must address several key imperatives (including around customer support and data privacy and security) and be rolled out gradually.

“To be successful, the IRS would need to test, grow, and improve functionality over multiple tax years,” the third-party report to Congress states.  “The IRS would need to implement functionality in an iterative manner and avoid trying to deliver too much functionality at one time.”

The third-party report also noted several challenges to including state tax filing in the Direct File platform.

For example, the report notes that since state governments rely on existing IRS systems for tax collection, benefit administration, and fraud prevention, any potential Direct File system provided by the IRS would need to take care not to disrupt the current business processes of state governments.

Since taxpayers are used to filing federal, state, and local returns at the same time, a potential Direct File tool would need to make it easier for taxpayers to file their state returns using data from their federal returns, the report notes.

However, there are “complexities” presented by an IRS-run e-filing system that commercial products don’t have, Kleiman and New America wrote.

Specifically, once taxpayer information is submitted to the IRS, it is designated Federal Tax Information (FTI), which is subject to restrictive rules on how it’s used.

“Taxpayers, on the other hand, have no such restrictions and are free to provide their information to any party they choose,” the report notes, with one of the outstanding issues the IRS has to address is whether taxpayers using the Direct File system would have to manually copy information from their federal tax returns to their state returns or whether this could be done automatically.

All major existing commercial tax software products allow users to file federal and state taxes together, with data usage restrictions that the IRS faces amounting to a potential user experience hurdle and a problem the tax agency needs to solve.

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