IRS Direct File progresses through internal testing

The Internal Revenue Service's Direct File free tax system has passed a key hurdle in the pilot test, passing muster with a dozen IRS employees successfully filing returns in as many states.

The IRS plans to open up testing of the Direct File system more widely in March, but it showed a demonstration of the free tax program last month, saying it would be available in 12 states. 

"The 'First Filers' have successfully and securely filed their returns for free through Direct File, and the IRS is continuing to progress through internal testing," said Bridget Roberts, Direct File pilot lead, in a statement Thursday. 

As a first step in the internal testing phase, a small group of IRS employees volunteered to file their returns through Direct File, according to an IRS official who asked not to be identified. The "first filers" include over a dozen employees from across the 12 pilot states. The IRS prioritized filers from the states without an income tax so it could test Direct File and ensure a successful filing experience for a small initial group of taxpayers before the pilot expands to states with an income tax that are participating in the pilot to ensure successful integration with state tax-filing tools.  

The 12 states where it will be available include Arizona, California, Florida, Massachusetts, Nevada, New Hampshire, New York, South Dakota, Tennessee, Texas, Washington and Wyoming.

The IRS is continuing with this internal testing phase, with a limited number of approximately 1,200 taxpayers in nonincome tax states able to file their returns through Direct File. The IRS plans to continue to provide updates as the internal testing phase progresses. 

Despite the progress on the pilot test, the IRS is facing hurdles with opposition from some Republicans. A group of Republican attorneys general from 13 states signed a letter in late January denouncing IRS efforts to pilot a Direct File system, claiming it's unconstitutional. Rep. Jason Smith, R-Missouri, who chairs the tax-writing House Ways and Means Committee, has also called for ending the program.

Before launching the program, a group of researchers conducted a study that was authorized by the Inflation Reduction Act to examine the feasibility of such a system, and the IRS announced plans last year to test it in a pilot program. One of the outside researchers who was part of the independent review task force was Ariel Jurow Kleiman, a law professor at Loyola Marymount University's Loyola Law School in Los Angeles.

"My interpretation of the statute that gives the IRS its administrative mandate is that this does fall within the purview of the IRS's powers," she told Accounting Today. "The IRS has the charge of administering the tax system. We could quibble over what 'administrative' means. My read of the word 'administer' would include offering a system through which taxpayers can file a tax return. That seems to me part of 'administer.' And also, if you look at the history of the IRS, they have offered tax-filing portals before. They offered a telephonic one. They tried to offer an internet-based one very early on in the '90s that was ill fated, Cyberfile. They help people prepare their returns in person, so it's not clear to me how those efforts differ in any meaningful way from Direct File. I have not yet read a convincing argument that the IRS doesn't have this authority."

The IRS has also offered a basic Free File Fillable Forms option since tax year 2008. Currently the Direct File program does not pre-populate a tax return with information from a taxpayer's W-2 forms, but that could happen in the future. 

"That's something a lot of people obviously want and a lot of people have asked about," said Kleiman. "On the independent task force, we definitely asked about it repeatedly. Is it going to be included? When will it be included? Why is it not going to be included? And our understanding was that it was too much of a lift at this point, but that there is no technological barrier to doing it at some point in the future. In theory, based purely on the technology, there could be pre-populated returns, but it wouldn't have been possible to include them in the pilot. It just requires too many back-end changes to how the system works."

She believes the new system won't offer much competition to tax professionals. "I think accountants and tax professionals and in-person tax preparers are pretty well insulated from any competition from Direct File," said Kleiman. "People go to a tax preparer because they want a guide through the process. It's a scary system to interact with. And I think people really love and appreciate their tax preparers, so I can't imagine too many people are going to abandon their tax preparer to use free software."

The IRS decided to start out with a small sample of testers in the pilot program, but most people won't be able to try out the system until mid-March, when many taxpayers have already filed their returns.

"I was wondering why they didn't just keep it as a pilot for the entire first season and never do the bigger launch until the next filing season," said Kleiman. "But I don't know why they decided to do a pilot, and then a bigger launch in the same filing season after the time most people have already filed. It probably just has something to do with technological feasibility. It is certainly better that they start small, so I'm not at all concerned about their decision to start small. That is the right decision. My bigger question was why even expand in this filing season at all?"

The system has attracted opposition from commercial tax prep software vendors, even though the IRS has long worked with a group of them as part of its Free File program. However, some major tax prep software companies such as Intuit and H&R Block have left the Free File Alliance in recent years. It's possible that Direct File will simply be offered as part of the Free File program, alongside the commercial tax prep options.

"I think there's a lot of fear that it will change the relationship between the IRS and the members of the Free File Alliance," said Kleiman. "I think there's an assumption that it will. I don't know that it necessarily will because it's just one other free option. There are already many free options offered through Free File, so in theory, it could just be offered on Free File as another option. They all have slightly different eligibility rules and offer slightly different functionality, just like Direct File would. I don't see any reason why it couldn't just be another offering up there with the other ones."

Once the pilot is rolled out further, the IRS plans to offer live online support to users of Free File through its staff Monday through Friday from 7 a.m. to 10 p.m. eastern time. A chat button will be available where they can participate in a live chat with a trained customer service representative

But with the IRS in constant threat of funding cutbacks, maintaining that support could be a problem when the IRS is often overwhelmed with calls during tax season.

"I think customer support is going to be a major challenge," said Kleiman. "I was very impressed with the way that they described their customer service plan during the pilot demonstration phone call. They said that there would be live chat agents ready to answer questions about Direct File and about basic tax questions. That would be incredible. I don't know how they could sustain that level of customer support in future years with more users, and it's going to be the largest ongoing cost for the program. If they don't have sustained, dedicated funding for a Direct File program, the thing that will suffer the most is high-quality customer support."