IRS takes baby steps with new direct file program

The IRS is treading carefully with the launch of a free online tax filing system as the agency and its ambitious project face intense political scrutiny.

When the new “direct file” online tax filing system from the IRS is released to the wider public in mid-March, an unlimited number of citizens will be able to use it, the IRS has said. 

But the program is still in an internal testing phase, and only about 12 IRS employees from states that don’t have an income tax are filing returns with the new system so far, an IRS official said last week. 

The IRS will process returns from 1,200 people in states without income tax through direct file as part of the testing phase before opening it up to California, Texas, New York and other high-population states.

The agency has said repeatedly that it wants to start small with its new filing system, which is a public alternative to private software programs such as TurboTax and TaxSlayer. The initial sample of a dozen filers is indeed a far cry from the hundreds of thousands of tax returns the IRS expects to process using direct file during the current tax filing season.

Experts say that scaling the program up shouldn’t pose a problem for the IRS and that its technological infrastructure is robust enough to handle a system like direct file at a bigger capacity.

“In terms of scalability, there’s no reason to believe that the IRS would have any trouble processing tens of millions of tax returns through direct file,” Ariel Jurow Kleiman, a professor at Loyola Law School who helped evaluate the feasibility of the direct file program as part of a team of outside experts, told The Hill.

“We already e-file our tax returns. The IRS already receives them and processes them, and that part of the IRS process actually works very, very well. Adding direct file is just a small change on top of that. So the technological scalability did not seem to pose any concerns for our engineers,” she said.

Still, technology has long been an issue for the IRS, which is one of the reasons the agency got an $80 billion funding boost over 10 years in the 2022 Inflation Reduction Act (IRA).

Portions of that money are still effectively up for debate, as Republicans try to claw back regular appropriations for the agency to shrink the additional funding.

Last year, the government’s internal watchdog agency conducted a technology audit of the IRS and found that 33 percent of its computer applications, 23 percent of its software and 8 percent of its hardware assets were considered “legacy,” which can mean either more than 25 years old or as many as 15 software versions behind a current version.

Of nearly two dozen different modernization initiatives currently underway at the IRS, only three include a plan to update or replace legacy systems, which can undergird or coordinate with taxpayer-facing programs such as direct file, the watchdog Government Accountability Organization (GAO) found.

GAO notes that the direct file initiative is expected to provide various forms of tax preparation assistance, some of which may pose an issue for the capacity of the system to handle additional taxpayers, experts say.

“The thing that did cause some concern in terms of scalability is customer service. Customer service is the largest ongoing cost and will be the largest ongoing cost of direct file,” Jurow Kleiman said. “With more users, you need to have more customer service representatives. That’s expensive, and they require training.”

The IRS hired 7,394 taxpayer service reps in 2023 and expects to hire 6,489 service reps this year, though it didn’t specify how many of those will be working specifically on direct file accounts, according to an operating plan for the IRA funding released in April of last year.

Along with the issue of scaling the program, questions loom about how it will differ from other tax preparation software and services.

The sprawling U.S. tax code gives wealthier taxpayers and businesses several methods to minimize their taxes. Tax-filing software programs often bill themselves to customers as optimizing for the largest possible personal refund.

While direct file could replace many of those programs — and maybe even some private tax professionals — as the agency incorporates more artificial intelligence into its protocols in the future, the IRS doesn’t see it as an optimization tool.

Instead, the system is meant to help taxpayers file a correct return, one IRS official working on the direct file pilot told reporters in January during a walkthrough of the program.

Even so, the official said they want to make sure that taxpayers don’t leave money on the table and are receiving all of the credits that the law allows.

Direct file is built for individual tax returns, not businesses, but some business tax experts caution that the incentives built into private accounting standards and into tax returns inherently don’t line up.

“There’s as many differences as you can think of as to why your tax return and your financial statements do not look alike,” forensic accountant Dean Driskell of consulting firm J.S. Held told The Hill. “The purpose of the IRS is to maximize revenue to the Treasury.”

It is unlikely that many wealthy individuals will use the IRS program given its early limitations.

The IRS direct file system can only handle wage income as opposed to investment income, and it can only process the standard deduction and a handful of credits that are generally geared to lower-income households and individuals, such as the child tax credit, the earned income tax credit and the credit for other dependents.

The program could be expanded in the future to process more complicated cases and bring more people onto the same playing field of how taxes are filed. But some experts are concerned it could exacerbate a two-tiered tax-filing process that gives the wealthy an upper hand.

“As direct file is expanded over time, if the IRS and Treasury decide that it’s worth doing so, they should definitely keep in mind that they don’t want to create a system that worsens that type of stratification,” Jurow Kleiman said.

“We don’t want this to be something that only low- and middle-income people use, because then it does feel like there’s a two-track or a three-track system where there’s the public service for some people and the private service for wealthy people,” she said.