Complex Tax Rules Burden Taxpayers and Their Advisors
Why Does It Cost So Much to Prepare Individuals’ Tax Returns?

Each year the government’s National Taxpayer Advocate (NTA) is required to report to Congress on the most serious problems facing taxpayers.  In 2010, Nina Olson, the NTA, reported  that the number one problem facing taxpayers – and the IRS – is the complexity of the Internal Revenue Code.  "If tax compliance were an industry, it would be one of the largest in the United States," states Olson's report to Congress. "To consume 6.1 billion hours, the 'tax industry' requires the equivalent of more than three million full-time workers."  According to IRS estimates there are as many as 1.4 million paid tax preparers who must register with the IRS under new rules intended to regulate largely unregulated practice.  Not surprisingly, many taxpayers use paid-preparers because they do not understand the tax law.

For a system intended to be self enforcing, tax law changes at a staggering pace and is inordinately complex.  According to Olson, the primary reason for the complexity of the federal income tax code is the law's sheer, overwhelming size.  Over the last 10 years, there have been 4,428 changes to the tax code, an average of more than one a day, including 579 changes in 2010 alone.  In 2010, the tax code contained 3.8 million words. A 2001 study published by the Joint Committee on Taxation put the number of words in the income tax code at that time at 1,395,000. A 2005 report by a tax research organization put the number of words in the entire tax code at 2.1 million and found that the number had almost tripled since 1975.  In addition, the tax regulations issued by the Treasury Department to provide guidance on the meaning of the Internal Revenue Code now stand a foot tall.  (In 2005, tax regulations contained almost 7 million words -- more than double the number in 1975.)

Federal tax law is not just expanding; code sections – the rules which underpin every line on your tax return -- are undergoing continual change.  According to a Tax Foundation study, sections are amended once every four years on average (as of 1994). This instability has been much more pronounced in the past 20 years than it was during the 20 years immediately following the 1954 codification of the law.

The complexity of the tax code leads to what Olson's report calls "perverse" results. "On the one hand, taxpayers who honestly seek to comply with the law often make inadvertent errors, causing them to either overpay their tax or become subject to IRS enforcement action for mistaken underpayments. On the other hand, sophisticated taxpayers often find legislated “loopholes” that enable them to reduce or eliminate their tax liabilities."  The tax code is riddled with more than $1 trillion in deductions, exemptions and credits and they benefit people at every income level, according to data from the nonpartisan Joint Committee on Taxation, Congress' official scorekeeper on revenue issues.  To minimize taxes, taxpayers are compelled to identify and use all the benefits available to them, and this requires professional guidance.

If you think the IRS' 100,000 employees do not suffer from the complexity of the tax code, you would be wrong, according to the NTA's report.   Approximately 90% of the individuals preparing their own returns depend on tax preparation software; yet, the IRS still takes over 50 million calls for help per year and, according to Olson, the Service is unable to answer more than a quarter of the questions.  Despite this, the IRS continues to try to explain the law to individuals searching for guidance.  In 2011, the IRS announced its newest innovation to answer tax questions – a smart-phone application, IRS2Go, which can be downloaded for free.  The IRS also posts videos on YouTube® to provide assistance and has news feeds on Twitter® to help individuals understand their tax obligations.

According to Olson, individual taxpayers find return preparation so overwhelming that over 60 percent pay preparers to complete their returns. Among unincorporated business taxpayers, the figure rises to about 71 percent. According to OMB’s Office of Information and Regulatory Affairs, which estimates the time associated with various government forms, 200 forms and schedules need to be considered when one attempts to tackle an individual return.

Despite the increased reliance on software and outside providers, error rates continue to rise. The IRS contacted taxpayers 15 million times in 2010 to change their claimed tax liability, according to the report.  In addition, the IRS corrected 10.6 million "mathematical errors" in taxpayers' returns in 2010, more than double the 4 million it corrected in 2005, the NTA report said.  The rules of the “tax game” are seriously flawed, but we are obligated to participate and do the best we can.

The Increasing Cost of Tax Compliance

The complexity and changing nature of the tax law pushes up the cost of compliance. Even full-time tax professionals struggle to keep up with changes to the law, as well as new IRS guidelines, and court decisions.   In 2006, the Tax Foundation published a Special Report on the cost of federal income tax compliance from 1990 through 2004 and estimated future cost through 2015.  In 2000, the cost was     $172.90 billion and it was thought that it would increase to $ 409.50 billion by 2012.  The estimate seemed unimaginable.

Recently the Laffer Center released a comprehensive report on the tax law’s economic burden.  The authors assert that to pay taxes, the costs taxpayers actually incur are far greater than the net sums the government collects.  They estimate that U.S. taxpayers pay $431.1 billion annually, or 30 percent of total income taxes collected, just to comply with and administer the U.S. income tax system.  (This amount is very close to the Tax Foundation’s projection for 2013.)  Individuals spent 3.16 billion hours complying with the income tax code, which weighted by time spent by income group, costs the U.S. economy $216.2 billion annually.

Tax compliance costs are staggering, given the number of households that pay no federal income tax.  (Although these individuals pay no federal income tax, they still remain subject to federal social security, Medicare, and employment taxes.)  According to a study by the Urban/Brookings Tax Policy group, about 46 percent of American households (about 76 million families) owed no federal individual income tax in 2011 because of rules that provide basic exemptions for subsistence level income and for dependents. The other half are nontaxable because tax expenditures— special provisions of the tax code that benefit selected taxpayers or activities—wipe out tax liabilities and, in the case of refundable credits, result in net payments from the government, benefiting senior citizens and low-income working families with children. At these income levels, having to pay to prepare returns to claim over-withholding or a refundable credit is a regressive, unfair burden.  Surprisingly, 21.1 percent of the 10.5 million simplest, one-page, 1040EZ Forms filed in 2001 were also signed by a paid preparer representing over two million taxpayers. 

The federal income tax burden is borne by those in the top 50-percent of adjusted gross income (AGI), with the top 10-percent bearing most of the costs.  These taxpayers require the expertise of paid tax preparers.

With higher incomes, tax planning is both more important and valuable.  Accurate tax compliance is important at all income levels, but those in higher tax brackets have far more complicated tax returns and usually require many more forms and schedules that need to be filed with their returns.  It is the complex tax law and mix of income that makes the returns of these taxpayers so complicated and costly to prepare.

Federal law requires that the IRS disclose the estimated average taxpayer burden associated with preparation of tax filings.  Even the simplest individual return (Form 1040EZ with 43 pages of instructions), completed by 13-percent of filers, takes 7 hours to prepare and is likely to cost $50 in out of pocket expenses.  Another 19-percent of taxpayers can file an alternative simple individual return (Form 1040A with 88 pages of instructions) and should expect to spend 10 hours and $120 meeting their federal tax filing obligations.  According to 2011 estimates in its 100 pages of instructions, Form 1040 will take, on average 22 hours to prepare with $290 of out of pocket expenses.  If the taxpayer has business expenses, the time to complete the return might jump to 32 hours and cost $ 410 in out-of-pocket expenses.  The IRS cautions that “reported time and cost burdens are national averages and do not necessarily reflect a ‘typical’ case.”

For taxpayers in the higher AGI levels, the type of income varies significantly from lower brackets where income is largely composed of simple salaries and wages.  These individuals may be expatriates claiming foreign tax credits or earning foreign tax credits.  This could add an average of 5 hours to a return according to government estimates and require more sophisticated information gathering.  Business owners that need to account for depreciation and amortization could expect to spend almost 40 additional hours preparing an individual income tax return.  Having to account for a foreign business could add over 125 hours to individual return preparation.  Passive-type investments could add as much as 29 hours to return preparation, according to government estimates. And none of these estimates consider the increasing burden of state and local tax compliance. Professional preparers are likely to shave hours off of return preparation because of their familiarity with the law and access to specialized software programs.  In addition, they can be expected to identify tax planning opportunities.

The government estimates that it will take an additional 75 minutes to report foreign bank accounts (Form 90.22-1), but in 2011 that estimate is flawed.  Whenever a new form is issued, revised, or compliance requirement changed, as was the case with Form 90.22-1, it could take 5 to 10 hours for taxpayers to understand the new requirements and comply.  Rarely is it just a matter of filling out a new form.

It is not just about filing a return for high-income taxpayers.  Millionaires are more likely to get audited by the IRS.  The IRS said it audited 12.48 percent of individual tax returns with income exceeding $1 million during fiscal 2011, a high reached at a time of debate over the taxation of top earners.  Its announcement marks the third consecutive year that the IRS increased its audit rate on returns showing income of more than $1 million. According to IRS data, the previous record was the 8.36 percent of returns in that category audited during fiscal 2010.

Until Congress gets the message, taxpayers’ compliance burdens are likely to continue to increase.  It is unlikely that we will ever again see an individual income tax return as simple as the first individual income tax return in 1913, which was 4 pages long including instructions.  (The top tax rate in 1913 was 6-percent on taxable income over $500,000!)