What's Behind H&R Block's Free Tax Service

As tax season begins, the hard-pressed filing service has a new strategy: Give it away for free

By Ben Steverman

The 2011 tax season is under way and the airwaves are full of a deal that sounds too good to be true: For another month, Americans can visit their local H&R Block (HRB) office and file their taxes for no charge.

How and why would the nation's largest tax filer give its service away for free? In a nutshell: 1) H&R Block is being forced to scramble harder this tax season to compete with other filing services. 2) It's unable to offer a service that brought in customers in years past. 3) The "free taxes" offer isn't for everyone.

Here are the details:

What's the Catch?

The promotion only covers those filing the 1040EZ federal form, which is about 16 percent of H&R Block customers. The 1040EZ form covers only the very simplest tax issues. It can't be used by anyone who has dependents, makes more than $100,000 per year, is age 65 or older, claims adjustment to income like alimony or tuition deductions, or itemizes deductions. Thus, homeowners who deduct mortgage interest or people with large charitable contributions can't use the 1040EZ.

Even those customers who can use a 1040EZ will have to pay H&R Block extra to file any state income tax returns. Just seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—have no income tax.

The offer began on Jan. 14, when H&R Block's local offices started filing 2010 returns, and ends on Feb. 15. From Feb. 15 to Apr. 18 (the tax filing deadline is different this year because of a holiday on Apr. 15 in the District of Columbia), customers will be charged to file a 1040EZ at an H&R Block office. That's an important consideration for taxpayers who may still be waiting for key end-of-the-year paperwork.

What Does H&R Block Get Out of the Promotion?

The free returns aren't a charity project, even if many of H&R Block's early filers tend to be poorer people who want their tax refunds as soon as possible. "It's not about giving away business for free," says Amy McAnarney, H&R Block's senior vice-president for tax operations. One goal is to increase foot traffic at H&R Block offices. " 'Free' can be a very powerful word," she says. Until they arrive for their appointment, many of these new customers might not realize they actually need more complex tax forms—and thus will wind up paying for them.

Another goal is to attract younger taxpayers—those who can still use the 1040EZ—and win their loyalty in future years. The company estimates 55 percent of EZ filers will need to file a more complex form within two years.

Why This Year?

H&R Block's retail operation has been losing customers, with retail returns falling 6.1 percent last year. Morningstar (MORN) senior equity analyst Vishnu Lekraj says in-office tax preparation services continue to lose market share to tax software and websites, which can be much cheaper. "The taxpayer is becoming more and more comfortable doing their own taxes," he says.

Many software or online tax tools have already offered 1040EZ filings for free, including those from H&R Block and Intuit's (INTU) TurboTax. Last year, McAnarney says, H&R Block tried offering free 1040EZ returns in offices in three cities—Miami, New Orleans, and Atlanta—"and it was received very well."

Offering free returns is also part of the company's effort to bounce back from some rough years, analysts say. A rise in unemployment has hurt business for all tax preparers, with industrywide IRS filings dropping 1.7 percent last year, the largest decline since 1971.