In Depth April 2, 2009, 5:00PM EST

A Boom for Tax Prep

New tax breaks will drive fresh customers to H&R Block, Liberty Tax, and others. But the IRS fears increased fraud in the unregulated industry

By Ben Elgin, Keith Epstein and Brian Grow

As federal stimulus dollars begin to flow, one unlikely beneficiary is the $30 billion tax-preparation industry. Prep specialists from top dog H&R Block (HRB) on down are celebrating as the Apr. 15 deadline approaches. The fresh treat: billions of dollars in new and expanded tax credits for individuals and small companies.

The good news for tax preparers could turn into bad news for the IRS, however, as well as an early illustration of what might be many unintended consequences stemming from the stimulus.

Tax-prep pioneer John Hewitt calls the huge federal spending package "the H&R Block and Liberty Tax Stimulus Plan." Twenty-seven years ago, Hewitt founded Jackson Hewitt Tax Service (JTX), the second-largest chain in the business. He now runs No. 3 Liberty Tax Service.

Hewitt has instructed his staff to explore leasing additional stores being vacated by Starbucks and other victims of the recession. "I love it whenever [lawmakers] pass tax changes," he says. "This one helps us because there are more tax changes that affect more people than any bill I've ever seen."

The mood is less cheerful at the IRS. Officials there are girding for a wave of questionable credit claims and outright fraud. A major problem, explains Nina E. Olson, the IRS taxpayer advocate (or ombudsman), is that most tax preparers are unregulated. The vast majority aren't licensed accountants or lawyers. Only three states—California, Maryland, and Oregon—certify tax preparers. In an industry of more than 1 million service providers, the IRS imposes fewer than 300 penalties a year, most quite modest.

"There are too many areas of this country where you have to go through more work to be licensed as a beautician than to do someone's taxes," says Representative Xavier Becerra of California. A senior Democrat on the House Ways & Means Committee, he plans to introduce legislation this year to require that all preparers register with the IRS.

Olson fears that preparers will exploit the stimulus initiative's multibillion-dollar expansion of the Earned Income Tax Credit, which last year transferred $47 billion to low-income families. The inspector general of the Treasury Dept. estimates that, even before the stimulus, the EITC was resulting in $10 billion to $13 billion a year in improper claims, many of which the agency contends are encouraged by unscrupulous preparers. While prep companies aren't supposed to charge fees based on how much money they obtain from the IRS, in practice many set higher prices for customers seeking refunds.

The stimulus package also includes new or enlarged tax benefits for small businesses, first-time home buyers, certain parents and retirees, and people who improve the energy efficiency of their dwellings—all of which are susceptible to abuse in the hands of dishonest or incompetent tax preparers, says Olson. "Some of the provisions in the economic stimulus legislation will dwarf the EITC in terms of rate of fraud," she predicts.

An estimated 60% of all tax returns are handled by paid preparers, up from 48% in 1990. The preparers have plenty to dig their teeth into: The stimulus legislation enacted in February provides for $154 billion in additional refundable tax credits to families and small businesses over the next three years. Using proprietary software, prep companies charge $200 to $450 for a basic return, with the fees often set toward the high end of the range if the taxpayer receives a credit-related refund. This creates a strong incentive to encourage customers to seek credits based on their income, number of children, willingness to insulate their homes, or a purchase of real estate.

Even when done properly, the tax-prep business can yield impressive profits. "We were charging people $300 to $400 for 10 minutes of work," says Greg Gillihan, who ran a franchise in Kansas City in 2007 for the fourth-largest chain, Dayton-based Instant Tax Service, which has 1,200 offices.

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