The Benefits of XML Implementation for Tax Filing and Compliance
By Stephen C. Gara, Khondkar E. Karim, and Robert E. PinskerDECEMBER 2005 - Tax complexity increases with each annual enactment of legislation by Congress. This complexity has forced greater numbers of taxpayers to turn to professional tax-return preparers. Taxpayers face substantial recordkeeping and compliance costs under the present tax system. Moreover, the government faces substantial administration and enforcement costs. Greater complexity, increased filings, and reduced budgets have traditionally strained the government’s ability to effectively administer the nation’s tax laws. The overall audit rate hovers around 2%, and examinations may frequently take months and even years to resolve, due partly to the voluminous documentation that needs to be analyzed.
Fortunately, recent technologies have reduced this compliance burden. The majority of tax returns are prepared utilizing software that produces completed returns for mailing or electronic filing. The government faces a congressionally mandated goal that 80% of returns be e-filed by 2007. Whether this goal will be met is still unclear. E-filing, however, offers advantages to both the taxpayer and the government. The taxpayer benefits from immediate confirmation of filing and quicker refunds. The government benefits from quicker and more accurate return processing.
A new technological advance to lessen tax compliance costs is extensible markup language (XML).
XML is an Internet-based information-content standard. It provides context to information to facilitate its dissemination via the Internet. XML provides a grammatical structure to define and tag data, both textual and numerical, for use across various applications, such as spreadsheets and tax-preparation software. It provides a framework that facilitates the description of data and the sharing of it across applications, servers, and systems. XML provides a mechanism to attach uniform tags, or labels, to data that is then transmitted, typically via the Internet, to others. The tags allow the data to be recognized by various applications across a multitude of systems.
XML’s biggest contribution is the ability to transmit, receive, and share information without data re-entry, enabling greater automation and less redundancy. Data coded, or tagged, with XML can be uploaded or downloaded into multiple applications by multiple users without manual intervention or translation. Financial data, for example, may be downloaded straight from a company website into a spreadsheet application for immediate analysis (A. Thomas, K. Ramin, and M. Willis, “New Languages of Transformation,” European Business Forum, 2004). The power of XML, however, lies in the development of the tags, which rely upon uniform standards known as XML schema that are created by a diverse international consortium.
The most recognized specification of XML for the purposes of financial reporting is the extensible business reporting language (XBRL). XBRL is a variation of XML in which financial statement data is tagged based upon various GAAP standards, such as U.S. GAAP and International Financial Accounting Standards. XBRL has been under development for several years and is being utilized by many organizations, including public companies and regulators. For example, the United Kingdom’s Inland Revenue allows corporate tax returns to be filed automatically using XBRL-tagged data.
XML and the IRS
The growth and usage of XML-based applications in the realm of U.S. federal taxation is tied closely with the e-filing initiative imposed by Congress in 1998. As part of the IRS Restructuring and Reform Act of 1998 (IRSRRA), the IRS is obligated to have 80% of all returns e-filed by 2007. As of 2004, over 50% of returns were filed electronically.
There are several reasons for this initiative. E-filing shortens the processing time for returns and reduces error rates, as return data is no longer rekeyed into the IRS’s systems. Faster processing results in quicker refunds for taxpayers, and lower error rates result in fewer false audits by the IRS. Above all, e-filing lowers the cost of processing returns, thereby increasing the IRS’s revenue yield. The IRS estimates that, through e-filing, processing costs are reduced from $5 per return to less than $2.
While e-filing refers primarily to the means of transmission of return data (i.e., electronic as opposed to postal), it does necessitate changes in content format as well. Electronic transmission requires that the return data already be in electronic format. While there is more than one format available, XML-based applications present the strongest and most versatile format.
The IRS has begun developing XML-based schema for various tax returns. This project addresses three series of federal tax returns: IRS Forms 94X, 990, and 1120. XML implementation of other forms is likely, particularly the 1065 and 1041 series for partnerships and trusts or estates. California has even developed XML-based sales tax filings.
The Form 94X series (e.g., IRS Forms 940, 941, and 945) is used by employers to file quarterly and annual employment tax returns that report liability for employer Social Security and unemployment taxes, as well as withholding for employee Social Security and income taxes. The XML implementation of these forms started in 2003, and is part of a joint collaboration with various state authorities. Aside from benefits of speed and accuracy, this joint implementation will also reduce the redundancy of multiple state and federal filings faced by employers.
Form 1120, the corporate tax return, accounts for over 85% of the total data items used by the IRS; each form often consists of over 35 pages of data. XML-based filings of Form 1120 would automate a substantial amount of tax data currently collected by taxpayers and processed by the IRS. Furthermore, corporate use of XBRL for financial reporting would provide a valuable link between tax and financial reporting.
IRS Form 990 is used by tax-exempt organizations, and is filed not only with the IRS but usually with state authorities as well. It is publicly available, and thus serves as both a tax return and a financial statement, revealing the organization’s financial operations.
While implementation and usage of XML-based tax filings will produce benefits for the IRS, perhaps the greatest beneficiaries are taxpayers. Corporate taxpayers are likely to benefit both from their adoption of XBRL for financial reporting and from its links to an XML-based tax filing system. Tax-exempt organizations will also likely benefit from the use of XML, as it will not only ease their compliance costs, but also increase the transparency of their operations.
Corporate taxpayers, particularly public companies, are likely to be the first to use XML for tax-return preparation and filing. The SEC has offered strong incentives for registrants to use XBRL for financial reporting. The use of another XML application for tax reporting is a logical next step. The taxonomy of tax reporting defines a way to format tax information so that the many heterogeneous systems within and outside tax administrations, including legacy systems, can capture, transmit, and store data consistently. It allows clear identification of items by using tax terminology.
The use of XML would ease tax compliance and create lower costs for taxpayers. The result will be shorter audit-cycle times, fewer errors, easier integration, and reduced costs for validating returns. It would also allow easier transitions when there are tax changes. Additionally, the adoption of reporting in XBRL by other regulators will further streamline companies’ accounting functions and systems. A single XML-based accounting system could prepare required reports for filing with the SEC, the IRS, and other agencies and users, all from a single data source.
Aside from increased links between financial and tax reporting, the use of XML for tax compliance will greatly facilitate the audit process. Companies using XML for tax and financial reporting will have supporting data in a digital format. As a result, IRS requests for schedules and other records can be answered almost instantaneously. Examinations can be completed in a shorter timeframe, and at a lower cost for both the taxpayer and the government.
Individuals, with needs very different from a business’, are likely to start using XML for tax-return preparation and filing. Unlike a business, an individual’s tax return is likely the only substantial accounting documentation prepared.
Unfortunately, the IRS’s current XML initiative does not include the common Form 1040 for individual taxpayers. A number of personal financial software vendors, however, have started implementing XBRL add-ins for their products (e.g., Intuit’s Quicken and Microsoft’s Money and Excel). Accordingly, individuals soon will possess the means to prepare, save, and produce accounting records electronically in XBRL format.
Individuals will be impacted in a number of ways. Once the IRS has developed an XML format for Form 1040, individual taxpayers will be able to seamlessly integrate their personal financial software or Excel spreadsheet data into their tax filings, which will greatly simplify the tax-filing process. Additionally, tax filings will be quicker and less error prone. Individuals will also be able to analyze their tax and financial data at the same time as part of an integrative financial-planning scenario. Because XML is nonproprietary, data is not be locked into a single application. Data can be exchanged between applications, including spreadsheets and personal financial software packages.
There are over 1.5 million exempt organizations in the United States, and they make up a significant part of the economy, almost 10% of the gross domestic product and 10% of the workforce (M.J Gross, R.F. Larkin, and J.H. McCarthy, Financial and Accounting Guide for Non-Profit Organizations, 2000).
Exempt organizations are not subject to the same market forces and oversight as are public companies. External oversight of exempt organizations rests with state authorities and the IRS. Instead of investors and creditors, an exempt organization possesses donors or members. Exempt organizations are generally required to file an annual return with the IRS—Form 990—and an annual report with the relevant state agency, though many states simply accept a copy of Form 990. Form 990 includes information on the organization’s exempt mission, finances, contributions, expenditures, and fundraising, as well as the names of the organization’s trustees, officers, and highly compensated employees. While these reports are publicly available, they consist of paper forms that must be copied and transcribed or rekeyed for further analysis.
The reporting system for exempt organizations begins with the preparation of Form 990, which may be prepared manually or electronically. The return is then mailed to the IRS and possibly one or more state agencies. The returns are received by the IRS, and possibly state agencies, and rekeyed manually into their own systems, as well as scanned onto a CD-ROM that is forwarded to the National Center for Charitable Statistics (NCCS) and GuideStar. Both the NCCS and GuideStar upload the forms, as pdf files, to their respective websites, for public viewing and download. Additionally, members of the public may contact exempt organizations directly for a copy of their Form 990.
One improvement in XML usage would be the electronic filing of an exempt organization’s Form 990 with the IRS and the state. This would eliminate rekeying the data from the form into the IRS’s systems, as well the states’ systems. The adoption of XML for Form 990 would further improve public access to exempt organizations’ financial and operational data (C. A. Strand, B.L. McGuire, L.A. Watson, and C. Hoffman, “The XBRL Potential,” Strategic Finance, 2001).
With XML, an organization’s Form 990 data would be publicly available within days. Additionally, prospective donors or organization members could download the data directly into their spreadsheet application and perform their own analysis, cross-sectional or times series, of the organization’s performance. The public, media, and government officials would have nearly immediate access and use of an exempt organization’s performance results. This would facilitate greater public and governmental oversight of the nonprofit sector, similar to the oversight provided by regulators and investors over public companies, via XBRL filing with the SEC’s EDGAR system.
There are speculations concerning how XML will transform tax compliance and reporting. Organizations worldwide cumulatively spend billions every year to find and rekey business information (H. Stock, “XBRL Coding Slowly Gains Momentum,” Investor Relations Business, 2003). XML eliminates the bulk of these costs and provides faster and more-accurate tax compliance.
The recent momentum of XML has pushed these efficiency and transparency issues into the limelight. As a result, several XML-enabled software packages are available at a reasonable cost to governmental entities, companies, and individuals for gathering and comparing critical business information.
Stephen C. Gara, PhD, CPA, is an associate professor of accounting at Drake University, Des Moines, Iowa,
Khondkar E. Karim, DBA, CPA, is an associate professor of accounting at the Rochester Institute of Technology, Rochester, N.Y., and
Robert E. Pinsker, PhD, CPA, is an assistant professor of accounting at Old Dominion University, Norfolk, Va.