The era of the tax advance is over, the final chapter in a case study of how businesses can reap billions of dollars from the unintended consequences of government policies.
These high-cost, short-term loans were designed to take advantage of the inefficiency of the Internal Revenue Service, plugging the gap between when taxpayers filed returns and when their refunds came through — very much like a payday loan. An overhaul of the federal tax code intended to put more money in the hands of low-income families sent demand for the advances skyrocketing. At the industry’s peak in the 2000s, more than 12 million people a year took out refund anticipation loans — and paid more than $1 billion in fees.
“Some of the worst impulses just simply took over,” said Mark Ernst, former deputy IRS commissioner and former chief executive of H&R Block.
Although the loans gave many taxpayers faster access to money, federal investigations found the industry fraught with fraud, inaccurate information and murky disclosures.
Now, a confluence of new regulations, improved technology and an uproar from consumers is sounding the death knell for the once-lucrative loans. Industry giants such as JPMorgan Chase and H&R Block have stopped offering them, and the market has shrunk to one-third of its size during its heyday. Only one bank is still providing the loans this year — for one last tax season.
The concept of tax advance loans emerged in the late 1980s. Personal computers were growing popular, and the IRS planned to modernize its stores of data by digitizing tax returns.
To pilot the program, the government turned to tax preparers, who had the resources to invest in technology and training.
Ross Longfield, a former executive at Beneficial Corp., now part of HSBC, said his firm tested the service in a few cities. “It was mildly successful, but the bottom line was there was no reason for people to do it,” he said. “Even though it promised faster refunds, it wasn’t that much faster.”
The IRS often took a month or longer to process refunds, and checks were mailed to taxpayers’ homes. Longfield said customers reported the money being stolen from their mailboxes. The IRS also tested electronically depositing refunds into bank accounts, but many lower-income taxpayers did not have accounts.
The agency had set ambitious goals for electronic filings and encouraged companies to come up with solutions, Longfield said. The ultimate incentive for consumers to file electronically would be a nearly instant tax refund — money they could put in their wallets within a day or two of leaving Beneficial’s offices.
In 1989, Longfield patented the process for what would become known as the tax advance, or, in industry jargon, refund anticipation loan. Beneficial calculated the estimated refund when it filed a customer’s tax returns, then issued loans for the same amount, minus fees. When the IRS processed the return, Beneficial took the refund as the payoff for the loan.
Longfield said the industry agreed to safeguards to prevent loan sharks from entering the market: Fees could not be calculated as a percentage of the refund, and only regulated banks could make the loans. Longfield said it was banks that got hit when IRS glitches delayed refund payments by weeks.
“It creates a buffer between . . . the IRS and the taxpayer,” he said. “The ones who suffer, if you will, will be the banks, and they can afford to suffer.”
In the 1990s, two changes to tax policy drove demand for the loans to skyrocket.
First, Congress expanded the earned income tax credit (EITC) in an effort to help low-income working families keep more of their paychecks and stay off welfare. Not only did more Americans become eligible for the credit, but their annual refunds increased dramatically.
According to John Wancheck of the Center for Budget and Policy Priorities, the maximum refund for a family with two children more than doubled from $1,511 in 1993 to $3,556 in 1996.
Getting the money, however, required filling out an extra form in each tax return, Wancheck said. The added step encouraged many workers to turn to tax preparers for help. In addition, the refund was often the biggest lump sum these taxpayers would receive all year — and they wanted it as quickly as possible.
“A good aspect of it was the [tax preparation] industry was promoting awareness of the EITC,” he said. “Of course, it had a self-serving purpose, too.”
Beneficial’s banking division pioneered the field by partnering with H&R Block to offer “instant refunds” or “tax advances.” Soon, major banks such as JPMorgan Chase and HSBC joined in.
One main challenge in the industry was underwriting what were essentially short-term loans to a risky population. If the refund was less than expected, people had to repay the balance — and banks often had to expend considerable resources to get it.
So the industry pressed the IRS to share a key piece of data, now known as the debt indicator. The code reflects whether the IRS will divert part of a taxpayer’s refund to pay outstanding bills, such as child support or federal student loans. If banks could have this information, they argued, they could make better lending decisions, reduce risk for the industry and consumers, and bring down prices.
The IRS agreed, but it soon regretted the move. As concerns over fraud in the industry mounted, the agency briefly stopped providing the debt indicator to tax preparers in the mid-1990s. But it soon returned amid lobbying by the industry and new promises of lower prices and fuller disclosures.
“We went into it with really good intentions,” said Ernst, who, as head of H&R Block, pressed the IRS to reinstate the debt indicator. “Over time what we found . . . is that consumers were very price-insensitive. They didn’t really know what they were paying. Whatever price concessions were promised by the industry, they long ago had been taken back.”
Tax advances peaked in 2002, with 13 million people taking out the loans. More than half of those who received the earned income tax credit signed up for the service, and the industry brought in $1.1 billion annually.
That caught the attention of consumer advocates. Because the refunds seemed like “free money,” many customers paid little attention to the fees they were paying. In some cases, tax preparers were not disclosing the information.
A National Consumer Law Center report in 2002 described three fees consumers paid for tax advances: an electronic filing fee, a preparation fee and a loan fee. Together, they typically amounted to $129 to $429. The NCLC said that amounted to an annual percentage rate of 67 to 774 percent for what usually was a 10-day loan.
“It sort of all came together, the realization that tax preparation was a little bit of the Wild West out there,” said Chi Chi Wu, a staff attorney. “The refund anticipation loans were contributing to that.”
In 2007, the Justice Department sued several of Jackson Hewitt’s major franchisers, alleging more than $70 million in fraud. The complaint described inflated tax returns, including a barber who claimed he was eligible for tax credits for buying 25,000 gallons of fuel in one year — the equivalent of a 1,370-mile commute each day.
The franchisers agreed to settle the case and leave the industry.
In a 2008 report, the Government Accountability Office recounted tax advances being peddled out of a trailer in a gas station parking lot and auto dealers marketing the loans as down payments for used cars.
When the financial crisis hit, public sentiment against such risky, high-cost loans swelled, and lawmakers and regulators searched for ways to curtail the industry.
Reenter Ernst. He resigned as head of H&R Block in 2007 amid millions of dollars in losses on subprime mortgages. He landed at the IRS as a deputy commissioner and quickly was named to lead a task force charged with scrutinizing tax advances. He zeroed in on the debt indicator.
“Having come from the industry, I knew what it was that enabled this product to exist and what would happen if certain of those enablers didn’t exist anymore,” he said. “This one policy tool that had been given to the industry was the thing that was holding the product together.”
Ernst said that after he lobbied to keep the debt indicator while at H&R Block, he tried to make good on the promise of lower prices, partly out of fear of more draconian regulations if he didn’t. But he said his competitors never followed suit, and customers didn’t seem to mind.
“Frankly, people were making too much money,” he said. “The industry, for its own sake, needed to reform.”
By 2010, Ernst’s task force had its answer for the tax advance industry: The debt indicator was going away for good.
Post-financial crisis, banking regulators did not look favorably on loans made without the underwriting tool of the debt indicator. On Christmas Eve 2010, H&R Block said its partner bank, HSBC, would no longer provide tax loans after receiving a notice of concern from the Office of the Comptroller of the Currency. JPMorgan Chase, one of the three biggest providers of tax advances, had pulled out of the market earlier that year.
This tax season marks the final year that a bank can offer the loans. Republic Bank, based in Kentucky, is the lone holdout. Early last year, the Federal Deposit Insurance Corp. notified the bank that extending the loans without the debt indicator compromised its “safety and soundness.” The regulator also alleged numerous violations, including failure to disclose the annual percentage rate and discrimination based on marital status. The FDIC said nearly half the tax preparation centers it visited that distributed Republic’s loans committed three or more regulatory violations.
The FDIC proposed a $2 million fine. Republic settled the case for $900,000 late last year and agreed it would stop making tax advance loans.
Some analysts say the industry was on its last legs anyway. Advances in technology have shortened the time it takes for the IRS to process refunds to a week or two, reducing demand for the loans.
But others say that the loans filled a critical niche in many consumers’ budgets and that demand was inelastic.
“The people who think they know more than the consumer does and what’s good for them — and that’s an opinion — decided that they don’t like this, that people shouldn’t have to pay to get their money faster,” Longfield said. “The pendulum, as it always does, swings too far in the other direction.”
Tax preparers have developed alternatives to tax loans for customers who do not have bank accounts. Refund anticipation checks or prepaid cards allow customers to deduct the cost of tax preparation from their refunds. Also, some non-banks have begun offering tax advance loans on a more limited basis.
According to the NCLC, about 5 million tax loans were made
last year, generating roughly $338 million in fees — one-third of the size of the market at its height. It is expected to shrink even more this year.
“It had kind of served its purpose to solve a problem when people weren’t getting refunds as quickly as before,” Ernst said. “The need to enable an industry to exist to accelerate refunds, we didn’t believe that was a good policy choice.”