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Jackson Hewitt Dragged Down by the IRS


The IRS is concerned that RALs create an incentive for a tax preparer to prepare a return that results in a refund, since if there is no refund there is no RAL.

"The avoidance of taxes is the only pursuit that still carries any reward."
John Maynard Keynes

Jackson Hewitt (JTX) declined significantly yesterday on news the IRS proposed regulation to ban refund anticipation loans, or RALs. Fear of the impact the new rules could have on JTX's business drove it and H&R Block (HRB) down, although HRB faired better as it had already been beaten down by company specific issues stemming from its subprime mortgage business.

RALs are originated to customers who don't want to wait a couple of weeks to get their tax refund from the IRS, and thus are willing to pay a 2-2.5% (capped at $95) fee to get their money right away. Though RALs are as controversial as payday loans that charge annualized triple digit interest rates, this is not the reason why the IRS is zeroing in them. After all, the IRS mandate is to collect taxes, not to legislate morality.

The IRS is concerned that RALs create an incentive for a tax preparer to prepare a return that results in a refund, since if there is no refund there is no RAL. Although RALs account for only about 25% of JTX's revenues, they carry a very high profit margin thus if taken away could wipe out 35-50% of the company's earnings.

Although it may appear that the IRS could simply disallow RALs, it is not that simple. Even in its own press release the IRS said the following (bold is mine):

"The final rules affirm a general rule in place for more than three decades that taxpayers, not the IRS, control their own tax return information held by preparers and, within appropriate limits and safeguards, taxpayers are able to direct preparers to disclose tax return information as taxpayers see fit. More than 60 percent of individual taxpayers use a preparer."

It is very difficult to prohibit consumers from providing their tax information to lending institutions or using future tax refund as collateral against which to borrow – it is the taxpayers' money after all. Remember, we use our tax information on a constant basis when we get almost any type credit.

Pacific Capital Bancorp (PCBC), one of JTX's partners that underwrites RALs originated by JTX said the following in its press release (bold is mine):

"Following discussions with the IRS and other industry participants, the Company believes that the Treasury Department and IRS are not considering the elimination or ban of RALs or similar products, but are considering changes in the manner in which RALs are offered to taxpayers."

The IRS's objective is to lessen the incentive for tax preparers to commit fraud, but I think they understand that getting rid of incentives completely is impractical. JTX's franchise operation accounts for 90% of its revenues, franchisees don't see a dime from RALs and JTX's financial partners (PCBC and HSBC) pay the company a flat fee. The same is true for HRB, which in its press release said the following:

"H&R Block's tax professionals are not compensated on the sale of ancillary products, so there is no incentive for them other than serving taxpayers' best interests. In addition, RALs are currently regulated by 10 federal laws and IRS rules."

It will take awhile for uncertainty around RALs to be resolved. The IRS is soliciting comments on the proposal until April 2008. The regulation is not likely to come out until November and probably won't take effect until 2009 tax season. There is a good chance that the IRS may pressure tax preparers to provide a flat fee product where the fee doesn't vary much by the size of the tax refund.

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