Corporate Tax Compliance:The Role of Internal and External PreparersKenneth Klassen, Univ. of Waterloo Petro Lisowsky, Univ. of IllinoisDevan Mescall, Univ. of Saskatchewan

2012 IRS Research Conference June 21, 2012

Disclaimer

Confidential tax return data are obtained from the IRS via the Large Business & International Division. These data are not publicly available.

Because tax return data are confidential and protected by data non-disclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate; no statistics with three or fewer observations are disclosed.

Any opinions are those of the authors and do not necessarily reflect the views of the Internal Revenue Service.

Overview

• How do companies incorporate tax incentives into their decisions?

• What is the process that leads some companies to use aggressive tax strategies?

• Does the tax advisor matter?– If the company internally prepares, will it

report differently for tax purposes?– Is there a difference between external

advisors depending on if they are also the auditors?

Research questions

• Specific questions addressed① Do internally-prepared tax returns

differ from those with an external advisor?

② Do auditor firm preparers differ from other preparers in the aggressiveness of the resulting tax positions?

③ Can we infer tax compliance work from public tax fee data?

Why are these questions important?

• The role of tax advisors is important to the working of the tax system– Renewed focus by IRS on role of preparers

• Tax advisory role is significant– $816 M in Tax Fees paid to Auditors in our

sample– Role of preparers in individual and non-profit

settings; little known in corporate setting• Tax fees are used extensively in research–What do they suggest about tax compliance

work, if anything? Can we use them? If so, how?

Survey

• Tax Executives Institute Survey– October - December 2010– 8.1% response rate– Our respondents: slightly larger than

TEI population– Tool to “look inside” the corporate tax

department

Theory

• Why choose one preparer over another and how does this affect tax reporting outcomes?

• Phillips and Sansing (1998)• Taxpayers have an aversion to audit

adjustments– Affects whether taxpayers file favorable

position if uncertain; more averse taxpayers will not file favorably.

Theory• Low Aversion Internally Prepare– Fees paid to hire advisor are greater than the

benefit of certainty from advisor’s research– Internally prepared returns signal favorable

positions

• Medium/High Aversion Hire External Advisor– Research causes favorable or unfavorable filing

• H1: Tax returns filed w/o external preparer will be more aggressive than those filed w/external preparer

Theory• Cripe and McAllister (2009) survey:– “Low Cost” was #1 reason to use auditor as preparer– 31% pay higher fees by foregoing auditor as preparer– To be rational, benefits from external non-preparer

must exceed incremental cost: “preparer quality” was #2 reason to not purchase tax services from auditor.

• If external non-auditors are higher quality, marginal taxpayers can report more favorably when uncertain.

• H2: Tax returns filed with a non-auditor external preparer will be more aggressive than those filed with an auditor preparer.

Research Design

Log(UTB EB) = f(INTERNAL PREP, OTHER PREP, Controls)

• OLS, Tobit, Multinomial Treatment Effects

• Tax Return, Compustat, FIN 48 disclosures,

Audit Analytics

Who Signs the Tax Return?

External Tax Preparer: is the Auditor 312 (20%) is not the Auditor 378 (25%)Total External 690Internal Tax Dept. 843 (55%)

81% disclose tax feespaid to the auditor

Main ResultsOLS Tobit Selection

Internal Prep 0.29 ** 0.35**

*  0.67 ***

Other Prep 0.22 * 0.27 * 0.55 **

Log Assets 0.92 *** 0.96**

* 0.90 ***

Pretax ROA -0.46 -0.54 -0.41

Foreign Income

3.48 *** 3.48 ** 3.27 **

NOL0.28 *** 0.30

*** 0.28 ***

R&D 2.50 ** 2.54 * 2.60 **

Leverage 0.08 0.11 0.05

n 1,5331,53

3 1,533

R2 60% *** 21%**

*

Tax reserve is 29-67% higher for Internal Prep

Tax reserve is 22-55% higher for Other Prep

Selection ModelInternal Prep Other Prep

Log Assets 0.66**

* -0.13

Pretax ROA -0.34 -0.88

Foreign Income 5.15 * -0.18

NOL -0.26 0.08

R&D -5.06 * 2.51

Leverage 0.80 -0.08

Non-tax fee ratio -1.64 * -2.07 *

n 843 378

Analysis with Tax Fee Data

• Because only tax fees paid to auditors are publicly disclosed, many have used them– As a proxy for tax planning level, use of the

auditor for compliance, or other features

• We attempt to replicate our results using tax fees– Are tax fees a reasonable proxy to infer

compliance?

• We cannot replicate the positive coefficient using tax fee data to infer tax preparer

Benchmark: Using Tax Returns

OLS Tobit

Non Auditor Prep 0.26 ** 0.32 **

All Controls YES YES

Adj./Pseudo R2 60% *** 20% ***

n 1,533 1,533

Non Auditor Prep = 1 if

Internal Prep=1 or Other Prep = 1

Iterations: Using Tax FeesNon Auditor Prep=1 if OLS Tobit

Tax Fees=0 -0.01 -0.03

Tax Fees/Total Fees < 1% -0.06 -0.06

Tax Fees/Total Fees < 5% -0.14 * -0.14

Tax Fees/Total Fees < 10% -0.13 -0.13

Tax Fees/Total Fees < 25% -0.30

** -0.35 ***

Tax Fees/Total Fees < 50% 0.86 1.17

Classification Accuracy

10-K suggests non-auditor prepares, but auditor prepares

10-K suggests auditor prepares, but a non-auditor prepares

Conclusion• Companies choose a variety of preparers, but

most do compliance and planning work internally

• Relative to companies with external auditor preparers– Companies with internally prepared returns are more

tax aggressive– Companies with external non-auditor prepared tax

returns are also more tax aggressive• Tax-fees are not sufficient to infer tax

compliance work– 20-62% inaccuracy rate

Thank You!lisowsky@illinois.edu