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How can I file an electronic tax return for free?

With just over a month left to file his tax return, John in Chicago is steamed that he has to pay to file electronically. Turns out there's a little-used service that may let him-- and you --  e-file for free.
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With just over a month left to file his tax return, John in Chicago is steamed that he has to pay to file electronically. Turns out there's a little-used service that may let him-- and you -- e-file for free.

Free filing
If the IRS wants me to e-file, why do they insist that I have to go through a third party? I realize that this creates jobs, but it cost me money.
John U., Chicago, Ill.

It doesn’t have to. A little-used program offered by the IRS and tax prep software makers lets most Americans prepare and send in their returns electronically – for free.

The program, called Free File, was set up three years ago in a deal the IRS struck with companies that make tax preparation software. In return for not competing with them by developing its own tax preparation package, the IRS required tax software makers to provide a free version of their services to 70 percent of all taxpayers, according to an IRS spokeswoman. Because higher income taxpayers have more complicated returns, those with adjusted gross incomes in the top 30 percent aren't eligible. This year, the cutoff is about $50,000.

Aside from getting your return processed faster, filing electronically makes it much more likely your return will be error free. The IRS figures the error rate on electronic returns is about 1 percent, compared to an error rate for paper returns of more like 20 percent. The most common errors are failure to sign the return, math errors and incorrect Social Security number. (E-filing eliminates the last error because the IRS will promptly kick back an e-filed return with the wrong Social Security number.)

To use Free File, you’ll have to choose among the 20 providers that participate in the program. You enter your information into the preparer's Web site and then send the competed return electronically to the IRS. Each of these tax prep sites offers their own ways of guiding your through the process.

Free File is not completely free: you’ll have to pay a fee to prepare your state return, for example. And be prepared to get pitched a variety of paid services, including what are called refund anticipation loans – where the tax preparer offers to give you an “instant refund” – which is really just a way to charge you interest on a loan against the refund you’ll get in a few weeks anyway. (You don't have to sign up for any of the paid services to use the free site.)

So far, the three-year-old program is not widely used – possibly because the tax preparation companies would rather promote their paid software. Last year, only 5.1 million of the more than 92 million taxpayers who were eligible to for Free File - or about six percent - used the service. The rest of the 68 million people who filed electronically – just over half of all returns - paid a fee.

The IRS has looked at the idea of letting anyone file directly from any PC, without using one of its designated intermediaries, but the security problems are just too daunting. By restricting e-filing to a relatively small number tax preparers, the system can rely on secure, encrypted lines. If the system were open to anyone on the Internet, you could probably find a savvy 13-year-old who could set you up with a nice refund every year for the rest of your life.

I am a small business and produced a book for a New York community. It had paid advertising in it (to help with the production cost), but the book was to be sold and is on Amazon and other book retailers. I still have a very large quantity left and would like to donate them and get a tax write off. Please advise.  
Sally, Babylon, N.Y.

You’re going to have to come up with a way of determining the “fair market value” of these books, which is a bit dicey. The IRS could argue that if the books didn’t sell, they have no market value. In that case, the paid advertising is income and the cost of producing the unsold books is a business expense against a loss.

If you sold a few of them, you may be able to use that sales price as the value of each unsold book. You’ll also need to get the recipient of the donation to provide a receipt indicating the value of the gift, but that receipt is not proof of the books' market value.

If I won the lottery and wanted to give money to family and friends, who pays the taxes? Can you gift money pre-tax so they can pay at a lower tax amount (assuming that the person receiving the gift is a lower tax bracket)?
Thomas,Saint Paul, Minn.

Since you’re already fantasizing about winning the lottery, there’s no harm in fantasizing about making taxes go away.

But, alas, in the real land of lottery winnings, the tax first hits you the minute you win. There’s no way around that: lottery winnings are income, reported to the IRS. Even if you gave it away immediately, it was still your money -- if only for a moment. That makes it your income. And the IRS will want its share. 

Your tax bracket would be based on your total income for the calendar year. So if you collect a million in a lump sum, you’ll in the same bracket with all the other millionaires. For 2005, that would put you in the 35 percent bracket (meaning you’ll owe 35 cents of every dollar over $326,450.)

If, after you collect your winnings, you then decide to give the money away, you’re subject to gift taxes for any amount you give over $11,000 a year to any one individual. (You pay the tax, the person getting the money owes nothing.) The gift tax rate for 2005 starts at 18 percent and goes to 47 percent depending on how much you give. (Gifts to recognized charitable organizations aren’t taxed.)

You might try to lower your taxes by asking to have your lottery winnings spread out over, say, 20 years. But you’d probably lose in the long run. Taking $50,000 a year for 20 years is not the same as $1 million right now. That’s because the value of those $50,000 payments gradually melts away, year by year, as inflation wears away your spending power. If inflation continues at, say, 3 percent a year for the next 20 years, a $50,000 check paid in 2026 only would only have $27,190 worth of spending power in today’s dollars.

So when your ticket finally pays off, check with an accountant. If you win big, you may be better off paying taxes all at once.

I am an IT professional and I connect to my systems from home almost daily, can I deduct the cost of my internet?
Jerry S., Florence, Ala.

This one is pretty close to a “home office” deduction – which the IRS has made very difficult to claim. Some of the questions the IRS will want answers for include: 1) Does your employer require you to have this access from home as part of your job? 2) Do you use this exclusively for work?

If you claim this as an unreimbursed business expense, the bar is a bit lower, but those two questions will still need answers. (If you’re self-employed, this becomes a little easier, but question can still trip you up.)

If you don’t have solid “yes” answers, the IRS will likely argue that this is no different than the other forms of telecom you have hooked up to. You probably use to use your telephone for work related calls, but you’d have a hard time calling your monthly phone bill a business expense. Ditto trying to write off your cable hook-up - even if you watch a lot of shows about computers.