By Russ Wiles
Gannett News Service

The tax-return filing season is kicking off this year with a controversy related to privacy concerns.

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At least two tax-software firms are upset with a new Internal Revenue Service directive requiring them to identify or flag returns filed for free.

The controversy could undermine enthusiasm for the Free File Alliance, an IRS-industry partnership started last year to encourage paper-free filing of tax returns. The IRS will begin accepting electronic returns through the free service later this month.

The alliance accounted for 2.8 million returns out of the 53 million filed electronically for tax year 2002.

Among the dissenters is Intuit's Turbo Tax, which accounted for 1.2 million free returns last year, or 43 percent of the total. The company objects to the IRS directive, adopted last fall, on grounds it could undermine taxpayer privacy.

"Intuit vehemently opposes electric tagging because we truly believe it will compromise the privacy of our customers," said Julie Miller, a Turbo Tax spokeswoman.

Intuit won't flag returns but will continue participating in the free service, she said.

Meanwhile, Petz Enterprises of Tracy, Calif., which runs TaxBrain, is withdrawing from the alliance altogether.

Company spokesman Craig Petz views the IRS directive as a "back-door mechanism for regulating the (tax-software) industry" and complains that taxpayers shouldn't have to provide information about how they prepare returns and who they hire to assist them.

Some wonder if flagging returns from the free service could boost the risk of an audit.

"The problem is that the IRS collects data like this and then doesn't tell anyone the 'formula' for identifying returns for audit," said Bob Kamman, a Phoenix tax preparer and attorney.

In an interview with webcpa.com, a news service for tax preparers, Terry Lutes, an IRS deputy chief for information technology, denied taxpayer privacy might be compromised.

"At the IRS, taxpayers' privacy is protected unequivocally. To suggest differently is flat-out wrong," he said. "We have processed more than 300 million tax returns since the inception of electronic filing and have never once compromised the privacy of a taxpayer," he said.

The IRS has used such data in the past to follow e-filing trends, and has long been able to tell whether a return was prepared by tax software, volunteers or IRS walk-in locations, he told the news service.

Electronic filing accounted for 40 percent of all personal returns for tax year 2002. The free option debuted last year after the IRS signed a deal with a couple of dozen tax-software firms, most of which offer a free service in limited form.

For example, Turbo Tax offers free filing to people 22 and younger, to those 62 and older, to active military personnel and to people eligible for the earned-income credit.

The IRS list of Free File Alliance members with eligibility requirements for each will be available at www.irs.gov later this month.