aper tax returns are going the way of the dinosaur and the dodo: The Internal Revenue Service (IRS) reported that more than 39.5 million individual taxpayers (73% of the total returns filed) had filed electronically by early March this year.

About 450 of the country's largest corporations have also electronically filed taxes early. Individual taxpayers still have a choice, but as of this year, large corporate taxpayers (those with over $50 million in assets) were required to e-file.

Uncle Sam is encouraging the trend because each electronic payment costs $0.53 less to process than paper returns and checks. The IRS also cites the decreased risk of error and the quick turnaround for those receiving refunds, although the quick turnaround for the IRS in receiving payments may also be a factor.

"Congress has given the IRS a mandate to increase electronic filing," said James Weaver, Chairman and Chief Executive Officer of Tier Technologies Inc., the parent company of Official Payments Corp., a processor that has worked with the IRS since 1999. "It is a much more efficient and economical way for the IRS to process payments. But the consumers are demanding it as well."

E-filing has had ripple effects in the credit card processing industry. The IRS started accepting credit/debit card payments for tax bills in 1999, and in 2005 credit card tax payments outnumbered electronic funds transfers by 310,000 payments.

So far this year, individual taxpayers have made 629,251 credit card tax payments for a total of $355 million and an increase of 41% over last year. Weaver expects that number to grow as the deadline approaches. "In general, those who expect a refund file early; those expecting to pay file later," he said.

"Consumers have embraced the option of using their payment card to settle tax obligations given the flexibility, security and the availability of rewards and loyalty points," said Adrienne Chambers, Vice President, Acceptance, of MasterCard International.

"Last year taxpayers paid over $260 million in federal tax obligations with MasterCard cards, up from nearly $200 million in 2004."

"We've seen an explosive growth," Weaver said. "In 1996, we processed 24,000 tax transactions and about $3 million in dollar volume. In 2005, it was 2.9 million transactions and nearly $2 billion in dollar volume."

The popularity of electronic filing and the proliferation of tax software programs are the primary factors driving the trend. "The home computer is increasingly replacing the paper tax form," said IRS Commissioner Mark W. Everson in a statement released by the IRS. "Both individual taxpayers and tax professionals are turning to e-file more and more because it's fast and accurate."

Businesses may now pay some taxes with plastic

The number of credit card tax payments is expected to skyrocket this year, when businesses will be allowed to pay with a credit card for the first time. The IRS will allow businesses to deduct their convenience fees as a business expense if they pay with a credit card, Weaver said.

The business taxes that can now be paid by credit card include the Form 940 series (Employer's Annual Federal Unemployment Tax Return) and Form 941 series (Employer's Quarterly Federal Tax Return).

Who's behind tax payment processing?

Only two third-party payment processors are licensed by the federal government to accept credit card payments: Reston, Va.-based Official Payments Corp., and Nashville, Tenn.-based Link2Gov Corp. (Pay1040.com).

Both processors charge a convenience fee to taxpayers for credit card payments, usually about 2.49% of the tax amount paid. The IRS does not charge extra for credit card payments.

In an Official Payments promotion, if you pay your tax bill online through a special Official Payments portal, MasterCard will reduce your convenience fee from 2.49% to 1.99% on payments made through April 17, 2006.

Incentives for paying taxes with plastic

Tax payments are becoming a lucrative opportunity, and various special promotions have sprung up to sweeten the deal. Some credit card issuers offer discounts or rebates on the tax payment convenience fees for using particular cards or particular portals; others offer extra bonus points or miles for using specific cards to make tax payments. (Some issuers, however, treat the tax payments as a cash advance, so the payments don't always earn mileage or rewards points.)

"I think, originally, banks saw this [tax payments made with credit cards] as a potential for losses," said Dennis Moroney, Senior Analyst for TowerGroup, a MasterCard-owned research firm. "But candidly, banks are scrambling to get volume on cards. Any opportunity to grow balances on cards that will drive revenue is being seized, and a tax payment can be a substantial chunk in one transaction."

United's Mileage Plus Visa card is offering double miles for federal and state personal income taxes, property taxes or quarterly estimated tax payments made on the Mileage Plus Visa.

American Express Co. is offering double Starpoints on Starwood's Preferred Guest Card holders' first $5,000 in personal federal tax payments made between March 1 and April 17, double miles for Delta SkyMiles Credit Card holders payments made between Feb. 1 and April 17, and Hilton HHonors Platinum Credit Card holders earn three points for every eligible dollar spent on federal, state and local tax payments.

H&R Block, the world's largest tax services company with nearly 21.6 million clients in the United States, in conjunction with Link2Gov, is marketing a promotion that blocks some convenience fees for some individual tax payers.

H&R Block customers that come into an H&R Block office or pay from H&R Block'sTaxCut Online programs (through special links arranged with Visa) pay no convenience fees if they pay using a Visa debit card. If the H&R Block customer pays with a Visa credit card, the standard fee is reduced to 1.99%.

H&R Block TaxCut Online clients, who pay their balances using a MasterCard debit card, will pay no convenience fee. If they use a MasterCard credit card, the taxpayer will receive a convenience fee rebate on the first $350 of the tax payment. In addition to Visa and MasterCard, H&R Block clients can also make tax payments using their American Express and Discover cards.

"While every taxpayer obviously prefers a refund, the reality is that many Americans owe taxes at the end of the year, so it's important that we help make paying in full as efficient and low-cost as possible," said Tim Gokey, President of Tax Services for H&R Block. "Our collaboration with the credit card companies and Link2Gov ... helps our clients reduce or eliminate fees that would add costs. It is a more convenient, less expensive way to pay in full."

"Convenience, rewards and cash management are the main reasons people use credit cards to pay their taxes," Weaver said. "They can know instantly that their payment is recorded and not have to worry about a piece of postal mail arriving postmarked correctly. And, unlike the IRS payment plans, they can pay their tax bills over time, but in the manner they see fit."

The risks

Some consumer advocates are concerned that the convenience of paying by credit card can distract taxpayers from the real cost of doing so.

When making payments on a tax debt with the IRS, interest (compounded daily) is charged on any unpaid tax from the due date of the return until the date of payment. The interest rate is the federal short-term rate plus 3%. According to Moroney, the average interest on a revolving credit card balance is 12%, which is considerably higher than either the IRS payment stricture or a conventional bank loan.

"In the segment of the population that most needs to use a credit card balance to pay off these kinds or debts, the interest rate may be far north of 12%," he said. "In addition, the recent [Office of the Comptroller of the Currency] OCC ruling about minimum payments can certainly affect these people.

"Plopping a tax payment of several thousand dollars on top of an existing balance can drive that minimum up, it could come as quite a shock to some people. That segment of the population can get hit by a double whammy, and they're often the ones least likely to have alternatives."

Each year since 1996 the IRS has added new programs, or tax forms, that can be paid by credit card, to encourage e-filing and prompt payment.

"In the beginning, the IRS didn't allow delinquent taxpayers to pay by credit card," Weaver said. "They changed that, and it makes a lot of sense. Being able to pay by credit card makes it easier to get paid up: The taxpayer doesn't have to go in to the IRS and set up payments; some people are very intimidated by that. "And if they want to pay more one month and less the next, they can do that, too. Making it easier for delinquent taxpayers to pay saves the IRS the expense of going after those people." According to Chambers, 1.5 million taxpayers paid their taxes by payment card in 2005, a 53% increase over the prior year. "Cardholders tell MasterCard they find paying taxes by card to be convenient, fast, flexible and secure," she said.

Tax refunds in the form of prepaid debit cards

Recently, refunds as well as payments have entered the card processing arena.

JPMorgan Chase & Co. recently announced the rollout of prepaid debit cards to speed payment of tax refunds to low-income tax filers without bank accounts.

The Chase Direct Benefit Card allows taxpayers to get their refund in a debit card instead of a paper check, eliminating check cashing fees and allowing consumers to access their refund at stores, ATMs and online. The card is being marketed toward people who qualify for refunds under the Earned Income Tax Credit.

"The Chase Direct Benefit Card provides an alternative banking service for consumers without bank accounts. Participants in this program will get their refunds faster, eliminate check cashing fees and not have to worry about carrying around cash," said Mark A. Willis, Executive Vice President, JPMorgan Chase Community Development Group (CDG).

The JPMorgan Chase CDG is working with the Volunteer Income Tax Assistance (VITA) in 15 cities to promote awareness of its benefit card. VITA offers taxpayers with low-to-moderate-income ($38,000 and below) free tax information and assistance in completing tax returns. Most locations also offer free electronic tax filing.

"Chase doing this is a big deal," Moroney said. "It's not just the money involved, but the fact that they are finding ways to make nontraditional entrances into a very large market segment: the unbanked.

"I think in the future, we'll see a lot more of these kinds of things: a lot more nontraditional alliances, aimed not only at driving new sources of revenue but at offering immediate rewards and reaching directly to the consumer at a point-of-sale level. We'll see a lot more creative approaches as issuers try to manage households by understanding what their consumers are doing in real-time, or close to it."