Jackson Hewitt Tries to Limit the Damage

Shares of the tax preparer recovered some ground lost Apr. 3 on news of a Justice Dept. investigation of five of its franchises for tax fraud

After the U.S. Justice Dept. and Internal Revenue Service said they were suing 24 people at five Jackson Hewitt Tax Services (JTX) franchises for depriving the Treasury of $70 million on Apr. 3, the company's stock price tumbled 18%. But the stock recovered some ground Apr. 4 after Jackson Hewitt emphasized that the lawsuit involves only a sliver of its business, and one analyst reportedly upgraded the stock following its plunge. Market players bid up the shares by 8.9% to $28.89 on the New York Stock Exchange Apr. 4.

Franchise owner Farrukh Sohail of Atlanta, Ga., and other defendants allegedly fostered an environment that encouraged fraudulent tax return preparation. Lawsuits claim that the defendants filed returns claiming refunds based on phony W-2s.

Defendants also did things like taking fuel tax credits in absurd amounts for customers not entitled to them, the government complaint said. One customer, who claimed in a tax return to be a barber, said he should have a tax credit for buying 25,000 gallons of gasoline for off-highway business use. The customer would have had to drive 1,370 miles each day, seven days a week, to consume that much fuel in one year, leaving little if any time to cut hair, the complaint alleges.

"I am deeply disturbed by the allegation that a major franchisee of the nation's second-largest tax preparation firm is intentionally preparing improper tax returns with inflated refunds," said IRS Commissioner Mark W. Everson in a statement Apr. 3. "I'm particularly concerned that many taxpayers of modest means could actually end up owing the government thousands of dollars if they claimed an improper refund."

Jackson Hewitt countered that the entities involved represent around 2% of its total revenue. "We do not believe that this matter is likely to have a material adverse effect on our financial position," the company said in a statement Apr. 3.

The problematic franchises prepared and filed over 105,000 federal income tax returns last year. They allegedly operate more than 125 Jackson Hewitt retail tax preparation stores in the Chicago, Atlanta, Detroit and Raleigh-Durham, N.C. areas. Jackson Hewitt has more than 6,500 locations nationwide.

Morgan Stanley reportedly upgraded the stock to equal-weight from underweight, saying that Tuesday's selloff on news of the investigation was overdone.

However, some saw the news as a red flag. "While the complaints are limited to the franchisee, who is responsible for errors made by its own offices, we think there's been some damage to the brand, which may impact customer acquisition and retention," Standard & Poor's Equity Research analyst Esther Kwon said in a research note. (S&P, like BusinessWeek.com, is owned by The McGraw-Hill Companies.) Kwon downgraded the stock to hold from buy, and trimmed her earnings per share forecast for fiscal year 2008 to $2.11 from $2.22 and cut a 12-month target price to $31 from $38.

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