Part 1 of 2
Introduction
The recent IRS Restructuring and Reform Act of 1998 is aimed at “reorganizing” the IRS — an oxymoron to many. Spurred on by the media parade of IRS horror stories, Congress has enacted significant reforms for those ensnared by the IRS bureaucracy at the audit and collection levels. Taxpayers have new procedural rights and some of the more egregious abuses have been eliminated.
But the legislation’s underlying premise, that by passing a law IRS can be successfully reorganized as a “consumer-based” organization, is suspect. My recent encounters with IRS, as well as the chorus of complaints from tax attorneys, CPAs, and the public, demonstrate that the agency suffers from a siege-mentality, and its agents, especially the front-line audit and collection levels, too often have an arrogant and confrontational attitude — the exact opposite of a consumer-based orientation.
Also, IRS personnel are often over-worked, poorly trained in tax law, and are often more concerned with scoring points within the bureaucracy than providing fair and impartial administration of our tax laws. And the situation appears to be getting worse.
Much of the blame can be placed with Congress and its incessant need to gather campaign dollars from special interest groups, which causes it to draft complex and often incomprehensible tax legislation filled with special-interest loopholes (these tax breaks are then offset by tax increases, usually in the form of complex accounting changes). Congress passes this legislation without measuring the enforcement impact on IRS, and then it fails to provide the funds necessary to educate IRS agents regarding the changes. The result: Agents who have little or no understanding of the law they are supposed to enforce. At the audit level, if there are sophisticated legal issues presented, the auditor is often clueless as to the law. Traditionally, taxpayers could rely on IRS Appeals to rectify the situation, but the level of tax expertise at appeals has also dwindled.
Unfortunately, the new legislation does not address these issues. It assumes that structural changes within IRS, not a major upgrade in the attitude and skills of its agents, will fix the problems. While I’m skeptical, the changes do provide relief and expanded rights to taxpayers who have suffered at the mercy of unscrupulous or incompetent IRS agents.
It should be noted that the legislation relies on “safety-valves” within the system, rather than reducing the current tax and penalty burdens. When taxpayers are mistreated, they have new appeal rights and expanded Tax Court jurisdiction. But, those taxpayers who legitimately owe taxes, have significant assets and are not victimized by IRS in the audit or collection process will not benefit much from the new legislation. There are no amnesty programs or major breaks on the payment of taxes, penalties and interest for those who owe. However, any additional rights given to taxpayers is a blessing, and professionals representing taxpayers with collection problems should find the legislation a boon to their practices.
This legislation is focused almost entirely on reforming the IRS with respect to audits and collection. Investors however, enjoy an important change in the capital gains holding period which could lower their taxes.
Income Tax Changes
Capital Gains
In 1997, the capital gains rate for certain long-term investments held 18 months or longer was reduced from 28% to 20%. For taxpayers in the 15% bracket, the long-term capital gains rate was reduced to 10% while their taxable incomes remained in the 15% bracket. The new law lowers the holding period from 18 to 12 months for all sales occurring on or after January 1, 1998. This will reduce some complexity in computing the tax, but there remains multiple capital gains rates for various assets and holding periods.
- Example: If you bought $1,000 shares of XX stock on April 30, 1997 and sold it on May 1, 1998 for $1,000 profit, the new law is effective (you sold your stock after December 31, 1998) and you’ll pay $200 federal tax (or $100 if you were in the 15% bracket).
Roth IRA
Those converting to a Roth may elect to recognize all the income during 1998, rather than in equal installments over 4 years. This is an advantage if your income is low this year or if you may have expiring loss carry-forwards. Also, if you plan to marry next year and file a joint return, if your income will be greater in the future, then consider recognizing the conversion gain this year.
Those ineligible for a Roth conversion have until the due date of their return, plus extensions, to reconvert a Roth back to an IRA. Also, a surviving-spouse beneficiary of a 1998 Roth conversion may continue to defer income over the special 4-year period. Unfortunately, if a taxpayer names someone other than a spouse as the Roth beneficiary and the taxpayer dies within the 4-year period, the special 4-year period and the remaining income is claimed on the decedent’s final tax return.
Audits
Burden of Proof
In some situations, the burden of proof in tax cases on factual issues now shifts to IRS. While this provision is hotly debated in tax publications, it is not significant in most tax cases. Currently, taxpayers have the burden of proof (they must prove they are correct by a showing of 50.1% – called a “preponderance of the evidence”). Therefore, the shift to IRS will affect only those cases where there is no evidence or the evidence for and against the taxpayer is dead-even.
The shift will have the biggest impact when the taxpayer is the sole witness. Under old law, if the tax court did not believe the taxpayer and no other evidence was presented, the taxpayer lost because he or she could not prove their case by a preponderance of the evidence. Now, under the same situation, the taxpayer should win since the burden of proof is on IRS. In other words IRS must come forward and provide evidence supporting its position. Under old law, IRS could play defensively (sit back and attack the taxpayer’s evidence without providing evidence of its position), but now it must play offensively.
The actual impact of this new change is limited by numerous restrictions and requirements. This shift does not apply to corporations, trusts or partnerships with net worth exceeding $7 million. To shift the burden taxpayers must have reasonably cooperated with IRS and provided to IRS all reasonable requests for information; also taxpayers must have maintained records and substantiated items as required under present law. IRS could become more aggressive in seeking information to meet its new burden which could make audits more complex and expensive for taxpayers.
Tax Representative Confidentiality
The existing attorney-client confidentiality privilege will apply to non-attorneys authorized to practice before IRS in non-criminal tax administrative or court proceedings. Once again, this privilege is designed to protect non-attorneys who give advice from testifying about the advice given. This privilege does not extend to (and never has extended to) communications regarding the preparation of tax returns, therefore, it will be of little utility to representatives who advise taxpayers regarding issues on the tax returns prepared by the representative.
In a blow to the larger accounting firms, this new privilege does not apply to “corporate tax shelter” advice. Tax attorneys expect years of litigation over what is meant by a corporate tax shelter.
Attorney Fees
Fees and costs can be recovered from the date IRS first issues a proposed deficiency. There is no longer an hourly limit on attorney fees (additional fees may be awarded in difficult or complex cases, or where tax representation is not readily available). Also, those who represent a taxpayer on a “pro-bono” basis or for a nominal fee may recover full attorney’s fees.
Fees are awarded when IRS is not substantially justified in its position. If IRS has lost on similar issues in another U.S. Court of Appeal, attorneys fees may be awarded. In addition, if a taxpayer offers to settle with IRS and it refuses, if IRS does not win in court more than what was offered, the taxpayer may recover attorney’s fees, even though the taxpayer may have lost in court. This is similar to the rule in effect in U.S. District Courts.
Also, in tax collection matters, if IRS negligently disregards the law in connection with collecting your income tax, taxpayers may sue for civil damages up to $100,000. Negligence will occur if IRS does not follow its rules and regulations. This amount is increased to $1,000,000 if an IRS employee willfully violates the law governing collections.
Tax Collections
Innocent Spouse Relief
The most significant changes enacted by this new legislation involves innocent spouse relief. In the past, IRS aggressively pursued spouses who signed joint returns, even though an additional tax increase was caused by the other spouse. Often, the innocent spouse never received an audit notice and had been divorced or separated from the person with whom a joint return was filed. The biggest surprise, however, affected an innocent spouse’s new spouse who sometimes found his or her wages levied to pay the tax debts caused by a errant ex-spouse in the prior marriage!
Congress gratefully put an end to these abusive situations by enacting sweeping protections for innocent spouses that should eliminate the tax liability of an innocent spouse just because they happened to file a joint tax return. If a spouse is still married when audit time comes, innocent spouse relief has been extended to all “erroneous” income items (prior law required “grossly” erroneous income items). Now, if the spouse did not know or had no reason to know about any item of income or deduction, no matter how large or small, he or she can claim innocent spouse relief.
But the major beneficiaries of the new innocent spouse rules are spouses living apart for at least 12 months or who are divorced or legally separated. These spouses may make a “separate liability election” to be taxed only on their share of the income on the joint return. In essence, they can now file as married filing separately, and pay tax on their share of income only.
The spouse may make the separate liability election within 2 years after collection activity begins against the innocent spouse. Notice to the former spouse is not considered notice to the innocent spouse. The election does not apply unless the full amount of the tax shown on the joint return was paid in full. If a taxpayer makes a separate liability election, the Tax Court will have jurisdiction to determine the tax liability.
Note: There’s an interesting loophole in the way the election is made. For example, assume a husband and wife are married and living together when a notice of an audit is received. Husband tells wife he failed to report income of $100,000 on their joint return. He is not working, but his wife has a high-paying job.
Wife has 2 years from the date she receives notice to file as a separate taxpayer. She can live apart from husband for 12 months and thus become eligible to make the election. Then she has another 12 months to make the election. In effect, married couples can take advantage of the election even though they remain married! Eligibility is measured from the date the innocent spouse makes the election, not the date the audit notice was received.
Income is generally attributed to the party who earned it. If spouses co-own a business or investment, income is allocated in proportion to their ownership (usually 50/50). Personal deductions are usually allocated 50/50, unless one taxpayer establishes that a different allocation is more appropriate.
Also, the new innocent spouse provisions apply to all outstanding liabilities arising after the date of enactment, as well as unpaid liabilities on the date of enactment. Therefore, spouses with tax liabilities should determine whether they qualify for this new relief. The bottom line: spouses who may have had an arguable innocent spouse claim under old law could benefit greatly from the new law.
To prevent abuses, there are several exceptions preventing innocent spouse claims. Relief will be denied in those situations where IRS can demonstrate the innocent spouse had “actual knowledge” of the item causing the deficiency. There is a presumption that if the guilty spouse transfers assets to an innocent spouse within one year of the date when the first notice concerning the deficiency was mailed, the transfer was fraudulent and the separate liability election in unavailable. Transfers made in contemplation of divorce or separate maintenance are exempted. Also, the parties may rebut this presumption by showing the transaction was not intended to avoid tax or the payment of tax.
The innocent spouse cannot have transferred assets as part of a fraudulent scheme. IRS has the burden of establishing the transfer was part of an actual fraudulent scheme.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**