Audits, Collections and the New Taxpayer Bill of Rights
Tax time is rapidly approaching, and although most people associate April 15th with filing tax returns, it is also the time when the IRS is likely to send notices for back taxes. This newsletter discusses some recent developments involving IRS-taxpayer disputes and the practical steps you should take if the IRS says you owe money.
The Taxpayer Bill of Rights
In 1988, the Congress passed the Taxpayer Bill of Rights — over the objection of the IRS — to curb the egregious conduct displayed by some over-zealous IRS agents attempting to collect taxes. Congress changed the rules regarding IRS – taxpayer conferences, collections efforts by the IRS, and in a surprising move, permitted taxpayers to sue the IRS in court for damages arising from its misconduct.
Taxpayer Contact with the IRS
The ground rules regarding an audit of a taxpayer’s books and the examination of the taxpayer’s return must be explained in writing by the IRS prior to the first meeting. The taxpayer must be informed of his or her rights during an audit as well as the procedures for appealing an adverse decision. Tax-due or deficiency notices mailed after January 1, 1990 must clearly describe the basis for any amounts due and must specifically identify the tax, interest, additional amounts and additional penalties due. To insulate themselves from penalties, taxpayers may now rely on written advice given by the IRS.
During an audit interview, the IRS must inform you that if at any time you want to consult with an attorney, Certified Public Accountant (“accountant”) or enrolled agent (an individual specially admitted to practice before the IRS), the interview must stop. Also, unless unusual circumstances apply, the IRS cannot compel the taxpayer to be present with his or her representative during an interview. This is a substantial change from prior audit practice and means the great majority of taxpayers will not have to be subjected to a face-to-face “interview” (interrogation!).
The taxpayer, upon advance notice to the IRS, may make an audio recording, at the taxpayer’s expense, of any in-person interview with the IRS concerning the determination or collection of any tax. The IRS, upon advance notice to the taxpayer, may also make a recording. The IRS, however, must make a transcript of the recording available to the taxpayer upon request and at the taxpayer’s expense.
The time and place of the taxpayer interview must be reasonable. For instance, the taxpayer can prevent an audit at his or her place of business if, because of a lack of physical space, the audit would cause the business to close down.
When the taxpayer enters into an installment plan to pay his or her tax liability, the plan remains in effect for the term of the agreement. Limited exceptions include failure to pay tax or an installment, the failure to provide accurate information or a significant change in the taxpayer’s financial condition.
The Taxpayer Bill of Rights created a Taxpayer Ombudsman to intercede on behalf of the taxpayer. The Ombudsman may issue a “taxpayer assistance order” to a taxpayer who is suffering or is about to suffer a “significant hardship” caused by the IRS. This provision is designed to slice through bureaucratic red tape if a gross injustice is imminent.
Collection Methods by the IRS
In the past, the IRS has enjoyed virtual immunity from the consequences of its collection efforts and Congress has consistently given the IRS powers to collect taxes by seizing property in a manner unavailable to other creditors. The Taxpayer Bill of Rights has curtailed some of the more abusive measures used by the IRS, although the powers retained by this governmental agency remain formidable.
A taxpayer’s principal residence is now protected from levy (the seizure of property to satisfy a tax debt) unless the levy is approved in writing by the district director or the assistant district director. Also, no levy may be made on property with a fair market value less than the estimated expenses of its levy and sale. This prevents the IRS from punishing a taxpayer by selling property which may have personal value to the taxpayer but little economic value to the government (such as used clothing and furniture).
The period between the notice of levy and the sale date of the property has increased from 10 to 30 days, except in extreme situations when a jeopardy assessment is made. The levy statement must now apprise the taxpayer of his or her rights to appeal and redeem the seized property. Also, there is now a 21-day holding period on bank accounts garnished by the IRS. A garnishment is a legal notice sent to a third party attaching property (usually wages or bank accounts) belonging to the taxpayer to satisfy a tax debt. These provisions protect the taxpayer by providing more time to discover an improper levy or garnishment.
Taxpayers on the Offensive
Taxpayers now have a statutory right to sue the IRS in federal district court for damages resulting from the action of an IRS employee or officer who recklessly — or intentionally — disregards the laws or regulations relating to the collection of tax. Relief is available for actions after November 10, 1989, and are limited to the lesser of $100,000 or the sum of the taxpayer’s actual and direct economic damages, plus the costs of the court action. Taxpayers may also sue the IRS in federal district court for the actual and direct economic damages (plus court costs) resulting from an IRS employee’s knowing or negligent failure to release a lien. In both situations, a prerequisite to suit is that the taxpayer exhausted all the available administrative remedies within the IRS system. This means the taxpayer must use the appellate process within the IRS. The statute of limitations to bring the lawsuit is two years from the date the IRS conduct occurred.
Taxpayers may now also recover costs and fees as the “prevailing party” in an IRS administrative hearing. These include expenses incurred to compensate expert witnesses, to finance necessary studies and reports, and to pay fees of an attorney or other representative. These costs are recoverable for expenses beginning with the date the IRS either proposes a tax deficiency (commonly called the “30-day letter”) or gives formal notice of a tax deficiency (commonly called the “90-day letter”), whichever occurs first.
What To Do If You Get A Notice For Additional Taxes
An IRS notice of additional taxes causes even the most stable person to panic. This reaction is no doubt fueled by horror stories of friends who have been “plundered and pillaged” at the hands of the IRS. Therefore, be prepared!
Don’t Panic. Read the notice carefully. At least initially, take the position that the IRS is wrong until you conclude otherwise. Ask yourself to which tax year does the notice apply? What information is the government requesting? If you had someone else prepare your taxes for the year in question, contact that person and ask about the notice. If your tax preparer is unresponsive or if you feel your tax preparer is trying to cover up his or her mistake, immediately get a second opinion.
Review the Interest Charged. The IRS often miscalculates the interest charges; an estimated 25 percent of all IRS notices contain incorrect interest calculations. You should first determine whether the interest calculation is based on the correct year; then, check the amount. Although the interest rate is determined semi-annually and compounded daily, to achieve a rough estimate calculate the interest as 12% per year or 1% per month. If the notice states you owe interest on $1,000 for two years, the interest should be approximately $240. Interest, unfortunately, is not negotiable with the IRS; once the correct tax is determined, you will have to pay the full amount of interest on your unpaid taxes.
Check the Penalties. Does the IRS notice include penalties? Often, the IRS computer will generate penalties that can be abated in full. For instance, a negligence penalty does not automatically apply if the taxpayer is wrong — the taxpayer must be negligent. Unlike interest, penalties are negotiable.
Put Everything in Writing. Try to communicate with the IRS in writing. Avoid negotiating over the telephone, but if you do, immediately write a letter confirming your conversation. Always keep a copy of your correspondence. Also, do not throw away any correspondence from the IRS. As your matter progresses through the IRS bureaucracy, invariably the IRS will ask you for all copies of previous correspondence.
Don’t Pay Until You are Certain the IRS is Correct. Whatever you do, don’t immediately send a check to the IRS. If you pay on an erroneous statement, it is extremely difficult to get the money back. As long as you have something the IRS wants, you are in a much stronger bargaining position. If you then determine that you owe the tax and any penalties associated with the tax and that the interest is calculated correctly, then send in a check (write the tax year and your social security number on the check) along with the notice. Retain copies of the notice and your check.
An IRS Audit
Like going to the dentist, an IRS audit is one of life’s experiences that everyone dreads. Generally, an IRS audit starts with an examination of your tax return for a certain year by the examining agent. Verification of income and expenses is often the initial focus of the audit. If the audit request can be fulfilled by documentation (and you can supply the proper papers!) the process can be smooth and simple. For instance, if the audit notice requests verification of mortgage interest deductions, merely sending the annual statement from your lender will suffice.
Remember the Taxpayer Bill of Rights. Be sure to familiarize yourself with the examination process prior to the audit. The IRS must now provide you with information about the audit and you have the right to halt the audit if you want to consult with an accountant, attorney or enrolled agent. If you are going to meet the IRS without the assistance of a representative, notify the IRS of your intention to tape record your meeting and then record it. If you and the IRS agent successfully resolve the matter, then no harm done. If, however, the audit remains unresolved and you decide to hire a representative, the recording will provide him or her with insights regarding the focus of the audit, as well as the auditor’s experience, abilities and demeanor.
Do You Need a Representative? An IRS audit is the first step in the administrative process. Whether a taxpayer needs a representative at this stage is debatable. This decision depends on the nature of the audit, the issues involved (whether they are factual or legal) and the experience and personality of the taxpayer. First discuss the matter with acknowledgeable tax advisor to see whether you need representation. Generally, if the subject of audit notice involves factual documentation — such as the verification of mortgage or medical expenses — the taxpayer usually will not need independent representation at the initial audit. But there is always the danger that a taxpayer may inadvertently create an issue through conversations with the auditor by not appreciating the significance of his or her statements. If there is any problem in the verification of income or expenses or if the issue is legal rather than factual, then the taxpayer should be represented by a tax expert. Legal tax issues include:
- most tax shelter matters;
- personal expenses versus business or investment expenses;
- controversies involving the proper tax year for income or deductions; and
- disputes involving the character of income, loss or expenses such as capital gains versus ordinary income, taxable income versus a non-taxable gift, and the classification of passive activities, portfolio interest and investment interest.
Your Rights on Appeal. If the audit examiner makes an adverse determination (the IRS is asserting a “deficiency” in the amount of tax claimed by the taxpayer), the taxpayer may appeal within the IRS. At this stage, I strongly recommend taking advantage of the appellate process and employing a tax expert. The appellate division of the IRS is experienced and pragmatic. Disputes are often compromised in a business-like manner. If the taxpayer presents a strong case, the appellate officer will invariably acknowledge the taxpayer’s position and close the case. If the matter cannot be resolved, the IRS will then issue a notice of deficiency.
The Notice of Deficiency (90-day letter). The notice of deficiency is the final step in the administrative process and is a prerequisite to the assessment of additional tax. Once a taxpayer receives a notice of deficiency he or she has three choices:
- pay the tax without further contesting it;
- petition the Tax Court for a redetermination of the tax within 90 days of receipt of the notice of deficiency; or
- pay the tax and sue in federal district court for a refund.
If the taxpayer does nothing, the IRS will assess and collect the tax once the 90-day period expires. Petitioning the Tax Court is the most sensible option for most taxpayers since a petition can be filed and a determination can be made by a court prior to any payment. Once the Tax Court petition is filed, the IRS is prevented from collecting the alleged deficiency until a decision is finalized; as a practical matter, the IRS will have its appellate branch try to settle the case before trial
The drawback to the Tax Court is that its jurisdiction lasts only during the 90-day period beginning on the date the notice of deficiency is mailed. If the taxpayer ignores this critical deadline (as too many taxpayers do), he or she is left with little recourse against the IRS except to pay the tax in full (which could be an impossibility if the tax is high) and later sue for a refund in federal district court or the Court of Claims.
The Taxpayer Bill of Rights is a major piece of legislation designed to give the taxpayer a level playing surface when confronted by the IRS. Dealing with the IRS, however, can still be a daunting and frustrating experience. If the taxpayer receives a notice for additional taxes or becomes involved in an audit, remember there is no substitute for: (1) asserting one’s rights; (2) documenting all correspondence; and (3) complying with all deadlines.