Internal Revenue Service Reconstruction and Reform Act of 1998
IN THIS ISSUE
- Special Issue on New Tax Law
- Burden of Proof Shifted to IRS on Some Issues
- A Partial End to Interest Rate Differentials on Tax Underpayments and Overpayments
- Tolling of Interest in Individual Income Tax Audits
- Accountants Gain Partial Attorney-client Privilege in Civil Tax Proceedings
- Appeals Officers Will No Longer Talk to Examiners ex Parte
- Will Levies Go the Way of Dinosaurs?
- Innocent Spouse Rules Eased Retroactively
Special Issue on New Tax Law
This special issue is devoted to important changes to the federal tax audit, appeals, litigation, and collection process brought about by the Internal Revenue Service Restructuring and Reform Act of 1998. The Act has done far more than restructure the IRS. It has profoundly changed the balance of power in the tax controversy and collection process.
Burden of Proof Shifted to IRS on Some Issues
One of the most publicized provisions of the Act (Search7RH3001, adding new Code Search7RH7491) shifts the burden of proof from the taxpayer to the IRS in any court proceeding involving income, self-employment, estate, generation-skipping transfer, or gift taxes. This politically-driven provision leads off the Taxpayer Bill of Rights 3 portion of the Act. Unfortunately, as will be seen below, the provision is subject to such substantial limitations that the outcome of only a small percentage of litigated cases will be affected by the provision. However, the provision will likely have profound effects on the process of examinations and trials.
The burden shift is effective for court proceedings involving examinations commencing after July 22, 1998, regardless of the taxable year or period involved in the examination. The burden shift does not apply to payroll taxes or excise taxes and does not apply at the administrative level of the case; thus, it only applies in court.
The burden shift is available to all individuals and estates. It is also available to those small partnerships, corporations, and trusts which can potentially get attorneys fees under Code Search7RH7430 in the case of unreasonable IRS conduct -- i.e., those partnerships, corporations, and trusts with a net worth no greater than $7 million and which have no more than 500 employees.
The burden shift will occur issue by issue. Thus, the IRS may have the burden on one issue, while the taxpayer has the burden on another. For the burden shift to occur, the taxpayer must have maintained all records required to be kept by the Code. Therefore, taxpayers who discard pertinent records will find that they still have the burden of proof.
To place the burden of proof on the IRS, the taxpayer will also have to cooperate with all "reasonable requests" by the IRS for witnesses, information, documents, meetings, and interviews. A whole area of litigation may arise concerning whether a request was "reasonable" and whether cooperation was full. For example, if a taxpayer in an interview answers ten questions, but declines to answer the eleventh or says he or she does not remember, has the taxpayer cooperated?
For items for which the courts have traditionally required the taxpayer to provide substantiation -- e.g., for most deductions and credits -- the taxpayer must still comply with all substantiation requirements. Thus, a taxpayer who never created or maintained the records required by Code Search7RH274 to support travel and entertainment deductions will still have the burden of proof on that issue (and can expect to lose). Since most litigated cases involve substantiation of deductions, this is a severe limitation to the burden of proof shift.
There is a distinction in the case law between the "burden of proof" and the "burden of production." While the new provision shifts the burden of proof, it does so while keeping the burden of production on the taxpayer. Thus, the taxpayer must first "introduce credible evidence" to the court going to the issue of the correct tax liability. If this evidence makes a prima facie case that the taxpayer should prevail, then it becomes the IRS' obligation to introduce contrary evidence. By the taxpayer's introducing credible evidence, the burden of proof is shifted to the IRS; thus, the court will have to decide whether the IRS' counter-evidence has overcome the taxpayer's evidence. If the evidence on each side appears equal, the court is directed to rule for the taxpayer.
A final limitation on the new burden-shifting provision is that where the Code already contains a specific statement as to who has the burden of proof (e.g., in Code Search7RH534, involving the accumulated earnings tax), that specific statement will govern instead.
Given the above limitations, the question of whether the burden of proof has shifted on an issue will in most cases not be answerable until after the trial. This puts both the IRS and the taxpayer in a difficult position:
The IRS will fear that it may end up with the burden of proof, and so can be expected to press harder in examinations for documents and information. This will run up taxpayer costs in responding to examination requests.
Since taxpayers will also be unsure as to whether they will be held to have shifted the burden or proof, they will probably still try cases the way they always have -- i.e., by taking the initiative and introducing all pertinent documents and testimony. Unfortunately, if the taxpayer intends to argue that the burden of proof has shifted, the taxpayer will also have to expand the trial and introduce evidence about how it cooperated during the examination or show that certain IRS requests were not reasonable (e.g., show the court how burdensome a document request was). Now, more than ever, it will be necessary to carefully document responses to IRS requests for information during an examination and to draft responses to IRS requests in a way that reflects full cooperation. If the taxpayer is a partnership, corporation, or trust, the taxpayer will presumably also have to introduce evidence at trial about its net worth and number of employees or provide that information to the IRS attorney in order to have the matter stipulated. All this additional evidence and trial time will, no doubt, further increase taxpayer litigation costs.
Given the probable increase in audit and litigation costs and the uncertainty as to whether the burden will be shifted after all, one wonders whether the new provision is actually a helpful addition to the Code. Some cases involve issues of law, where the provision will not be relevant. Most cases involve substantiation, where the burden will not shift. The burden shift will apparently have primary benefit in cases involving issues such as valuation or the reasonableness of compensation. The provision may also be of use in other cases when they are before an IRS Appeals Officer prior to trial. The Appeals Officer's concern that the IRS may end up with the burden of proof at trial may cause the Officer to have a more generous settlement attitude.
Finally, new Code Search7RH7491 contains a shift in the burden of production (i.e., apparently, not the burden of proof) in cases where the IRS seeks a penalty against an individual. In the past, taxpayers who failed to introduce any testimony or documents going to the issue of penalties often found that the Tax Court automatically found against them on the penalty based on an absence of proof. Now, the IRS will have to first come forward with some evidence that a penalty should apply -- e.g., show that a position taken by the taxpayer was contrary to published authority. Once this is done, the taxpayer will have the burden of proof to rebut the penalty -- e.g., by showing reasonable cause or good faith reliance on a tax advisor. But if the IRS introduces nothing about penalties at trial, any penalties asserted will not be sustained.
A Partial End to Interest Rate Differentials on Tax Underpayments and Overpayments
Since the mid-1980s, the Internal Revenue Code has provided that when you owe money to the IRS, you pay the IRS 1% more in interest than the IRS would pay you if it owed you a refund. Currently, for most taxpayers this means that you pay the IRS 8% interest on tax underpayments, while the IRS pays you 7% interest on tax overpayments.
For corporations, the interest rate differentials can be worse. Currently, corporations that have large tax underpayments (i.e., over $100,000) must pay the IRS 10%. Currently, corporations that have tax overpayments exceeding $10,000 receive 5.5% from the IRS on the amount exceeding $10,000.
The Act makes two changes to the Code to eliminate some of the differentials. First, under Act Search7RH3302 (amending Code Search7RH6621(a)), effective for interest accruing after January 1, 1999, the interest paid to non-corporate taxpayers on overpayments will be raised to the same rate which is charged them on underpayments -- i.e., the "applicable federal rate" plus 3%, currently 8%.
Second, under Act Search7RH3301 (new Code Search7RH6621(d)), the interest rate differential is eliminated for all taxpayers (including corporations) where there are equivalent underpayments and overpayments by the same taxpayer and the periods of interest accrual overlap. For example, assume that as a result of an examination, an individual owes $10,000 of additional gift tax for 1995. The due date for the gift tax return (Form 709) was April 15, 1996. Interest on the $10,000 deficiency would be due from April 15, 1996 to the present. Assume that the individual also overpaid his 1997 income tax by $4,000, but has not yet been sent a refund check; interest is payable on the $4,000 from April 15, 1998 to the present. Under the new law, the net interest rate on the $4,000 overpayment and $4,000 of the $10,000 underpayment is zero for the period of interest accrual overlap -- i.e., from April 15, 1998 to the present.
There are some peculiarities about the drafting of this overlap-elimination statute which present questions. It has long been the rule that if, in the above example, the IRS had credited the $4,000 income tax overpayment against the gift tax deficiency, there would be no interest payable on the $4,000 overpayment and $4,000 of the gift tax underpayment would cease bearing interest as of April 15, 1998. Code Search7RHSearch7RH6601(f) and 6611(b)(1). This rule has two effects: it not only eliminates the interest rate differential, but ensures that no interest is paid to the taxpayer -- an important fact for individuals today because, literally, the Code expects individuals to pay tax on interest income but, in most cases, allows no tax deduction for interest paid on tax deficiencies. This rule applies only when the IRS applies the overpayment as a credit against the underpayment -- something the IRS is not required to do by law. Thus, the rule does not apply if the IRS refunds the overpayment to the taxpayer in a check.
The new law, which does not repeal the existing law, applies where the IRS does not apply the overpayment as a credit, but mails out a refund check. In providing for a "net" interest rate of zero, however, the new law leaves unclear whether the gross interest payable on the overpayment is now 0%, 7% (the refund rate), or 8% (the deficiency rate). Hopefully, the law will be interpreted to impose a gross interest rate on both overpayments and underpayments of 0%. Otherwise, individual taxpayers may still face the problem of having to pay tax on interest income without a corresponding interest deduction.
The new law is effective for interest accruing after October 1, 1998, regardless of the taxable year involved. The new law is also effective for interest accrual periods beginning before July 22, 1998, but only if the taxpayer (1) contacts the IRS not later than December 31, 1999, (2) requests that the new law apply, and (3) "reasonably identifies and establishes periods of such tax overpayments and underpayments for which the zero rate applies." Thus, a taxpayer who recently received a refund check including interest and recently paid a tax bill charging interest should look into whether there was an overlapping interest accrual period. If one exists, Form 843 (a refund claim for overpaid interest) should be filed with respect to the interest charged on the underpayment. Presumably, the statute of limitations for refund claims (usually, two years from the date of payment or three years from the date the return was filed) will apply to preclude taxpayers from making claims for overcharges occurring many years ago.
Some taxpayers may currently be in the midst of income tax examinations in which they expect eventually to have overpayments and underpayments in different years, but the exact amounts are not known. If the overpayment and underpayment amounts are still not fixed by December 31, 1999 (because of continued audit, Appeals Office, or court proceedings), consider making a protective request under the new statute by that date so that pre-October 1, 1998 interest which is eventually charged gets the benefit of the new statute.
Tolling of Interest in Individual Income Tax Audits
One of the frustrations expressed in hearings before Congress last year was the inordinate time it often took IRS examiners to state the amount of the asserted tax deficiency. In response to this complaint, Act Search7RH3305 amends Code Search7RH6404(g) to suspend interest on tax, interest, and certain penalties where the IRS delays in sending an examination report (30-day letter) or notice of deficiency (90-day letter) to an individual undergoing an income tax audit.
The suspension applies only if the individual filed a timely return and only if the IRS has not issued a 30- or 90-day letter within 18 months of the later of the due date of the return or the date the return was filed. In that case, interest stops accruing on the tax, penalties, and interest accrued up to that date, and only begins accruing again 21 days after the 30- or 90-day letter is issued.
This provision applies to audits of income tax returns for the taxable years 1998 through 2003. For later taxable years, Congress expects the IRS to work even faster and has set the interest suspension period to commence after 12 months, rather than after 18 months.
Interest is not suspended on unpaid taxes reported on the return (or to penalties thereon) or to fraudulently underreported tax. Nor is interest suspended on fraud, late-filing, late-payment, or criminal penalties. As a practical matter, therefore, the only penalty on which interest will typically be suspended will be the accuracy-related penalty of Code Search7RH6662 -- a penalty which applies in the case of negligence, substantial understatement of tax, or valuation misstatement. The Search7RH6662 penalty of 20% of the tax normally accrues interest from the due date of the return until it is paid.
Ironically, the new changes that shift the burden of proof will put pressure on IRS examiners to do more thorough and time-consuming audits (just in case the IRS is held to have the burden). Also, other changes dealing with reimbursement of attorneys fees in Code Search7RH7430 brought about by the Act will put further pressure on examiners not to take hasty, unreasonable positions, and also will cause them to want to slow down their examinations. The interest suspension provision pushes examiners in the exact opposite direction -- speed up the examination or lose interest. It will be interesting to see whether IRS managers urge their examiners to accelerate or slow down individual income tax examinations as a result of the Act..
Accountants Gain Partial Attorney-client Privilege in Civil Tax Proceedings
After much lobbying by accounting firms, accountants have gained a partial attorney-client privilege in certain federal tax matters. Act Search7RH3411 adds new Code Search7RH7525, which provides that a communication "with respect to tax advice" between a taxpayer and a "federally authorized tax practitioner" (i.e., a certified public accountant or enrolled agent) is privileged to the extent that such communication would be privileged if between a taxpayer and an attorney under common law protections of confidentiality.
This new privilege may only be asserted in tax matters before the IRS or the courts. In the courts, it may only be asserted if the United States is a party to the proceedings. The privilege is not available in the case of criminal prosecutions or proceedings before other administrative agencies, such as the Securities Exchange Commission. The privilege may also not be raised in private-party suits, such as in a product-liability suit brought against a taxpayer, or in state tax proceedings.
Thus, accountants should not encourage taxpayers to tell them confidential or embarrassing facts on the assumption that they are protected from public disclosure as in the case of the usual attorney-client communication. An accountant will usually not know in advance whether some private litigant, perhaps bringing a securities fraud suit or a divorce action, will force public disclosure or whether an IRS investigation will turn criminal, in which case disclosure could be forced.
Under traditional attorney-client privilege rules, once a conversation's substance is made public, the privilege has been waived, and the substance of the conversation can be introduced into evidence. Thus, if a private litigant forces the accountant to disclose the conversation in the private litigant's suit, the IRS will be able to make the accountant relate the same conversation in a civil tax matter. Moreover, accountants must be wary of violating the privilege by making unauthorized disclosure of the client's confidential communications, as such a violation could result in a malpractice action against the accountant.
Accountants should also be very conscious of the existing limitations on attorney-client privilege in tax matters: First, there is no attorney-client privilege if the client is involving the attorney in an ongoing fraud. Second, conversations connected to return preparation are not privileged -- on the theory that the return, in effect, discloses the information, so the conversation was never intended to be confidential. This latter limitation gives rise to constant litigation over what pre-return discussions were for tax planning (privileged) as opposed to return preparing (not privileged). There is no bright-line answer.
The only accountant who can feel fairly comfortable in being covered by the new privilege is the accountant retained specially to represent the taxpayer during an IRS examination -- i.e., not the accountant who prepared the return. Even such an accountant, however, should not encourage taxpayer disclosures, since persons other than the IRS might be able to learn their substance. The new privilege is best simply viewed as a defense available if the taxpayer, unprompted, tells the accountant something which the taxpayer would want kept confidential.
Finally, due to Congressional outrage over certain large accounting firms' marketing of corporate tax shelters, the new accountant privilege does not apply to any written communication between the accountant and a director, officer, or employee, agent, or representative of a corporation in connection with the promotion of the direct or indirect participation of such corporation in any "tax shelter." For this purpose, "tax shelter" is given the same broad definition contained in the accuracy-related penalty of Code Search7RH6662 -- i.e., any plan, arrangement, or entity, if a "significant" purpose (not even the primary purpose) is the avoidance or evasion of federal income tax.
Many accountants fear that this tax shelter communication exception may make even ordinary written communications to the client for routine tax planning discoverable. While some in Congress have stated that the exception does not apply to routine corporate tax planning advice, the question is still open and may only be resolved by future Treasury regulations or court opinions.
Appeals Officers Will No Longer Talk to Examiners ex Parte
Currently, IRS Appeals Officers are encouraged to speak to the IRS examiners concerning issues raised in the examination report. Indeed, for taxpayers in the Coordinated Examination Program, meetings between Appeals Officers and examiners are mandatory. Appeals Officers may also speak to Revenue Officers when reviewing a Revenue Officer's denial of a taxpayer's offer in compromise. Typically, the taxpayer is not allowed to participate in such contacts.
Practitioners complained to Congress that these ex parte contacts bias the Appeals Officers in their quasi-judicial role. Accordingly, Congress enacted Act section 1001(a)(4), which directs the IRS Commissioner in his forthcoming reorganization plan to "ensure an independent appeals function within the Internal Revenue Service, including the prohibition in the plan of ex parte communications between appeals officers and other Internal Revenue Service employees to the extent that such communications appear to compromise the independence of the appeals officers." Presumably, this means that Appeals Officers cannot speak to examining agents about substantive issues outside the taxpayer's presence. However, Appeals Officers will probably still be able to speak ex parte on non-substantive issues -- e.g., to ask the examining agent about missing pieces of the administrative file. Since the Commissioner has not yet finalized his reorganization, the ex parte contact ban has not yet been put into effect.
Will Levies Go the Way of Dinosaurs?
The Act imposes substantial new roadblocks to the IRS' use of levies. These roadblocks are so substantial that it may be the rare taxpayer who in the future is actually subjected to one.
First, Act Search7RH3421 requires the IRS to change its procedures so that any levy or filing of a notice of tax lien be reviewed by a Revenue Officer's supervisor before it is done. Disciplinary action would be taken against the Revenue Officer or supervisor for violating this rule.
Second, Act Search7RH3445 amends Code Search7RH6334 to require the advance written personal approval of a District Director or Assistant District Director for any levy on real or tangible personal property used in an individual taxpayer's trade or business. For levies on principal residences of the taxpayer, advance written approval from a judge or magistrate of a district court will be required. Finally, where the balance due does not exceed $5,000, no levy may be made on any real property used as a residence by the taxpayer or any other person.
Third, under Code Search7RH6331(d) of current law, a Revenue Officer planning to make a levy must send a "notice of intention to levy" at least 30 days in advance in order to give the taxpayer time to satisfy the liability or make other collection arrangements before the levy occurs. Act Search7RH3401(b) adds a new Code Search7RH6330 which would require the Revenue Officer to include a notice that the taxpayer can protest the proposed levy to the IRS Appeals Office during the 30-day period. This provision applies to levies on all taxpayers, not onlyt individuals. If the taxpayer protests, the levy may not take place during the Appeals Officer's consideration of the matter.
The Appeals Officer is charged with verifying that the IRS has taken all appropriate procedural steps. He or she also must consider whether any collection alternatives, such as bonds, substituting assets, installment agreements, or offers in compromise would be more appropriate. The Appeals Officer must balance "the need for the efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary." If the taxpayer did not receive a notice of deficiency (e.g., because it was sent to a wrong address) or did not otherwise have an opportunity to dispute the underlying tax liability, the Appeals Officer may also consider whether the tax is actually owed.
If an Appeals Officer's resolution is not satisfactory to the taxpayer, the taxpayer has 30 days from the date of the Appeals Officer's decision to petition the U.S. Tax Court. A Tax Court judge or special trial judge will reconsider the same matters considered by the Appeals Officer. Once again, the levy may not take place until after the Tax Court proceeding is concluded, and only then if the Court agrees.
Availing oneself of the levy appeal procedure has only one downside: The statute of limitations on collection is suspended during the process. However, it will be the rare taxpayer who receives a notice of intention to levy who will not want to stop the levy. Accordingly, nearly every levy can be expected to be appealed so that the taxpayer can put off the IRS for possibly one to two years while the Appeals and Tax Court proceedings occur. Given that any levy can be stopped dead in its tracks this way, will Revenue Officers ever use the levy again as a collection tool?
A similar procedure for Appeals and Tax Court consideration of a protest to the IRS' filing of a notice of tax lien is created by Act Search7RH3401(a), creating new Code Search7RH6320. This procedure is likely to be used far less frequently, however, as it is available only after the IRS files a notice of tax lien and it appears that the notice will remain filed until an Appeals Officer or judge directs it to be removed, although the statute is not entirely clear on this last point.
These new Code Search7RHSearch7RH6320 and 6330 apply in the case of tax liens filed and notices of intention to levy issued after January 18, 1999.
Innocent Spouse Rules Eased Retroactively
Under prior law, spouses filing a joint return were jointly and severally liable both for the tax shown on the return and any tax which should have been shown on the return but was not. Under innocent spouse rules at old Code Search7RH6013(e), in the event that tax was underreported, a spouse could be relieved of liability for the tax deficiency only if (1) the erroneous deduction, credit, or omitted income was an item of the other spouse, (2) the spouse had no knowledge or reason to know that there was an understatement of tax, (3) equity favored relieving the spouse, (4) in the case of an erroneous deduction or credit, the deduction or credit was "grossly erroneous" (i.e., was so erroneous that it had "no basis in fact or law"), and (5) the tax understatement was "substantial" (i.e., it exceeded a percentage of the spouse's adjusted gross income, not in the tax year at issue, but in the last tax year ending before a notice of deficiency was sent). An innocent spouse was expected to make that claim in response to a notice of deficiency and prove the above facts in Tax Court. Otherwise, the innocent spouse would have to pay the tax (if the other spouse did not) and file a refund claim.
In the past, when a joint notice of deficiency was issued, often the culpable spouse would handle the tax litigation on behalf of both spouses and the innocent spouse defense would not be raised. Once the Tax Court case was over, if the culpable spouse lost, the other spouse would then be foreclosed from ever raising the innocent spouse argument under the doctrine of res judicata.
In Tax Court cases where the innocent spouse claim was raised and deductions or credits were at issue (typical in 1980s tax shelter cases), the culpable spouse would argue for the validity of the very items which the potentially innocent spouse would simultaneously argue had no basis in fact or law. Often, the culpable spouse's arguments, although not sufficient to prevail, would undermine an innocent spouse defense by demonstrating some basis in fact or law. Even if the culpable spouse did not challenge the notice of deficiency, a spouse seeking relief under Search7RH6013(e) had to prove that tax shelter items were grossly erroneous; in effect, this required a spouse unfamiliar with a shelter having to argue a case from the perspective of the IRS, but with a higher burden of proof than the IRS had to meet merely to disallow the items.
Congress heard the pleas of many testifying innocent spouses and, at Act Search7RH3201, repealed Code Search7RH6013(e) and replaced it with a new Code Search7RH6015. Under the new section, a spouse who did not meaningfully participate in any Tax Court case where innocent spouse status could have been raised may now wait to be contacted by IRS collection agents before raising the innocent spouse issue. In fact, any joint filer seeking relief under Search7RH6015 need only file an election (on a form the IRS will create) no later than two years after the IRS begins collection activities against that person. Once an election for relief under Search7RH6015 is made, the IRS must cease collection actions and consider the merits of the election. If the IRS denies innocent spouse status, it sends the electing person a notice of deficiency, which can be protested to Tax Court. Collection activity is again suspended during the Tax Court proceeding.
New Search7RH6015 is both prospective and retroactive to all prior tax years to the extent the amount due has not yet been paid. In no event will the period for making the election expire before July 22, 2000. This means that even as to spouses who have been pressed for collection by the IRS for years, there is now a two-year window for electing new Search7RH6015.
New Search7RH6015 not only provides this new way to raise innocent spouse claims during the collection process, but also changes the substantive rules -- again, retroactively. Spouses no longer have to prove that the deductions or credits were grossly erroneous (i.e., had no basis in fact or law). A spouse merely has to show that the deductions or credits were erroneous -- something which the IRS will have already proven or will concede.
Further, new Search7RH6015 eliminates the complex requirement for proving that there was a substantial understatement exceeding a percentage of adjusted gross income in a different year. Now, all tax understatements, even of $1, can get relief under the innocent spouse rules.
For some spouses, Search7RH6015 relief is even easier to obtain. For spouses who, at the time the election is filed, (1) are divorced, (2) are legally separated, or (3) have not been members of the same household for the prior 12 months, relief will be granted even if the spouse had reason to know, but not actual knowledge, of the understatement. For such spouses who can also show that they signed the return under duress, relief will be granted even if the spouse had actual knowledge. Relief for these spouses is provided essentially by recomputing their taxes as if single and using a complex proportional method of allocating the joint liability. The provisions of Search7RH6015 are very detailed. This article gives only a brief overview of them.