Taxpayer Relief Act of 1997
Newspapers and tax publications have been busy highlighting major substantive changes in the tax laws brought about by the Taxpayer Relief Act of 1997. Less publicized are numerous changes to administrative and court procedures brought about by the Act. This special issue of our newsletter is devoted exclusively to discussing some of the more important procedural changes brought about by the Act.
Tax Court Jurisdiction Has Been Expanded in The Areas of Employment Taxes, Gift Tax Valuation Disputes, and Estate Tax Installment Payment Elections
Employment Tax Disputes.Previously, the Tax Court did not have jurisdiction to hear cases involving an employer's liability for income tax withholding, FICA, or FUTA. Rather, employers had to pay some or all of those disputed taxes and proceed (after denial of their refund claims) to bring suit in their local United States district court or the United States Court of Federal Claims.
In order to provide a prepayment forum and one known to be speedier and more consistent in its rulings, Congress created new Internal Revenue Code ("IRC") Search7RH7436. The section allows an employer who has been audited regarding these employment taxes to file a petition in the Tax Court to litigate the issue of whether a worker is an independent contractor or employee or whether the employer is entitled to relief from any misclassification under Search7RH530 of the Revenue Act of 1978. (Section 530 is one of those provisions which Congress enacts and which, for some reason, it does not put into the Internal Revenue Code, making it hard to find. Section 530 allows employers to continue their erroneous treatment of a worker as an independent contractor in certain limited cases.) The collection of any underpayment of employment taxes is barred while the action is pending. The effective date of this amendment is August 5, 1997.
Declaratory Judgment Concerning Gift Valuation.With the increase in the unified credit for gift and estate taxes, more people will be filing gift tax returns showing gifts, but no tax due, because their unified credit has not been exhausted. In the past, if the IRS audited such a return, it could issue a notice of deficiency (i.e., a ticket to the Tax Court) only if it determined that, after revaluing the gift, a gift tax was immediately due. If the IRS concluded that the gift was worth more than reported, but the tax thereon was less than the unified credit, there was no way to immediately contest the IRS's determination. Any contest would have to wait until a later year when a subsequent gift was made which, in the IRS's view, brought the tax above the unified credit, or for an estate tax proceeding.
In order to speed the resolution of gift tax disputes, Congress has created new IRC Search7RH7477. This section allows the IRS to issue a final notice of redetermination of value even when no additional gift tax is currently being asserted. Such a notice may be contested within 90 days by the filing of a petition in the Tax Court. The Tax Court will have jurisdiction to fix the value of the gift, which will be determinative for all later gift and estate tax filings. The new provision is effective for gifts made after August 5, 1997.
Estate Tax Installment Payment Plan Elections.Under IRC Search7RH6166, certain estates consisting largely of interests in closely-held businesses are allowed to elect to pay estate taxes in extended installments at a favorable interest rate. If certain events occur during the payment period (e.g., the business is sold), full payment of all deferred estate taxes is required at that time. Until now, if an estate got into a dispute with the IRS over its entitlement to use Search7RH6166 or its continued eligibility under that section, the estate's only method of obtaining judicial review was to pay all of the tax immediately and seek a temporary refund of the tax. This judicial review mechanism defeated the very purpose of Search7RH6166.
In the Act, Congress created new IRC Search7RH7479. It provides for the IRS, if requested, to issue a notice determining the failure of an estate's initial or continuing eligibility to make installment payments under Search7RH6166. The estate may contest such a notice in the Tax Court within 90 days, and the Court will have the right to review the dispute. If the IRS fails to act on an estate's request to issue a notice on Search7RH6166 eligibility, the estate, after waiting 180 days after making the request, may also petition the Tax Court on the issue of initial or continuing eligibility. The new provision is effective for estates of decedents dying after August 5, 1997.
Long-awaited TEFRA Partnership Audit Procedure Changes Enacted
In the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), Congress enacted a set of rules providing for audits of most partnerships at the partnership, rather than the partner, level. The TEFRA procedures are cumbersome, but they have served to make it easier for the IRS to audit large partnerships and to keep the statute of limitations open against nearly all partners until such audits are concluded.
By the late 1980s, both the IRS and private practitioners recognized that there were certain unintended gaps and inequities in the TEFRA procedures and that the procedures covered more partnerships and partners than the increased administrative costs of TEFRA audits justified. As early as 1990, a group consisting of representatives of the Treasury and private practitioners (including the authors) gathered together to draft about one dozen legislative fixes to TEFRA. Although these fixes have been mostly noncontroversial, they have only finally been adopted in the most recent Act. Among the more important changes adopted by the Act are the following:
Small Partnership Exception Expanded.Until recently, the TEFRA procedures applied to all partnerships except certain small partnerships where the procedures were deemed unnecessary. Small partnerships were those where (1) the partnership had ten or fewer partners each of whom was a natural person (other than a nonresident alien) or an estate and (2) each partner's share of each partnership item was the same as his share of every other item. Effective for partnership taxable years ending after August 5, 1997, the small partnership exception is expanded to eliminate the same-share requirement and to allow C corporations to be partners. Previously, any partnership with a C corporation as a partner -- even one with only two partners -- was subject to the TEFRA procedures.
Extension of Period for Filing Refund Claim.Most practitioners know that in the non-TEFRA context, if the taxpayer signs an extension of the statute of limitations for assessment of additional tax, such extension also serves to extend the period in which the taxpayer can file a refund claim for the same duration plus six months. The theory of the parallel extension is that if the IRS chooses to audit a return over an extended period, but finds that there really was an overpayment of tax, the taxpayer should be able at that time to file a refund claim to force the IRS to give the taxpayer the benefit of the overpayment, either by way of refund or credit.
Many practitioners assumed that the same rule applied in the TEFRA partnership area. However, it did not. There was no way to extend the TEFRA refund claim period. This was a trap for the unwary who were presented with TEFRA extension forms to sign.
To remedy this trap, the Act amends the Code to provide that an extension of the partnership's statute of limitation for assessment extends the period in which a partner can file a refund claim (more properly called a "request for administrative adjustment") for the same duration plus six months. Thus, the TEFRA and non-TEFRA rules have been harmonized. Because many taxpayers had unwittingly fallen into this trap, the amendment is made retroactive "as if included" in the original TEFRA. Thus, anyone who has already signed a TEFRA extension can breathe a sigh of relief. Both the amendment in the Act and its retroactive effective date were made at the initial suggestion of the authors.
Innocent Spouse Provisions Added.The drafters of TEFRA did not consider how a spouse would raise the argument that the spouse was not liable for the partner-spouse's tax liability attributable to a TEFRA partnership adjustment because the spouse was an "innocent spouse" under IRC Search7RH6013(e). Under prior law, the Tax Court has held that it has no jurisdiction to decide an innocent spouse issue in a TEFRA proceeding. It is unclear under prior law whether the innocent spouse issue could even be raised after the innocent spouse paid a TEFRA tax liability and filed a claim for refund.
Effective retroactively, "as if included" in the original TEFRA, the Act amends IRC Search7RH6230 to provide both a prepayment forum in the Tax Court and post-payment forums in the district courts or United States Court of Federal Claims in which spouses of partners can raise the innocent spouse issue.
Penalties to Be Determined at Partnership Level.The drafters of TEFRA knew that the courts had traditionally determined whether to impose negligence penalties on tax deficiencies arising from partnership adjustments by looking at the knowledge, sophistication, and intent of the partner. In order not to upset this judicial precedent, TEFRA was designed to determine liability for tax against all partners in a partnership-level proceeding, but to determine liability for negligence and other penalties (now subsumed in the current accuracy-related penalty of IRC Search7RH6662) in separate partner proceedings. These penalty proceedings commence after the partnership-level case concerning the tax was concluded; the IRS issues a notice of deficiency to each partner asserting only penalties. Each partner may contest the notice of deficiency, without first paying the penalties, by filing a petition in the Tax Court.
The IRS has found the TEFRA penalty procedures cumbersome. Accordingly, effective for partnership taxable years ending after August 5, 1997, the Act includes the issue of liability for penalties in the partnership-level proceeding. The court in that proceeding will decide whether or not all partners should pay penalties. If the court rules that penalties apply, all partners become immediately liable to pay the penalties upon receipt of a bill from the IRS. Any partner thinking it has a "partner-level defense" to the penalties may pay them, file a refund claim, and pursue that claim, if it is denied, in the local United States district court or the United States Court of Federal Claims.
Private practitioners (including the authors) unsuccessfully opposed this provision of the Act. It will lead to more penalties being sustained, since few partners, after paying the penalties, will mount a refund suit to get them back. Further, the Act leaves the courts at sea as to whose knowledge, sophistication, and intent determines the application of the penalties at the partnership level. Is it the general partners' knowledge, sophistication, and intent or that of all partners? Also, what is a partner-level defense in this context? Does an individual limited partner's lack of knowledge, lack of sophistication, and good faith relieve the partner from the penalties where the general partners were knowledgeable, sophisticated, and acted in bad faith? If so, what is the purpose of imposing the penalties using a different standard in the partnership-level proceeding than will be used in the partner-level proceeding?
Stopping of Interest 30 Days After Signing a Waiver.Many tax proceedings are resolved by settlement and the execution by the taxpayer of a waiver allowing the IRS immediately to assess and collect the agreed tax. IRCSearch7RH6601(c) provides that if the IRS fails to send the taxpayer a bill (i.e., a "notice and demand") for the agreed tax plus interest within 30 days after the waiver was executed, interest stops accruing after 30 days, until such bill is sent. Prior to the Act, assessments based upon waivers regarding TEFRA tax underpayments were not covered by this 30-day rule. Often, the IRS waited nearly a year after the settlement waiver was signed to issue a bill, which reflected interest for the entire period up to the date of the bill.
Effective for adjustments with respect to partnership taxable years beginning after August 5, 1997, the Act provides that TEFRA waivers will be treated like non-TEFRA waivers for purposes of Search7RH6601(c). As a result, interest charges will stop 30 days after the TEFRA waiver until a bill is sent.
Beneficiaries of Estates and Trusts must Report Consistently with Returns of Estates and Trusts
One of the Code changes which was brought about by TEFRA is that, generally, a partner is required to treat a partnership item on the partner's return in a manner which is consistent with the treatment of the partnership item or the partnership return. Thus, if a Schedule K-1 is issued by a partnership to a partner showing a $100 item of net income from rental real estate activities, the partner generally is required to include $100 of net income from rental real estate activities on the partner's return. A partner who does not report consistently (e.g., he reports $80 of income in the above example) is subject to being immediately billed by the IRS for the tax which results from conforming the partner's return with the partnership's return (i.e., the tax on the $20 of additional income).
A partner wishing to report inconsistently can avoid this instant billing by attaching a form to the return (Form 8082) identifying the inconsistency. That form is also required to avoid instant billing if, at the time the partner's return is filed, no partnership return has yet been filed. Where such a form is attached, the IRS may still argue that the partner reported the wrong amount or character of a partnership item, but the IRS may do so only by issuing a notice of deficiency. The notice of deficiency allows the partner to contest the issue of the correct item in Tax Court without the need for paying the disputed tax until the case is over.
Rules similar to the partner/partnership consistency rules were later added to the Code for S corporations and their shareholders.
In the Act, effective for beneficiary returns filed after August 5, 1997, beneficiaries are required to report estate and trust items consistently with the treatment of the items on the returns of the estates and trusts. For such beneficiaries, rules similar to the partnership rules apply for avoiding immediate assessment of taxes on inconsistencies. It is not yet known whether Form 8082 will be modified to add trusts and estates or a new form will be issued for beneficiaries to identify inconsistencies between their returns and the returns of the trust or estate.