In an effort to appease angry taxpayers, the House passed the Internal Revenue Service Restructuring and reform Act of 1997 ("Act"). Congress has adjourned without the Senate acting on this legislation, although it should eventually become law with some minor adjustments. Part of this Act is a new Taxpayer’s Bill of Rights III ("TP III"), expanding, in limited fashion, the rights of taxpayers. November’s Hot Topics will focus on several of its major provisions.
Under current law, there is no confidentiality between the taxpayer and his or her non-attorney representative. The IRS is permitted to question the representative about his or her thoughts, impressions, opinions or analysis, and may obtain any notes or correspondence regarding the taxpayer’s situation. Congress believes that taxpayers are often unaware that when they meet with their representative and ask for advice, the IRS may gain access to what was said.
The Act expands the traditional attorney-client privilege in limited circumstances to taxpayer representative’s authorized to practice before the IRS (enrolled agents and CPA’s) with respect to non-factual thoughts and impressions during a non-criminal administrative proceeding. This will permit taxpayers to consult with their representatives in confidence.
Analysis: The expansion for the confidentiality privilege is limited in scope, but will protect taxpayers when they candidly discuss their situation with their advisors. As under current law, confidentiality (including attorney-client confidentiality) does not apply to a representative’s work product involving preparation or filing of tax returns.
Another portion of TP III restricts the use of "economic reality" audits to those situations where the IRS reasonably believes there is a likelihood of unreported income. But under those circumstances, there exists the possibility of criminal action since under-reporting of income could amount to the crime of tax evasion, and the confidentiality provisions would not apply. Also, the confidentiality protection is most important when there is a potential for a criminal investigation. As under current law, the taxpayer must consult solely with an attorney to protect his or her communications in criminal matters.
Moreover, the new privilege is limited to administrative hearings. The privilege could not be claimed in court proceeding since it is not intended to change the existing federal rules of evidence. Since often the same representative who would be advising a client on a tax matter (confidentiality applies) also prepares and files a tax return (confidentiality does not apply), it would be difficult to determine in what capacity the representative was acting when the advice was given.
As the tax law exists today, if the IRS asserts an understatement penalty (claiming the taxpayer significantly understated his or her income), the taxpayer’s primary defense would be reliance on the opinion of a representative. In order to use that defense, however, the confidentiality of that opinion would have to be waived.
In summary, although providing protection against disclosures of consultations between a taxpayer and a non-attorney sounds appealing, its usefulness will be severely limited. Nevertheless, this is a positive change and can prevent IRS abuses in civil tax examinations when the IRS attempts to access the representative’s thoughts and impressions.
If ever a provision had a political ring to it, it the proposed shift of the burden of proof to the IRS in tax cases. Politicians can stump the land, trumpeting this triumph, but in reality, it is largely, if not wholly, an illusory change. First, the burden of proof currently is on the taxpayer. That means the taxpayer must show he or she is "more-likely-than-not" to prevail on the disputed matter. Only when the evidence is dead even (50% to 50%) will the taxpayer lose under current law. If there is 50+% on the taxpayer’s side, he or she wins under current law. This change will affect those rare cases where there is no evidence, or where the evidence is a toss up.
Analysis: There’s a new catch: In order to shift the burden of proof to the IRS, the taxpayer must have "fully cooperated" with the IRS at the administrative level. To meet this cooperation requirement, the taxpayer must provide all witnesses, information and documentation reasonably requested by the IRS. This could include the information claimed to be confidential under the newly-expanded confidentiality provisions discussed above.
The determination of whether the burden of proof has shifted (i.e. that the taxpayer fully cooperated with IRS demands for information) will necessitate court rulings, thereby complicating the judicial process. Once again, what Congress gives with one hand, it takes away with the other. While the shift in burden of proof sounds appealing, it only applies to cases where the evidence is exactly equal on both sides and requires that the taxpayer fully cooperate with the IRS. It will take years and several court cases to decide what this requirement means.
Instead of overhauling the joint return liability provisions, Congress has decided that notification to taxpayers regarding their "joint and several liabilities" is enough. When a husband and wife file a joint return, they are treated as a single unit; therefore, each is individually responsible for all tax liabilities, penalties and interest with respect to the tax return, even if an additional tax liability was caused by other spouse. This makes each spouse personally liable for an unlimited amount.
In contrast, the benefit of filing a joint return can be measured precisely. It is the difference in taxes owed between filing a joint return and each spouse filing as married filing separately. Usually, the joint return advantage amount to between $1,000 to $2,000 in taxes saved. In my October Hot Topics, I argued that the liability for an innocent spouse (a spouse who files a joint return but is not responsible for misreporting income or deductions) should be limited to twice the benefit received by filing a joint return. In other words, if the difference between filing a joint return compared with married filing separately is $2,000, then the innocent spouse’s liability should be capped at $4,000. There should be some parity between the benefit received and the risk incurred.
Congress, however, has decided to describe a joint return’s potential unlimited liability in publications, rather than eliminate the mismatch of benefits verses risk. This, of course, creates a potential conflict of interest between husband and wife. Often one spouse will sign a joint return because they have been advised of the tax savings, without the other spouse disclosing that they are misreporting income or expenses or taking an aggressive position regarding their obligations under the law. In short, an innocent spouse, because of the marital relationship, may not question the information placed on the return by the other spouse, especially when the innocent spouse is told that filing a joint return saves taxes.
Under current law, a spouse may claim they are innocent and thus not liable for additional taxes when three conditions are met: (1) The other spouse misreports income or deductions, causing a substantial understatement of tax liability; (2) the innocent spouse did not know, or had no reason to know, about the understatement; and (3) it is inequitable to hold the innocent spouse liable. Courts have been reluctant to grant innocent spouse relief, forcing the spouse to use an "I am stupid" defense. Usually, the spouse must show they are relatively uneducated and unsophisticated in financial matters, and that they were "tricked or misled" into signing the joint return because they could not comprehend that something was amiss.
In addition, even if the return was prepared by a CPA and the spouse relied on the tax expert, this was not a valid defense to joint and individual responsibility. The spouse must have made an independent determination that the joint return contained a true and accurate presentation of the couple’s income and expenses.
The Act provides relief if innocent spouse establishes that when the return was signed, he or she did not know, and had no reason to know, that there was such understatement and that under the circumstances, it would be inequitable to hold the other spouse liable for the deficiency. There is also an apportionment of relief if the spouse was innocent as to some items, but not others.
The difference in the current law and the Act is the removal of the requirement that must be a substantial understatement of tax liability. This is hardly a significant change, although it is helpful when the understatement might not rise to the level of substantiality (a 10 to 25% misreporting may not have qualified as "substantial" under current law). For the innocent spouse relief to be effective, if a qualified tax representative prepared the tax return, there should be a presumption that the spouse did not have reason to know of the misreporting.
Small Tax Case Limitations: The jurisdiction for a small tax case (similar to small claims court) has been raised from $10,000 to $25,000.
Tax Refunds: The period to claim a refund is two years. This limitation period will be extended if the taxpayer is under a medical disability during the two-year period which prevents him or her from claiming the refund.
Award of Fees and Costs: A court may take into consideration the difficulty of the issues presented in a case and the local availability of tax expertise to justify a higher rate for attorney’s fees. Also, taxpayers may recover attorney’s fees from the time a 30-day letter (Notice of Right to Appeal) is sent to the taxpayer, the date of the Notice of Deficiency or the date of notice of Appeal Division’s decision, whichever occurs first.
Attorney’s fees may be awarded for an individual, whether or not an attorney, who is authorized to practice before the Tax Court or the IRS. The court may also award attorney’s fees to a person who provided representation for no fee or a nominal fee.
In determining whether an IRS position is substantially justified (thus nullifying an award of attorney’s fees to a prevailing taxpayer), the courts may take into consideration whether the IRS has lost in other courts of appeal in other circuits on substantially similar issues.
Damages for Negligent Collection Action: For the first time, taxpayer may recover a maximum of $100,000 for the negligent collection actions taken by the IRS. Under current law, IRS actions must have been either reckless or intentional.
Expansion of Taxpayer Advocate’s Powers: The Taxpayer Advocate may consider the following factors when considering a taxpayer’s assistance order: (1) Whether there is an immediate threat of adverse action; (2) Whether the taxpayer will have to incur substantial professional fees if relief is not granted; and (3) Whether the taxpayer will suffer irreparable injury or long-term adverse impact, if relief is not granted. Also, and perhaps more importantly, if the IRS is violating applicable published administrative guidance, including the Internal Revenue manual, the Taxpayer Advocate shall construe the facts in a manner most favorable to the taxpayer.
Offers in Compromise: When an Offer in Compromise is terminated due to the actions of one spouse, the Offer will be reinstated with respect to the spouse or former spouse who stays in compliance.
These modest changes are steps in a positive direction, but the final legislation could be greatly improved if Congress makes it clear that the IRS cannot compel a taxpayer representative to testify to his or her thoughts, impressions or conclusions regarding information provided by the taxpayer. Also, the burden of proof should shift to the IRS if the taxpayer reasonably complies with requests for written documentation, such as original books and records, cancelled checks and receipts.
The innocent spouse relief provisions should be addressed in terms of risk verses reward. The Act still provides for an all-or-nothing approach to innocent spouse relief based on subjective factors.
Permitting damages for negligent tax collection conduct is encouraging since many tax collectors operate with abandon of their rules and procedures. This provision should provide taxpayers with a weapon against IRS collection abuses.
Finally, the Taxpayer Advocate’s function has been given more teeth to protect taxpayers, but unless the Taxpayer Advocate is separate and independent from the IRS, it is doubtful that it will use its position and power to protect taxpayers against IRS abuses. The TA must have the attitude that the taxpayer is correct and place the burden of proof in the IRS to justify its actions.
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