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CHAPTER 13 DOING BUSINESS WITH THE IRS AFTER RESTRUCTURING AND REFORM by ELLIOTT H. KAJAN, ESQ. Synopsis 1300
Introduction 1301
History 1302 TBOR
3 1302.2
Innocent Spouse 1302.3
Burden of Proof 1302.4
Miscellaneous New
Rules 1303 IRS Reorganization 1303.1
IRS Structuring 1303.2
Oversight Board 1303.3
Taxpayer Advocate 1304 Conclusion 11 1300 INTRODUCTION On July 22, 1998, President Bill
Clinton signed into law the Internal Revenue Service Restructuring and Reform Act of 1998
(the "Act")1 which substantially changed the structure * Principal Kajan Mather and Barish, a
Professional Corporation, Beverly Hills, California.
Contributing assistance from Jason M. Silver, Esq. of Kajan Mather and
Barish, and Jacob Stein, Esq.
1Pub.
Law. 105-206. (Matthew Bender & Co.. Inc.)
13-1
1301 U.S.C. Law SCHOOL Tax INSTITUTE 13-2 and management of the IRS in addition to providing major equitable relief to taxpayers and greater rights to their practitioners. An exhaustive discussion of all the myriad provisions is beyond the scope and purview of this article and will be left to those practitioners who most assuredly have been digesting the ramifications of the Act, all to demonstrate that it no doubt qualifies as another attorney and accountant relief statute. The Act represented the most comprehensive IRS overhaul since 1952 and as a result it has been the most prominent piece of legislation in recent years.2 The Act contains five major categories, namely, Reorganization of the IRS (Title I), Electronic Filing (Title II), Taxpayer Protection and Rights (Title III), Congressional Accountability for the IRS (Title IV), and miscellaneous other provisions, including technical corrections and revenue provisions. This article will primarily focus upon the salient changes which have evolved since the passage of the Act under Title III.(entitled,"Taxpayer Bill of Rights 3" ["TBOR 3"]) (Act §3000); specifically, the law dealing with the confidentiality (accountant-client) privilege, new rules for the "innocent spouse" exception, shifting the burden of proof to the IRS in civil cases, and other miscellaneous rules worthy of note. Thereafter, the major provisions, and implementation of the IRS reorganization under Title I will be explored. 1301 HISTORY In the wake of reports of taxpayer abuse by the IRS,3 Congress established the National Commission on Restructuring the Internal Revenue Service (the "Commission") to review the structure and practices of the IRS and to recommend changes for improverilent and modernization. Its goal was to restore public trust in the tax system. An erosion of that trust over the years had occurred resulting from constant 2 Report of the National
Commission on Restructuring the Internal Revenue 3 See, e.g., Baker Says He Was Targeted
Falsely; IRS Employees Allege Wrongdoing, BNA,
84 DTR, G-8, May 1, 1998 and Taxpayers Tell
Finance Committee of abuse by Criminal
Investigation Division, 83 DTR, G-7, Apr. 30, 1998. (Matthew Bender & Co., Inc.)
13-3 IRS AFTER REFORM AND RESTRUCTURING 1 1302.1 mechanical and judgmental errors, erroneous responses to questions, and gross negligence all coupled with reports that the IRS used tax information for personal gain, cheating taxpayers, initiating unjust audits and taking advantage of its employees. Some observers concluded that the IRS failed to meet the very same standards of financial accountability and diligence that it imposed on the citizenry.4 The Commission, holding 12 days of public hearings, received input from taxpayers as well as tax professionals, experts, and academic and citizen's groups in reviewing operations of the IRS. It also reviewed thousands of reports and documents on IRS operation and management and conducted research and surveys to better understand IRS operations. The Commission's report was issued on June 25, 19975 containing key recommendations, namely, creation of an oversight board, setting a fixed term for the Commissioner of Internal Revenue, updating technology, developing an overall strategic plan, and simplifying the tax laws. The Commission's report was shortly followed by H.R. 2676, passed by the House on November 5, 1997 (by a vote of 425-4). The Senate companion bill (S. 1096) was passed on May 7, 1998 (by a vote of 97-0). Both bills survived major attacks and underwent numerous changes.6 The Joint Committee released the bill on June 24, 1998, both houses in Congress quickly passed it and, as referenced, it became law on July 22, 1998. 13O2 TBOR 3 1302.1 Confidentiality Privilege The Commission believed that a right to privileged information between a taxpayer and an advisor should be available 4 See, Michael Hirsch, Infernal Revenue Disservice, Newsweek, p. 32, Oct.
13, 1997, and Daniel J. Pilia, Why You Can't Trust
the IRS, The Cato Institute Policy analysis No. 222, Apr. 15, 1995. 5 Report of the National Commission on
Restructuring the Internal Revenue Service, A Vision For a New IRS, June 25, 1997. 6 For example, the Senate alone passed 24
amendments to H.R. 2676. See, BNA, Senate-Passed Amendments to H.R. 2676, IRS
Restructuring and Reform Act, 89 DTR L-7 to L-12, May 8, 1998. (Matthew Bender & Co., Inc.)
T 1302.1 U.S.C. LAW School Tax INSTITUTE 13-4 in noncriminal proceedings before the IRS and in Federal courts with respect to such matters where the IRS is a party, so long as the advisor is authorized to practice before the IRS. It was argued that since non-attorneys are authorized to practice before the IRS the privilege should also apply to them.7 The extension of confidentiality to non-attorneys was characterized as a taxpayer rights issue by accountants who contended that a taxpayer's choice of a tax advisor should not be affected by whether communications would be privileged. Based largely upon strenuous lobby efforts by the accounting profession, §7525 of the Internal Revenue Code of 1986, as amended ("I.R.C." or the "Code," as the case may be),8 extends the present common law attorney-client privilege of confidentiality to tax advice that is furnished by any individual who is authorized to practice before the IRS.9 The privilege applies to communications after the date of the Act.10 These federally authorized tax practitioners ("FATP") include attorneys, CPAS, enrolled agents and actuaries.11 Tax advice is defined as advice given by an individual with respect to a matter that is within the scope of the individual's authority to practice before the IRS.12 The privilege does not include communications regarding a taxpayer's whereabouts, contacts, physical characteristics (i.e., observations), fees and future criminal acts. The privilege may be asserted in any noncriminal tax proceeding before the IRS, as well as noncriminal tax proceedings in the Federal courts where the IRS is a party to the proceeding. The privilege may not be asserted to prevent disclosure of information to any regulatory body other than the IRS, e.g., 7
S. Rept.
174i 105th Cong. 2nd Sess. 36 (1998). See, Alyson Petroni, Note, Unpacking the Accountant-Client Privilege Under LR.C.
Section 7525, 18 Virginia L. Rev. 843 (1999); Theodore A. Sinars, The Confidentiality Privilege Extended to Nonlawyers:
How Limited is it?, Tax Practice & Procedure, April-may 1999, at 18.
8 26 United States Code. 9 Treasury Department Views on Major Issues
in IRS Restructuring Bill (H.R. 2676), BNA, 112 DTR L-5, Jun. 11, 1998.
10 Randall v. United Sates, 99-1 U.S.T.C. 150,596 (D. Mass 1999).
11
I.R.C. §7525(a)(3)(A).
12
I.R.C.
§7525(a)(3)(B)@, cf.
United States v. Adlman, 98-1 U.S.T.C. 550,230; 81 AFTR 2d 98-820 (2d Cir.
1998). (Matthew Bender & Co., Inc.)
13-5 IRS AFTER REFORM AND RESTRUCTURING 1302.1 Security Exchange Commission, Federal Trade Commission, etc. Moreover, the privilege does not apply to any written communication between a FATP and any director, shareholder, officer, 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.13 This so-called accountant-client privilege has been a source of major controversy. The Treasury Department advised the Senate Finance Committee that, ". . creating a new evidentiary privilege for communications between accountants and other tax advisors authorized to appear before the IRS and their clients would be unwise and unwarranted. The Department of Justice and the Federal Bureau of Investigation view the creation of this privilege as an impediment to the prosecution and investigation of fraud matters, and the existence of the privilege will inhibit the investigation of the types of civil tax matters that often lead to criminal tax referrals."14 The Department of Justice advised the Commission that, we strongly oppose the creation of a new privilege for accountant client communications. It would deny the Government access to information needed for bona fide investigations and would result in claims of privilege in non-tax contexts out of concern that disclosure of the information would constitute waiver of the tax advice privilege."15 Furthermore, uncertainty
exists as to the extent and nature of this privilege.
In particular, it is unclear whether it extends - to the work product of a
federally authorized practitioner; to an accountant's opinion on a taxpayer's financial
statements; and to audit papers. It is also
unclear as to what constitutes the scope of tax advice of the non-lawyer; when a
noncriminal tax proceeding becomes criminal; whether the privilege applies when both tax
and non-tax advice are given by a non-lawyer; and when a waiver of the privilege occurs,
to mention a few.16
13 I.R.C. §
7525(b).
14 Treasury
Department Views on Major Issues in IRS Restructuring Bill (H.R. 2676), BNA, 112 DTR L-6, Jun. 11, 1998.
15 Id. at L-9.
16 1998 Tax
Legislation, IRS Restructuring and Reform, Law, Explanation
and Analysis, CCH Inc. 51141, pp. 285-286
(1998).
(Matthew Bender & Co.. Inc.)
1 1302.2 U.S,C. LAw SCHOOL TAx INSTITUTE 13-6 Equally significant is that no
comparable privilege exists in California. The
problem thereupon arises that communications which may be privileged for federal income
and employment taxes are not privileged for those same California taxes. This dichotomy in the law could result in the IRS
possibly obtaining information indirectly which it could not otherwise obtain directly. Finally, but by no means least
important, there is concern that the confidentiality privilege will create confusion and
uncertainty as to its application. More
specifically, information for the preparation of tax returns is not privileged, even for
attorneys.17 Equally important, the privilege does not extend to communications
from the taxpayer-client to the FATP which involves actual or potential criminal fraud. In short, the concepts espoused under United States v. Kovell8 still remain,
namely, employment of the accountant who would not otherwise have the privilege per se to assist the attorney in the rendition of
legal services.19 In sum, the protection afforded the tax
practitioner under the confidential privilege is limited.
Indeed, it would appear appropriate for the non-attorney federally
authorized tax practitioner to review his or her professional liability insurance policy
before advising a client that an intended communication will be confidential. 13O2.2 Innocent Spouse In California and other community
property jurisdictions, the separate obligation of a spouse for federal taxes can be
satisfied from the community estate.20 Consequently, even if a spouse is not
liable for the tax, and the only property owned by that spouse is community property, the
IRS has a right to satisfy the other spouse's separate liability from that 17 United
States v. Bornstein, 977 F.2d 112 (4th Cir. 1992); Colton v. United States, 306 F.2d 633 (2nd Cir.
1962); United States v. Frederick, 99-1 U.S.T.C.
150,465; 83 AFTR 2d 99-1980 (7th Cir. 1999). 18 296 F.2d 918 (2nd Cir. 1961). 19 United
States v. Judson, 322 F.2d 460 (9th Cir. 1963). 20 Cal.
Fam. Code §910(a). (Matthew Bender & Co., Inc.)
13-7 IRS AFTER REFORM AND RESTRUCRURING 1 1302.2 property. Under this scenario, the innocent spouse rule becomes inapplicable. It is only when a spouse owns separate property during the marriage, or acquires separate property after separation or divorce that the innocent spouse rule becomes germane. A
basic premise is that spouses have joint and several liability for their taxes regardless
of who earned the income when they elect to file joint income tax returns.21 Under prior law, if a return
was examined which resulted in a tax deficiency, a taxpayer could qualify for the innocent
spouse exception and thus avoid the resulting tax assessment if he or she established that
a joint return was made, an understatement of tax was attributable to a grossly erroneous
item of the other spouse, the innocent spouse did not know or have reason to know that
there was an understatement of tax when signing the return, and it would be inequitable to
hold the innocent spouse liable for the understatement.22 A grossly erroneous item was any item of
income attributable to a spouse that was omitted from gross income or claimed as a
deduction for which there is no basis in fact or law.23 A substantial understatement was an
understatement exceeding $500 which also met certain adjusted gross income limitations.24 The Commission expressed concern that the provisions of the prior law were inadequate to protect the innocent spouse in a joint return situation. It concluded that a system based on separate liabilities would provide better protection.25 Accordingly, under the Act, I.R.C. §6015 provides that the innocent spouse is permitted to limit his or her liability for unpaid taxes on a joint return to the amount of that spouse's separate liability.26 Significantly, the statute provides that 21 I.R.C. §6013(a). 22 I.R.C. §6013(e)(1), 23 I.R.C. §6013(e)(2). 24 I.R.C. §6013(e)(3). 25 S. Rept. 174, 105th Cong. 2nd Sess. 29
(1998). 26 See, Julia K. Brazelton, Qualifying as an Innocent Spouse-New Equity Provisions Make it Easier but not Guaranteed, Journal of Taxation,
January 2000, at 26; Thomas R. White, III, Relief
from Liability on Joint Income Tax Returns (pts. 1 & (Matthew Bender & Co., Inc.)
W 1302.2 U.S.C. LAW SCI-IOOL TAX INSTITUTE 13-8 community property laws are to be disregarded for this relief.27 Thus, for purposes of determining innocent spouse relief, the income earned by a spouse belongs to that spouse together with the attending tax liability. Under
the general relief election, a spouse is eligible for relief from joint and several
liability for an understatement of income tax which is attributable to an erroneous item
of the other spouse when a joint tax return is filed.28 It is no longer necessary for an
understatement to be "substantial" or "grossly" erroneous.29
In other words, the additional income tax resulting from IRS adjustments increasing income
or disallowing deductions regardless of amount or their basis now qualifies. The remaining elements involving innocent spouse
relief remain the same, namely, it would be inequitable to hold the nonputative spouse
liable, i.e., that spouse did not benefit from the unpaid taxes.30 The rule requiring the spouse invoking relief to prove he or she did not know and had no reason to know the extent of the understatement still remains.31 However, in the event of a tax deficiency arising in a joint return, an innocent spouse is liable only to the extent items giving rise to the deficiency are allocable to that spouse.32 Thus, if the wife makes the general relief election and the deficiency is based solely upon the husband's unreported income, the entire deficiency is allocated to the husband. In that connection, items are allocable to the spouses on the same basis as they would have been allocated had the spouses filed separate returns, i.e., based on the source of income. 2), Tax Practice & Procedure,
April-May 1999, at 40, August-September 1999, at 37; Gary M. Fleischman and Jingzhi Shen, IRS Restructuring and Reform Act of 1998 Gives Innocent Spouses a Much Needed Break, Taxes,
August 1999, at 25; Steven Toscher, The IRS Offers
New Relief for Innocent Spouses, Los Angeles Lawyer, May 1999, at 24; IRS News Release
IR-98-73 (December 7, 1998) (interim guidance). 27
I.R.C. §6015(a), 28 I.R.C. §6015(b). 29 I.R.C. §6015(b)(1)(B). 30 I.R.C. §6015(b)(1)(D). 31 I.R.C. §6015(b)(2). This provision codifies the rule espoused by the
Ninth Circuit Court of Appeals in Wiksell v. Cornmissioner, 90 F-3d 1459 (9th Cir.
1997). 32 I.R.C. §6015(d)(1). (Matthew Bender & Co, Inc.)
13-9 IRS AFTER REFORM AND RESTRUCTURING 1302.2 The general relief election can be made with respect to income and self-employment taxes on Form 8857, Request for Innocent Spouse Relief (And Separation of Liability and Equitable Relief).33 The election may be made at any time not later than - (i) 2 years after July 22, 1998 or (ii) when the collection activities began with respect to the electing spouse.34 The electing spouse has the burden of proving the amount of tax for which he or she shall not be responsible.35 The Act also provides a separate liability election encompassing procedures to limit liability for those spouses who are no longer married, or are legally separated, or are not living together for the preceding 12 months before the deficiency is assessed.36 This separate liability election for such spouses takes on greater meaning by virtue of the rule that the IRS has the burden of proof that the electing spouse had actual knowledge at the signing of the tax return containing the item giving rise to the deficiency allocable to the other spouse.37 Moreover, the equitable standard does not apply here, i.e., the innocent spouse could have benefitted from the unpaid tax and still escape it. This is in marked contrast with the general relief election where the electing spouse has the burden of proving that he or she had no actual knowledge or reason to know of the understatement and could not benefit from the unpaid taxes. The separate liability election is unavailable where a transfer of property from the putative spouse to the innocent spouse is made to avoid tax. In that regard, there is a presumption of avoidance when the transfer occurs one year before the IRS issues a notice of proposed income tax deficiency ("30-Day Letter") or notice of deficiency, as the case may be. However, again it is the IRS which has the burden of proving the proscribed purpose.38 33 See, IRS Publication 971. 34 Act §3201(g)(2). 35 I.R.C. §6015(b)(1)(E). 36 I.R.C. §6015(c)(3)(A)(i); See, footnote 33, supra. 37 I.R.C. §§6015(c)(2) and 6015(c)(3)(C). 38 I.R.C. §§6015(c)(2) and 6015(c)(3)(A)(ii). (Matthew Bender & Co., Inc.)
T 1302.2 U.S.C. LAw SCHOOL TAx INSTITUTE 13-10 As
with the general relief election, the separate liability election provides that the
portion of the deficiency allocable to the innocent spouse is any amount of the deficiency
attributable to income or expenses of the innocent spouse, i.e., partial liability rule. Moreover, the two-year period for making the
separate liability election does not expire before the date which is two years after the
date the first collection activity begins after July 22, 1998.39 The
Act provides that a spouse who is denied the general relief and separate liability
elections has the right to file a petition with the U.S. Tax Court to redress his or her
grievance.40 Also, a spouse is entitled to reopen a Tax Court
case to consider liability under I.R.C. §6015(b).41 Interestingly, the Tax Court rules
provide that the nonelecting spouse will be given notice and an opportunity to become a
party to the proceeding.42 Finally, but by no means least important, the Act provides that a spouse may be relieved of joint liability where it would be inequitable to hold the spouse liable for any unpaid tax or deficiency (or any portion of either) where relief is not available under the general relief or separate liability elections. This applies not only to deficiencies, but equally significant, it applies to underpayments of tax, i.e., liability due under a joint return. Equitable relief is made available to the spouse who does not know or have reason to know that the funds were taken by the other spouse for that spouse's benefit instead of being used for payment of taxes. This provision should go a long way in providing relief to the unknowing spouse who finds himself or herself liable under a joint return where the income reported on the tax return is generated by the other spouse.43 Criticism of this provision was offered by the Treasury Department, which stated that the Senate bill on which the 39 ACt §3201(g)(2). 40 I.R.C. §6015(e). 41 Friedman v. Commissioner, 98-2 U.S.T.C. 150,717 (2nd Cir.
1998) revg. 66 TCM (CCH) 1404 (1993). 42 I.R.C. §6015(e)(4); Tax Court rule 325. 43 I.R.C. §6015(f). (Matthew Bender & Co., Inc.)
13-11 IRS AFTER REFORM AND RESTRUCTURING 1302.3 present law is based does not go far enough in eliminating unfair treatment of innocent spouses but creates an incentive for joint filers to learn as little as possible about their returns.44 On the other hand, this provision does go a long way in ameliorating the hardship of a tax burden encountered by an unknowing spouse who never received tax benefit from the acts of the other spouse. 1302.3 Burden of Proof Under prior law, when the IRS made a determination that a position on a tax return was incorrect there existed a rebuttable presumption that its determination was correct.45 This procedural device required taxpayers to present prima facie evidence to support a finding contrary to the IRS determination. Once the taxpayer's burden was satisfied, the taxpayer still had to carry the ultimate burden of persuasion on the merits.46 Although the presumption was never codified, there were a number of provisions in the Code revealing that Congress approved of it indirectly, i.e., provisions placing the burden of proof on the IRS in certain situations.47 Individual taxpayers and small businesses were frequently at a disadvantage when forced to litigate with the IRS and the lawmakers felt that placing the burden of proof on the taxpayer contributed to that disadvantage.48 Consequently, the law provides under I.R.C. §7491 that the IRS has the burden of proof in any court proceeding with respect to a factual issue that is relevant to determining taxpayer's tax liability if the taxpayer introduces credible evidence49 with 44 Treasury Department Views on Major Issues in
IRS Restructuring Bill (H.R. 2676), BNA, 112
DTR L-5, Jun. 11, 1998. 45 Welch
v. Helvering, 290 U.S. 111, 115 (1933). Also,
the taxpayer generally bears the burden of proof under Tax Court Rule 142. 46 Danville
Plywood Corp. v. United States, 16 Cl. Ct.
584 (1989). 47 E.g.,
I.R.C. §7454(a) (fraud), I.R.C. §6201(d) (verification regarding information
returns), I.R.C. §6902(a) (transferee liability), and I.R.C. §534 (accuii@ulated earnings tax). 48 Internal Revenue Service Restructuring
and Reform Bill of 1997, Ways and Means Committee Report Released on October 31, 1997, 48
Stand. Fed.
Tax Rep.
56 (CCH), Nov. 13, 1997. 49 The fact that the taxpayer has to bring forth credible evidence is likely to' cut (Matthew Bender & Co., Inc.)
1302.3 U.S.C. LAw SCHOOL TAx INSTITUTE 13-12 respect to that factual issue. Credible evidence is defined as the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted.50 The taxpayer is not considered to have produced credible evidence if he or she merely makes implausible factual allegations, frivolous claims or tax-protestor type arguments.51 Once the credible evidence standard is met, the taxpayer is then required to meet several conditions before the burden of proof shifts to the IRS. First, the taxpayer must comply with the requirements of the Code and the Treasury Regulations promulgated thereunder to substantiate any item and to maintain records.52 The substantiation requirement must be met, whether generally or specifically imposed, that a taxpayer establish an item to IRS satisfaction.53 Second, the taxpayer must cooperate with reasonable requests by the IRS for meetings, interviews, witnesses, information, and documents.54 A corollary to this cooperation condition is that the taxpayer must have exhausted his or her administrative remedies, including any appeal rights provided by the IRS.55 Finally, taxpayers other than individuals must meet the net worth limitations that apply for awarding attorney's fees.56 This provision applies to income, estate, gift and generation-skipping transfer taxes. There were prominent dissenters to the burden of proof statute. The Treasury Department, in a letter to the Senate |