New Offer in Compromise Article

The CCH Group has posted an excellent article on its website about the uncertainties posed by the new IRS offer in compromise rules in light of how the IRS is opting to administer the new rules. The article was written by Patti Logan and it was published in the Journal of Tax Practice & Procedure. You can find a copy of the article here: Does TIPRA Tip the Scales on Offers.

Interest on IRS Tax Debts

The legal framework for abating IRS tax penalties and interest often produces unfair and - depending on your perspective - questionable results. Beall vs. United States provides an example.

The Bealls were limited partners in two partnerships. The Bealls filed a joint tax return for tax year 1984. The IRS audited the Bealls' 1984 return as part of an investigation of a general partner of the two partnerships in which the Bealls were limited partners. As the court explains:

In March 1989, in connection with a grand jury investigation, the IRS entered the general partner's office and seized the partnerships' books and records. The grand jury proceedings remained ongoing for four years and were concluded without any indictments or charges being brought or filed. During this time, the United States suspended the civil examination and adjustment process. The IRS did not return the partnerships' books and records until 1993, and when the IRS did return them, some had been lost and the remainder were in disarray.

Sometime in 1996 the Bealls entered into a settlement agreement with the IRS for issues related to the partnerships. About a year and a half later the IRS notified the Bealls that the IRS had assessed an additional $29,978 of taxes and penalties and interest in the amount of $67,525, which the Bealls paid.

The Bealls asked the IRS to abate the tax interest, but the IRS refused. Tax litigation ensued. Ultimately the courts agreed with the IRS that the tax interest should not be abated because the IRS's decisions in regard to criminal investigation of taxpayers' partnerships' general partner and the IRS's returning taxpayers' partnership records in disarray, with some records missing, were not "ministerial acts" triggering abatement eligibility.

"Ministerial" acts are basically acts by IRS employees that do not require independent thought or judgment. The IRS has the discretion to abate IRS tax penalties that result from errors or delays resulting from IRS "ministerial" acts (I know what you are thinking, that by this definition all acts by the IRS are "ministerial" in some sense - but I will not address that thought today).

Lets think about this. Given these facts, in 1996 who was in the best position to point out that the Bealls owed an additional tax and penalties and interest? If the answer is the IRS and if the IRS failed to notify the Bealls of the additional tax and penalty and interest in a timely fashion, why then should the Bealls be required to pay interest during that time? Should it matter that the IRS "thought" about filing a criminal case that resulted in no indictments or that the IRS "thought" about losing and returning taxpayer records in disarray?

This exact issue comes up in nearly all IRS tax audits. Let me explain. Revenue Officers do not calculate interest. Calculating IRS tax interest is such a complicated matter that it takes a computer and a special IRS office to calculate – and even then, the IRS almost always gets it wrong. It really is that difficult to compute - even in relatively simple cases (I am not kidding here).

Thus, when the IRS Revenue Officer closes an audit they merely request payment for any addition to tax, they do not request payment for tax interest. I have not encountered one single case where the Revenue Officer has tried to be helpful by telling the taxpayer that, "hey, in approximately two years from now you will be getting a bill from the IRS for interest on the tax that we made the adjustment for today. You might consider making a tax tax deposit for that so that the penalty and interest do not continue to incur additional interest during this time. Otherwise you will probably have to hire a tax attorney to try to get the interest and possibly the additional penalties removed."

Why do IRS Revenue Officers not make this suggestion? For one, taxpayers cannot make deposits unless they know the amount "in dispute." Since the IRS will not yet have calculated the "amount in dispute" (and they will not do so for about two more years, or longer) and the calculation is so complex that few (if any) taxpayers could calculate the amount on their own, there is no way that the taxpayer can make a deposit to halt the accrual of interest. Moreover, few (if any) taxpayers are even aware that interest is a problem that they should address, especially since the IRS does not tell them about it until it starts asking for payment.

Second, why does the Revenue Officer care? They finished their duties by completing the audit and making the adjustment. The phantom interest is someone else's problem - namely, the taxpayers and the taxpayer is the opponent, irresponsible, and all sorts of other bad things.

When you take a step back and look at our tax interest and interest collection process, it becomes clear that this is not the result that Congress had in mind when it penned the "ministerial" and "managerial" acts statute. If Congress really wanted to make the US revenue collection system more friendly, they should start with the tax interest provisions.

Deducting Investment Advisor Fees Paid by Trusts

There has been a split in the various circuit courts of appeals regarding the deductibility of investment advisor fees paid by trusts. The Second Circuit Court of Appeals, in William Rudkin Testamentary Trust v. Commissioner of Internal Revenue, recently held that investment advisor fees paid by trusts are limited by the Section 67 two percent floor imposed on miscellaneous Schedule A itemized deductions. Previously the Sixth Circuit Court of Appeals ruled that the two percent floor did not apply to investment advisor fees paid by trusts and the Federal Circuit and the Fourth Circuit Courts of Appeals ruled that the two percent floor did apply to investment advisor fees paid by trusts. The result: the federal deduction for investment advisor fees paid by trusts is not subject to the two percent floor in Michigan, Kentucky, Ohio, or Tennessee, but they are in New York, Vermont, Connecticut, Virginia, West Virginia, Maryland, North Carolina, South Carolina, and the District of Columbia.

Colorado Tax Attorney Contests IRS Bypass Letter

People's Source International LLC v. United States is yet another interesting Colorado tax case. People's Source involved an Aurora, Colorado tax attorney and the issuance of a bypass letter.

A bypass letter is a letter that the IRS sends to a taxpayer when the IRS believes that the taxpayer's tax attorney has failed to respond to IRS requests. As outlined in the People Source court opinion, the IRS apparently believed that the Aurora, Colorado tax attorney had failed to respond to the IRS request for information and meetings.

Upon receipt of the bypass letter, the taxpayers sent notice to the IRS that they would bring suit against the IRS if the IRS failed to retract the bypass letter. The next day the taxpayers filed suit against the IRS in the United States District Court for the District of Colorado, seeking a temporary restraining order and a permanent injunction to prevent the IRS from contacting them directly. The taxpayers amended their complaint to ask for injunctive relief and up to $1 million in damages caused by the bypass letter. Two months later the IRS informed the taxpayer that it had determined it to be in the best interests of the agency to withdraw the bypass letter.

The taxpayers then agreed to withdraw the complaint for damages and the motion for injunctive relief, leaving only their claim for attorney fees. The District Court denied the request for attorneys fees. On appeal, the Tenth Circuit Court of Appeals essentially held that the taxpayers would have been entitled to attorneys fees had the taxpayers merely exhausted their administrative remedies prior bringing suit. In this case, the administrative remedies would have been exhausted if the taxpayers had attended one conference with the IRS Appeals Office.

Here are some of my thoughts about this case, as it is set out in the court opinion. First, the IRS often does not respond in a timely fashion (if ever) to the tax attorney's requests for information or meetings, yet the tax attorney cannot issue a bypass letter to the IRS. For example, I as a tax attorney cannot simply send a letter to the IRS Commissioner to tell them that I will be interacting directly with the IRS Commissioner because the IRS revenue agent has failed to respond to my request for information or meetings. Instead, I, and my clients, have to wait months (and in some cases, years) for the IRS to respond. I often wonder why taxpayers have to wait years for the IRS to respond, yet they are penalized when they fail to respond to the IRS in a timely fashion? Also, I wonder why the IRS has the ability to send a bypass letter, when taxpayers do not have that right?

Second, the IRS has a practice of contacting tax attorneys and taxpayers at odd hours (e.g., Friday at 6:00 pm). These types of calls often come months if not years after the tax attorney or taxpayer initiated contact with the IRS. When the IRS agent does not get through to the tax attorney or taxpayer on this one occasion, they often make a record that the tax attorney or taxpayer has not been cooperative.

The IRS will then generate a letter to the tax attorney or taxpayer, which requests that the tax attorney or taxpayer get in contact with the IRS within a certain number of days. The problem is that the date written on the top of the letter has often passed or is about to pass by the time that the IRS letter arrives.

Some IRS offices use a postal meter, which allows you to see that their letter was sent on day one, it was put in the US postal system on day twenty, you know that it did not arrive in your mail box until day twenty three, and the IRS letter asks you to respond by day twenty five. This problem is even worse for the IRS offices that do not use a postal meter, as tax attorneys and taxpayers are left in the dark as to when the IRS letter was sent. Again, when the tax attorney or taxpayer fails to respond by this date the IRS employee will make a note in their records specifying that the tax attorney or taxpayer have not been cooperative.

Taxpayers then lose some of their rights because of their not being cooperative. For example, the IRS will argue in court that the burden of proof does not shift to the IRS because the taxpayer has failed to cooperate.

Third, the bypass letter presents the IRS with the ability to bully and harass taxpayers. In many cases taxpayers attempt to represent themselves before the IRS or with the assistance of a CPA. In these cases the taxpayer usually will only hire a tax attorney when the IRS fails to apply the law in an appropriate manner, the IRS fails to respond in a timely manner, or the IRS employee otherwise acts unreasonably. Should the IRS be rewarded in any of these cases by being able to bypass the taxpayer's legal counsel - as the IRS was the party that misapplied the law, that failed to respond timely, or acted unreasonably?

Even though the taxpayer was not entitled to attorneys fees, this Aurora, Colorado tax attorney probably did the right thing. He put the IRS on notice that issuing a bypass letter is not appropriate and has consequences.

The Realities of Working with the IRS....

Most taxpayers are never contacted by the IRS and they never have any IRS tax troubles. Those lucky taxpayers really cannot understand how frustrating it can be to try to resolve IRS tax troubles. Take the case of Kuhl v. United States.

Kuhl owed the IRS approximately $100,000 in taxes. Because the taxes were sufficiently old and a tax return was filed, Kuhl decided to file bankruptcy to discharge or eliminate the IRS tax liability. After the bankruptcy proceeding was closed, the IRS imposed a wage levy to garnish Kuhl's wages to satisfy the then discharged tax debt.

The IRS took the position that Kuhl's timely filed tax return was not sufficient to count as a tax return, because Ms. Kuhl's then ex-spouse claimed that he never signed the joint filed tax return. It appears that the IRS pursued this argument because the IRS statute of limitations to collect this tax debt had expired, as a tax return was filed more than ten years prior to the IRS imposing the wage levy.

Ms. Kuhl then sent the following letter to the IRS:

In regard to the attached notice requesting payment of $92055.10 in unpaid taxes, please be advised, again, that I filed bankruptcy. I have enclosed copies of the Bankruptcy Discharge Papers, again.

I am writing you because calling the IRS is very time consuming and I have never gotten any results. I have faxed the Bankruptcy Discharged Papers directly to an IRS agent with no results.

Let's try this one more time. Please release the levy sent to my employer, Belesi & Donovan, PC, requesting a salary garnishment.

Please call me at [telephone number] to clear up this matter. Thank you.

According to the court, Ms. Kuhl then had to reopen the bankruptcy proceedings and have the bankruptcy court order that the tax liabilities were in fact discharged. The IRS initially appealed the discharge.

So at the end of the day the IRS had violated the bankruptcy automatic stay laws, it used a questionable position on whether a tax return was timely filed to keep the statute of limitations open, and it continued to contest the fact that the tax liabilities were discharged in bankruptcy.

This is what it is like in dealing with the IRS. Most taxpayers have some belief that this is what it is like to deal with the IRS, but I think they doubt whether it is actually true.

The Revenue Restructuring Act of 1998 put the IRS on notice that this type of IRS abusive behavior is not acceptable; however, the increased emphasis on IRS tax collection efforts cited by the President, Congress and the media has emboldened the IRS once again to engage in these types of activities.

I cannot help but reflect on my own practice. I myself have noticed a growing indifference with IRS employees as to our tax laws and their role in resolving tax controversies.

Compensatory Damages May Not be Taxable: Let the Tax Refunds Begin

This is one of those fascinating cases. Despite the long line of case law, the US Court of Appeals for the District Circuit, in Murphy v. Internal Revenue Service, has held that IRC Section 104(a)(2) is unconstitutional.

Murphy was awarded compensatory damages for emotional distress and loss of reputation. Murphy made the traditional argument that has failed in the past, i.e., that her compensatory damages were excludable pursuant to Section 104(a)(2) as they were received "on account of personal physical injuries or physical sickness." Murphy also made an alternative argument that Section 104 was unconstitutional as if fails to exclude from income revenue that is not "income" within the meaning of the Sixteenth Amendment.

The traditional analysis starts with Section 61, the section that says everything is taxable income unless there is a Code Section that specifically excludes a particular item. The courts have held that "everything" is basically any accession to wealth. So Murphy's argument was that compensatory damages were not income, as they were a restoration of human capital. In other words the damages did not put her in a better position; they merely put her in the same position. And since she was in the same position as before, she had no accession to wealth and no gain. Despite the IRS's creative arguments, the court agreed with Murphy.

The IRS will no doubt appeal this decision. In most cases similar to this the Treasury Department has been successful in convincing Congress to take action to reform the statute. The problem here is that it is the income tax itself, based on the Sixteenth Amendment that is in question. As such, Congress could probably not simply amend Section 61 so that compensatory damages are specifically added to that section. There would have to be a change to the Sixteenth Amendment, which is highly unlikely.

So what does this mean for the average taxpayer? Presumably nothing yet. Once the appeal time passes and the case is not appealed or the IRS appeal is unsuccessful, taxpayers who have been awarded compensatory damages in the past few years - either outright or via a settlement agreement - and who paid taxes on those amounts will need to put some serious thought into whether to file an amended tax return asking for a tax refund.

Given the thousands if not millions of trials, arbitration awards, and settlement agreements that award compensatory damages in any one year, this could produce a flood tax refund requests. Attorneys are in the best position to notify their clients of this new tax law change, so lawyers and law firms may need to start going through their client records to see which clients should be notified that they may be entitled to a tax refund.

Increased Fees for IRS Tax Installment Agreements

The IRS recently reviewed the government cost of processing IRS tax payment installment agreements, which has resulted in the IRS proposing to increase the costs for filing IRS installment agreements.

The IRS tax payment installment agreement is one of the remedies of last resort to taxpayers who have outstanding tax liabilities. There are a number of rules associated with the IRS installment agreement program, but generally the program allows taxpayers to pay their tax obligations out over time. In exchange for this extended payment time, the taxpayer is required to waive certain rights.

In Proposed Regulation 148576-05 the IRS has proposed to raise the cost of filing an IRS installment agreement to $105, from the current $43 fee. The Proposed Regulation also proposes that the IRS installment agreement filing fee will only be $52 if the taxpayer agrees to allow the IRS to draft the payments directly from the taxpayer's bank account.

According to the IRS the increase in the fee is due to the increased cost to the IRS to process IRS installment agreements and the reduced cost for those who allow the IRS to draft funds from their bank accounts is due to the IRS believing that it will result in fewer installment agreement defaults.

These “reasons” are suspect. First, few taxpayers are out of compliance with our tax laws for their entire lives. In most cases, non-compliant taxpayers do not have outstanding tax debts for more than ten years. As such, they have a lifetime of paying taxes in and a short time of non-compliance. Moreover, incompliant taxpayers make up for their tax errors by paying tax penalties and interest.

The taxes that are paid for the bulk of a taxpayer's lifetime and tax penalties and interest should offset any costs associated with collecting the tax from that taxpayer for the time in which they are not in compliance with our tax laws. As such, the IRS should not pass the fees for IRS tax payment installment agreements on to taxpayers as the taxpayers have already prepaid these costs or they pay them via payment of interest and penalties.

Imposing fees to come into compliance with our tax laws is particularly troubling if the taxpayer voluntarily comes forward to come into compliance with our tax laws by requesting an installment agreement. A better system would incentivize taxpayers to come forward to comply with our tax laws by not charging those taxpayers fees, such as IRS installment plan fees. A better system would also not impose fees on taxpayers who are not compliant with our tax laws for reasons out of their control, such as death, illness, divorce or other life-changing events.

If the IRS were looking to reduce the costs associated with processing IRS tax payment installment agreements, they could streamline the process by providing an online means for taxpayers to submit installment agreements directly to the IRS.

Second, the IRS reason for imposing lower fees on those who allow the IRS to draft installment payments from their bank accounts is also suspect. The real benefit to the IRS in these cases is that the IRS will easily know where the taxpayer's bank accounts are, which will permit the IRS to levy on the bank accounts should the need arise. This is much more efficient for the IRS in that they do not have to spend the time to try to locate taxpayer bank accounts in order to levy on them.

The bank draft installment agreement will also allow the IRS to continue to taking payments, even after the taxpayer has notified the IRS to stop taking payments from their account. We see scores of these types of issues for private companies that use bank drafts to collect payment from their customers, such as electricity and gas companies.

In these cases the private company bureaucracy will delay the processing of paperwork necessary to stop the bank drafts in a timely manner, resulting in additional payments beyond what is authorized by the customer. This will be particularly problematic where the taxpayer is undergoing some hardship, such as where a taxpayer cannot afford to buy life sustaining medicines because the IRS took a few payments too many when the taxpayer could not afford to send in the extra payments. This may sound like a bit of a stretch, but it isn't. The majority of taxpayers who enter into installment agreements are poorer taxpayers. Poorer taxpayers have very tight financial budgets, budgets that they actively have to manage in order to keep afloat.

With that said, bank draft installment agreements could have some benefits for taxpayers. The real benefit to taxpayers for entering into bank draft installment agreements will be to provide proof as to when payments were remitted to the IRS. Presently taxpayers inadvertently violate their IRS tax payment installment agreements because their payments do not get to the IRS in a timely manner or the payments are misapplied by the IRS.

For example, it is not uncommon for taxpayers to violate their installment agreements due to postal failures (such as the delayed delivery of mail by the US postal system around the Christmas holidays) or where the IRS applies one or more payments to the wrong taxpayers tax account. In bank draft installment agreements, at least taxpayers will have some record as to when their payments were sent out - even if the payment was not properly received or applied correctly by the IRS.

The IRS "Last Known Address" Rule

Receiving IRS notices in a timely fashion is critical to taxpayers because failing to respond may cause the taxpayer to forfeit certain rights and it often serves to increase the taxpayers tax liability. Given the importance of receiving IRS notices, many taxpayers are surprised to find out that there is no requirement that the taxpayer actually receive most IRS notices.

In general the IRS is only required to send IRS notices to the taxpayer's "last known address." The courts have defined the phrase "last known address" as:

the taxpayer's last permanent address or legal residence known by the IRS, or the last known address of a definite duration to which the taxpayer has directed the IRS to send all communications during such period.

Generally the taxpayer's "last known address" is the address on the taxpayer's most recent filed tax return, unless the taxpayer notifies the IRS that they have a different address.

It is incumbent on the taxpayer to keep the IRS apprised of the taxpayer's current address. However, if the IRS is aware of a new address, the IRS must exercise "reasonable care" in ascertaining the correct address.

In most cases this "last known address" issue arises when the taxpayer receives a letter from their bank or a letter from their employer, which indicates that the IRS has levied or seized their bank account or wages. At that point, the taxpayer contacts to the IRS only to find out that the IRS had sent several IRS notices to an incorrect address. The IRS is very quick to cite the "last known address" rule in these situations.

These missed notices can be most severe when IRS tax penalties and interest are accruing, as the taxpayer may not be put on notice of their tax debt for years or even decades. In these cases the penalties and interest will typically be more than 100% greater than the underlying tax liability.

While this rule may be necessary to keep taxpayers honest, it often harms taxpayers who honestly do not receive IRS notices.

This type of issue was not as pronounced in the recent past, as in the past most taxpayers did not relocate as frequently as they do today. The reality is that in today's society taxpayers frequently move to several different addresses in several different states and countries several times each year (especially when you think about airplane pilots, a hockey players, and traveling salesmen).

So what is today's mobile taxpayer to do? The IRS answer is that taxpayers are to submit IRS Form 8822 to update their address with the IRS each time they move. That is the official answer, but it is not one that is realistic.

For example, say a hypothetical taxpayer has lived in three countries, six United States states, thirty cities, and they have had forty different addresses in the past decade. That would produce forty Form 8822's and ten federal tax returns (and maybe more tax returns, depending on the taxpayer's assets and business interests).

In the event that the taxpayer timely filed each and everyone of these forms (and kept proof that they submitted the forms), it would be nearly impossible for the IRS to establish that they mailed each notice to the taxpayer's "last known address." Given these facts, by the time the IRS processed the taxpayer's Form 8822 the taxpayer would have already been living at a new address and have submitted a new Form 8822 to the IRS. Imagine the IRS backlog if every taxpayer submtitted a Form 8822 every time that they changed addresses.

So why do the current rules work and work in favor of the IRS? Because taxpayers almost never submit Form 8822 to the IRS when they move. So what is the lesson for taxpayers who do not want to pay their taxes? Find a job that allows you to move every few months and get in the regular habit of sending in Form 8822's to the IRS.

Taxpayers should keep in mind that the IRS has the burden of proving that notices were mailed and when they were mailed. In the event that certain notices are not timely sent -- and sent to the correct address, the IRS forefits some of its rights.

While this probably would not work (and I am certainly not recommending it), I bet the IRS would not be so quick to cite the "last known address" rule in cases such as these….

Employment or Payroll Taxes and Limited Liability Companies

The Limited Liability Company (LLC) is a flexible legal entity that allows taxpayers to elect how they want to account for their state and federal tax liabilities. Unfortunately many taxpayers do not understand issues surrounding whether they should use the LLC and in what form to achieve their tax and asset protection goals. This article will briefly discuss one issue in this analysis, namely employment or payroll tax liabilities.

The IRS regards a single member LLC (i.e, a LLC owned by one individual or entity) as not being a separate taxable entity distinct from the owner, unless the owner opts to have the LLC treated as a corporation for tax purposes. As a disregarded entity the sole owner of the LLC can simply account for the profits and losses of the LLC on the taxpayer's personal tax returns (on the taxpayer's Schedule C).

It is the sole owner of a single member LLC that is personally responsible for employment taxes related to the LLC's employees. The IRS has the ability to impose a lien or levy or seize the sole owner's personal assets if the LLC's employment taxes are not paid, but the IRS cannot levy or seize the LLC's assets to satisfy this type of liability. This is true regardless of whether the sole owner elected to use his or her name and social security number for the LLC tax reporting or if the sole owner elected to use the LLC name and a separate taxpayer identification number for the LLC tax reporting.

The result for the multi-member LLC (i.e., a LLC owned by more than one individual or entity) may be different depending on the applicable state law. If the state law provides that members of LLC's are not liable for LLC debts then the IRS's recourse with regard to the LLC's unpaid employment taxes lies with the LLC and not with the member owner.

For the most part businesses are started with the aim of making a profit. The thought of incurring a loss is often not planned for in the business formation or start up process. As such, this type of employment tax issue typically does not arise until after the LLC is facing financial difficulties. In these cases the LLC may be unable to meet its state and federal employment tax obligations. If the LLC employment taxes are not timely remitted, the question is whether the state and federal government may collect the employment tax liability from the LLC or the LLC owner or owners.

This issue is most important for LLC's that employ a number of employees and/or that employ highly paid service employees. In these cases the LLC owners with little or no assets and no expectation of having significant assets or whose only significant assets are those used in their trade or business (e.g., a mechanic whose only assets are his or her tools) may prefer that the IRS pursue him or her individually for the LLC's employment tax obligations. On the other hand, the financially well off LLC owner may prefer that the IRS only be able to pursue the LLC for the LLC's employment tax liabilities.

Given this dichotomy it may make sense for single member LLC owners to convert their single member LLCs into multi-member LLCs or to elect to have the LLC be taxed as a corporation once the LLC has achieved some measure of financial success. Of course, the business owner must also consider other tax factors, such as the trust fund recovery penalty and the role of self-employment taxes.