The Bankruptcy Abuse Prevention and Consumer Protection Act

For the most part the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 comes into full force on October 17, 2005. The Act contains a number of tax-related provisions, almost all of which are contradictory and unworkable. I will refrain from describing some of the more ridiculous non-tax provisions, instead focusing on some of the tax-related Congressional blunders contained in the Act.

First, the Bankruptcy Code now requires all debtors file either tax returns or tax transcripts shortly after seeking the protection of bankruptcy and to make those returns or transcripts available to the US Trustee and, upon request, to the creditors (the tax returns are then a matter of public record). The provision is mandatory. No exceptions are permitted. The penalty is dismissal of the bankruptcy case. That appears to make sense, unless you consider that not all taxpayers are required to file tax returns (in which case there would be no tax returns or tax transcripts).

For example, taxpayers are not required to file tax returns if their taxable income is less than the standard deduction plus the allowable exemption. Similarly, individuals and businesses located in certain territories and possessions, such as the Virgin Islands, are not required to file federal tax returns. So it now appears that those businesses and persons are now not entitled to seek the protection of our bankruptcy laws. Of course the provision is unconstitutional. Because of this Congressional blunder some unfortunate taxpayers will have to pay the costs of litigation to have a court make this ruling.

If that is not bad enough, it now takes the IRS over a month to provide taxpayers with copies of their tax returns or with tax transcripts. Yet, Congress required that the taxpayer present these documents in less than 30 days after commencing the bankruptcy case. How are taxpayers to do this, especially since more taxpayers are now going to be requesting tax returns and transcripts from the IRS? The answer is that Congress has created an opportunity for tax businesses to provide these transcripts sooner by their signing up to receive them electronically (i.e., yet another artificial and unnecessary government-created industry that reduces the efficiency of our markets). The result is that taxpayers will have to pay this fee instead of paying their creditors. Moreover, this rule begs the question as to what will happen in the cases where the IRS has lost the tax returns, there are no tax records entered in the IRS records sufficient to produce a tax transcript, but the IRS IMF file indicates that returns were filed? This scenario occurs quite often. For now, it appears that taxpayers in this situation will not be entitled to seek the relief of bankruptcy, so the IRS can conveniently lose records and prevent taxpayers from qualifying for bankruptcy relief.

Second, Congress failed to close several large bankruptcy-tax loopholes. For example, Congress failed to shutdown the ability of taxpayers to take out loans (which are dischargeable in bankruptcy) to pay off tax liabilities (that are not dischargeable in bankruptcy), with the intent of using the loan proceeds to pay off the tax liability. Taxpayers do this to minimize the amount of debt that they will owe after they emerge from bankruptcy. Congress did provide that a “debt relief agency” (FYI most bankruptcy attorneys will now be considered “debt relief agencies” when they are working with lower income taxpayers) can not now advise taxpayers about this option. Again, this provision is clearly unconstitutional (also, a bankruptcy attorney is subject to disbarment and/or malpractice if they do not fully advise their client). Even then, Congress did not prevent non-debt relief agencies (such as bankruptcy attorneys, who are individuals who help higher income taxpayers) from advising clients as to this loophole. So attorneys working with higher income taxpayers are still free to make this recommendation to higher income taxpayers (this even undermines the infamous means test that Congress devised to prevent higher income taxpayers from qualifying for bankruptcy relief). Moreover, attorneys and “debt relief agencies” are under a duty to provide taxpayers with copies of the law and in this instance handing the taxpayer a copy of the law would clearly tip off the client that they would benefit from taking the action that is proscribed in the rule. In essence the legislation points out the loophole to taxpayers. So Congress has done for debt relief agencies what the agencies could not do for themselves.

Third, Congress requires all taxpayers undergo and pay for budgeting and counseling in order to qualify for bankruptcy relief. The idea is that this will present the potential-bankrupt business or individual with an opportunity to hear non-bankruptcy options for dealing with debt. This is of little to no value in cases where the primary debt is a dischargeable tax liability, yet it is still mandatory. How is setting a budget going to help the taxpayer pay for an unpaid tax debt? Even if the counseling points out ways to avoid bankruptcy, why would the taxpayer want to pursue those options if the tax debt is fully dischargeable? This will create a new stream of income for credit counseling agencies, at the expense of the legitimate creditors.

Fourth, Congress changed the priority rules with respect to tax liabilities. In essence, the Bankruptcy Code provides that all of the taxpayers assets are to be added up and then applied to debts according to a priority list provided in the Bankruptcy Code. IRS tax liabilities are next to last on that list, which makes them payable before general unsecured creditors. This priority allows the IRS to collect most of all tax liabilities that are not otherwise dischargeable. Tax liabilities are not dischargeable if they are due to taxes for more recent tax years. Congress changed the Bankruptcy Code to extend this time period in accordance with any time period in which the IRS was not lawfully able to collect the tax debt, such as times during which a collection due process hearing request is pending or the case is before the Appeals Office pending placement on the Tax Court docket. So in essence this new provision now allows the IRS to delay processing such requests in order to make tax debts priority claims, rather than non-priority general unsecured claims (is it likely that the IRS would be accused of not acting timely?). The bottom line is that now the IRS should be able to, in bad-faith or by way of negligence, delay and make their claims superior to all other non-priority claims, taking money from the taxpayer at the expense of legitimate non-government creditors.

Fifth, Congress has prohibited debt relief agencies (i.e., bankruptcy attorneys who work with lower income taxpayers) from hiring a tax attorney to advise taxpayers on their tax obligations. The idea appears to be that attorneys should not be able to dissipate the bankruptcy assets unnecessarily by hiring other attorneys to work for the taxpayer (this is contradictory to Congresses requiring taxpayers dissipate assets to pay for unnecessary credit counseling and tax transcript fees). This rule fails to recognize that there are situations where hiring an attorney would increase the assets available to creditors, such as where the taxpayer needs to know whether they are required to pay tax on certain transactions. Thus, bankruptcy attorneys are no longer able to advise taxpayers to bring in a tax attorney when there is a tax issue that the bankruptcy attorney cannot answer, regardless of whether it is necessary and warranted. This rule can be really detrimental to taxpayers given that tax returns now must be filed (including some prior year tax returns) in order to qualify for bankruptcy relief. So the taxpayer will now have to tax positions on tax returns and taxable transactions without counsel and then they will be subject to non-dischargeable penalties and interest if they are incorrect.

These are just a few of the tax-related blunders created by the new Act. The non-tax issues are undoubtedly even more glaring and ridiculous. Almost every commentator that I have spoken with (including several judges) has stated that many of the provisions of the Act are clearly unconstitutional. The ensuing litigation is going to last for many years and will be very costly. Instead of focusing our efforts on making the country more productive and efficient, we are collectively going to spend a great deal of our national energies on correcting these Congressional blunders. Should we reduce our national GDP projections to account for this?

Even the most conservative of our citizens would disagree with most of the provisions in the new Act, if they were aware of the scope of the new law and how the new law will play out. Does this signal the failure of our democratic system - a system where the electorate does not listen to or care for the concerns of the citizenry? That post will follow….

October 8th, 2005 | No Comments »

Trust as the IRA Beneficiary

I continue to hear a number of financial planners, accountants and even attorneys say, “Don’t name a trust as the beneficiary of an IRA. ” The rationale is that naming individuals as the IRA beneficiary is preferable because the individual can take the IRA distributions over the course of the beneficiaries lifetime; whereas, a trust named as a beneficiary would require the beneficiary to take a lump sum distribution within five years of the IRA holders death. That was once true; however, the Treasury Regulations have since been amended, as evidenced by private letter ruling 2005-37-7044.

This ruling describes a “required minimum distribution conduit trust ” (RMD trust). RMD trust rules are somewhat involved, but essentially RMD trusts allow IRA proceeds to be held in trust for individual beneficiaries and the IRA funds can be maintained in trust for and paid out over the course of the beneficiaries lifetime. In general, these trusts involve two issues: (1) whose life expectancy IRA distributions are based on and (2) how the life expectancy is calculated when there are multiple beneficiaries.

The Treasury Regulations provide that the life expectancy of IRA distributions is based upon the beneficiary’s life expectancy. If there are multiple trust beneficiaries then the life expectancy is that of the oldest beneficiary. This can be disadvantageous for younger beneficiaries when there are also older trust beneficiaries (such as where a trust names the grandchildren and parents as beneficiaries). The Regulations and letter ruling address this inequity by providing that if the IRA proceeds are allocated to separate trusts with separate trust beneficiaries, the life expectancy for each individual beneficiary will be the life expectancy used for purposes of making distributions.

Skipping over the rest of the specifics, you might be wondering when these trusts might be useful or when they should be used. The short answer is that these trusts are useful when a significant portion of ones estate consists of an IRA (or IRAs), there are multiple beneficiaries who could benefit from stretching out IRA distributions for a long period of time, the beneficiaries will be likely to have taxable estates that are large enough to incur an estate tax liability, and/or one or more of the beneficiaries might have future creditor problems. In the later case, the trust can contain provisions granting the trustee the power to make distributions and a spendthrift provision. The net result is that IRAs can be stretched out for the maximum period allowed, income taxes are deferred for that period allowing maximum growth, the beneficiary does not increase their estate tax liability, and the IRA proceeds can continue to be a creditor-proof stream of income for beneficiaries.

RMD trusts are powerful estate planning tools. RDM trusts can solve a number of issues given the right circumstances. The bottom line: More advisers should be recommending RMD trusts, as opposed to saying that “trusts should not be named as IRA beneficiaries.”

October 1st, 2005 | No Comments »

TIGTA Audit Reveals A Few of the Deficiencies in IRS Procedures

In the Revenue Restructuring Act of 1998, Congress provided that taxpayers were to be provided a hearing before the IRS filed a lien or levy on taxpayer property. If filed timely, this involves a collection due process (CDP) hearing; if not filed timely, this involves an equivalency hearing. Typically both hearings are held before the IRS Office of Appeals. After seven years, the IRS Office of Appeals has not yet been able to produce a workable system for processing or managing the collection due process and equivalency hearings.

Earlier this month the Treasury Inspector General for Tax Administration (TIGTA) released its annual audit of the IRS collection due process and equivalency hearing procedures. This audit, which the Office of Appeals agreed with, revealed that:

• Files could not be located,
• Files did not contain enough documentation,
• Files did not document the Appeals prior involvement in the case,
• Determination letters did not contain explanations of decisions,
• Determination letters did not communicate results of hearings to taxpayers, and
• Files did not contain documentation showing that the CDP request was timely.

TIGTA made a number of recommendations in the audit report, all of which are steps in the right direction. However, the audit report missed one major issue: how cases get to the IRS Appeals Office. The audit report should have recommended that taxpayers submit all CDP requests to one Office or to the IRS Service Center that serves the particular taxpayer (i.e., where the taxpayer mails his or her tax returns). As things currently stand, taxpayers are to submit CDP requests to the IRS Officer that they are working with. There are a number of problems with this arrangement.

First, the taxpayer may be working with more than one office. For example, the taxpayer may be actively working with the local field office and the automated collection system office. Second, many IRS employees do not know that they should forward the CDP request to the IRS Office of Appeals and others do not even know what a CDP hearing is. I still run into situations where I have to specifically ask that the CDP request be forwarded to the Appeals Office. Recently I even had one IRS Officer tell me that he does and would not forward the request, that the CDP hearing request has nothing to do with his office, and that he was not sure what it was. In that case I had to forward the CDP hearing request to the appropriate Appeals Office myself. I knew to do this, but I would guess that many taxpayers do not.

Second, recipients of CDP requests often do not understand how to or fail to enter the appropriate code into the IRS computer system to reflect that the CDP request was received. This has the effect of keeping the case in collections status, which can result in the IRS illegally pursuing collections activities (such as levying on taxpayers assets).

Third, some IRS offices/employees are just too busy (or slow) to be able to process CDP hearing requests in a timely manner. Again, this can result in the IRS illegally levying on taxpayers assets long after the CDP hearing request was submitted.

A great number of CDP hearing requests get lost in this process. This highlights another procedural flaw: a flaw in TIGTAs annual audit process. Cases that are lost before they are processed would not even be included in the audit. The audit revealed that the cases that were processed were poorly handled, so just imagine how many requests did not even make it to the point of being processed….

September 24th, 2005 | No Comments »

Judicial Misstatement: Intentional, Error or Oversight?

Judicial opinions often include sentences that misstate the law. Often these sentences will be picked up by the IRS (and sometimes even taxpayers) years later to support arguments that courts should depart from the law. For example, this quote comes from the District Court for the Eastern District of New York in Johnson Home Care Services, Inc. v. US (2005):

In support of the IRS ability to reject installment agreements the court cites precedent that states, “Rejection of a taxpayer’s proposed installment plan will also be upheld where the taxpayer has a history of non-compliance with tax laws.” The court makes this statement, but it does not explain it. Instead the court immediately moves on to another argument. So what is wrong with this statement?

Generally having a history of non-compliance with tax laws is a prerequisite for a taxpayer requesting an installment plan. So the court is saying that courts will not overturn IRS determinations to reject installment agreements submitted by taxpayers. This would mean that there is no judicial review of installment plans proposed by taxpayers. But that is not what the law provides for. The law is well settled that such IRS determinations are to be reviewed by the courts under an abuse of discretion standard. Many courts have reviewed these types of IRS determinations before. In fact, this very court correctly stated this law at the outset of its legal analysis!

These kinds of misstatements bring into question the court’s motives. Courts are supposed to be unbiased bodies that apply the facts of the case to the law. Misstatements like this from the courts make it appear as if the court first determined how the case should be resolved and then went looking for arguments to support that outcome. That is not how courts are supposed to operate.

But this issue may be more complex than that. I often wonder if courts put these types of misstatements in their judicial opinions where the court believes that the unsuccessful party should prevail, but the unsuccessful party would have lost the case on other grounds. Such misstatements would help ensure that the unsuccessful party had the ability to appeal the case to a higher court and if the higher court could review the case de novo (from scratch), then the higher court could be in a position to re-write the law. Is this one of the subtle procedural ways that lower courts set higher courts up to create judicial legislation? Or is this a case of courts passing the buck? By including these misstatements the lower court could be saying that it did wanted to depart from the law, but it did not have the daring to do so. Or perhaps the courts do this when there is a sympathetic party that would otherwise lose their case — allowing the unsuccessful party to have their case heard by a higher court.

Any of these could be the case, but none of them appear to be the case here. The laws involved in this case are pretty mundane, so a higher court would not be likely to re-write these laws and there wouldn’t really be a reason for the court to depart from the law. Similarly, the taxpayers in this case were not particularly sympathetic. Perhaps this was just an oversight or poor legal analysis….

September 18th, 2005 | No Comments »

On Effective Tax Administration

I often wonder if our tax laws could be administered in a more cost-effective manner. Why is it that cases continue to come out where taxpayers have to spend years arguing about a tax debt with the IRS, only to have the IRS concede the issue when it comes time for the government to prove its case? This brings me to the recent case of Lites v. Commissioner.

Lites is a case that involves taxpayers who filed their federal income tax returns late (1999 and 2000 federal income tax returns were eight days late and 2001 federal income tax return twenty nine days late), failed to make the ~$66,000 tax payment, and who failed to comply with an installment agreement (after making ~$3,000 in payments). The evidence showed that the taxpayers were a husband and wife. The husband was a financial products salesman and the primary breadwinner for their family of four. The husband underwent a number of employment changes, due to a downturn in the financial markets and due to a heart condition. The taxpayer received the notice of levy, requested a hearing (a collections due process hearing), and proposed an installment agreement. Over the course of a year the taxpayers ended up making three such proposals: one for $750 per month, one for $1,000 per month, and one for $1,200 per month. In support of these offers the taxpayers asserted that they had $888 of monthly excess income. The IRS Appeals Office rejected the taxpayers’ offers, arguing that the taxpayers had $2,732 of monthly excess income and that that amount should be paid to the IRS on a monthly basis.

At trial the IRS conceded that the taxpayers excess income was $888 a month. The court opinion does not specify whether the IRS explained how they came up with the $2,732 figure or why the IRS stuck to this figure for more than a year if it was not accurate. Our tax laws require the IRS to perform an investigation of the taxpayers financial circumstances when they consider installment agreements, so the IRS must have conducted an investigation. Because the IRS conceded that the taxpayers $888 figure was correct, the IRS investigation must have confirmed the taxpayers $888 figure. Therefore the IRS claim that the taxpayers had $2,732 of excess income was not truthful, was deceptive, and was misleading. The IRS made these misrepresentations on several occasions over a period of several years.

One would think that after the IRS disclosed that it had made these misrepresentations it would agree to settle the case. However, that did not happen. Instead, the IRS took the position that it was correct in denying the taxpayers offers because the offers exceeded what the taxpayers could afford to pay. Note that the IRS had originally rejected the taxpayers offers because they were too low. Now the IRS argues that it was entitled to reject the taxpayers offers because the offers were too high.

The court correctly noted that there is no such law that permits the IRS to reject offers because they were too high. The court stated that it was confused and perplexed by the IRSs position. The court went on to say that the IRS could not have it both ways, so it remanded the case back to the IRS for reconsideration. It would be interesting to speak with these taxpayers to see if the IRS subsequently accepts their offer. It is likely that the IRS will reject the taxpayers offer once again, requiring them to seek judicial intervention again.

It is now late in the 2005 tax year and this case was partially to resolve tax liabilities for 1999. It is likely that the IRS will not fully deny the taxpayers most recent offer by the end of this year and perhaps not by the end of next year. Why is it that the IRS cannot just tell taxpayers such as the ones in this case that the IRS investigation corroborated the taxpayers claim? Why does a case like this have to drag out for the better part of a decade? The reality is that by the time that this case is resolved the government will have spent considerably more money defending its erroneous position than the amount of the underlying tax liability. It just seems like there is something wrong here. Are we missing the big picture?

September 16th, 2005 | No Comments »

The IRS Did What?

We all make mistakes. The IRS often prosecutes taxpayers who make mistakes. On the other hand taxpayers occasionally prosecute the IRS when its employees make mistakes. This brings me to the case of Ward v. United States, a Colorado Springs case.

Ward is a case where the IRS seized a taxpayers retail business that was located in the Colorado Springs mall. The taxpayer alleged that shortly after the seizure several IRS employees unlawfully disclosed the taxpayers confidential tax return information. The government admitted that its employees unlawfully disclosed the taxpayer’s confidential tax return information when IRS employees participated in a live radio talk show program, when IRS employees provided a fact sheet to the television program Inside Edition, and when an IRS employee wrote a letter to the editor of the local newspaper. The Colorado District Court awarded the taxpayer $325,000 in damages, which was $111 more than the initial tax assessed against the taxpayer.

For once I don’t think any commentary is necessary. This case seems to speak for itself.

September 13th, 2005 | No Comments »

The (D)Evolution of our Tax Law

Our tax laws seem to evolve (devolve?) over time. This evolution seems to follow a pretty predictable pattern. I will use Action on Decision 2005-001, which is an interesting decision in and of itself, to describe this process.

In this AOD the IRS announces that it will not follow the Ninth Circuit Court of Appeal decision in Estate of Paul Mitchell v. Commissioner. The Mitchell case is yet another stock valuation case. In this case the taxpayer estate reported a stock valuation of $28.5 million and the IRS issued a notice of deficiency based on a $105 million value for estate tax purposes. At trial the IRS valuation expert placed the value at $81 million, $34 million less than the IRS’ original claim. There was evidence that the IRS valuation expert had originally appraised the value at $85 million as a minority interest, but then increased the value to $105 million at the request of the IRS. The tax court set the value at $41 million after considering the evidence.

On appeal the Ninth Circuit rejected the method that the tax court used to reach the $41 million value, noting that the discount factor used was not within the range of figures provided by the evidence (contrary to the express statement made by the tax court). The valuation issue is interesting; however, that is not the issue that the IRS chose to dispute in its AOD.

The IRS AOD contests the Ninth Circuit holding that the burden of proof at trial remains with the IRS when there is evidence that the IRS determination is invalid. For the non-lawyers, the burden of proof is the procedural rule that slants tax cases in favor of the government and often results in taxpayers having no chance of winning tax disputes. In general the government starts out with the burden of proof. The court presumes that that burden is met if the government produces a notice of deficiency (which is simply an entry in the IRS records showing that the taxpayer owes a tax). However, if there is evidence that the IRS deficiency is invalid then the burden remains with the government. In that case the government must prove that there were additional taxes owed, not the taxpayer proving that no additional taxes were owed. This may sound like mere semantics, but it is really important in determining which party will prevail in many cases.

In Mitchell there was evidence that the value used in the notice of deficiency was changed by the valuation expert at the IRS request and the IRS even asserted in court that the stock value was much less than what the value asserted in the notice of deficiency. In its AOD the IRS takes the position that this evidence should be ignored. I do not think I need to address this argument because readers will understand that it is without merit.

The IRS also takes the position that the cases that support shifting the burden of proof are not applicable because they involved cases of unreported income, not stock valuation cases. The IRS position tries to distinguish unreported income and stock valuation; however, both concepts are essentially the same for tax purposes. The reason why stock valuation is important is because, as the IRS asserted in the Mitchell case, low valuations result in additional taxes being owed. Similarly, the reason why unreported income is important is because it results in additional taxes being owed.

Furthermore, the burden shifting process employed at trial is a matter that is in the courts discretion. The court, with guidance by Constitutional principles, has the authority to say when and how the burden of proof shifts. The courts do not answer to the IRS and the IRS does not have the authority to establish our rules of judicial procedure. So the IRS decision seems to be saying to the Ninth Circuit and the Tax Court that if those courts choose to spell out how trials are to be conducted, the IRS is going to: To what? To pout? To sulk? To huff and puff and blow the house down? To nothing?

So why would the IRS issue such an AOD? The short answer is that this is the process by which our tax law evolves (or devolves). This process starts with a pro-taxpayer ruling. The IRS then begins to respond to that ruling by issuing decisions and rulings that downplay or reject the pro-taxpayer ruling. A mountain of paperwork rejecting the pro-taxpayer ruling starts to build up.

Once the mountain is large enough the IRS begins looking for taxpayers who face the same situation, but where the facts are slightly more favorable for the government (i.e., in this case the IRS’ valuation discrepancy will only be a few million dollars off of what was in the notice of deficiency and what was asserted in court). The IRS will also look for taxpayers who do not reside in the circuit that issued the pro-taxpayer ruling (in this case, the Ninth Circuit). More precisely, the IRS will shop for a circuit court that they feel will reject the other circuit courts pro-taxpayer ruling and they will seek out a taxpayer in that circuit.

Once the unsuspecting taxpayer comes along the IRS will spring its trap. The IRS will give the taxpayer no recourse but to litigate his or her case. The IRS will either win or lose. If the IRS wins it will reset its trap, which is now baited with the lower courts pro-government ruling. Eventually an unsuspecting taxpayer will take the bait and the IRS will lose in the lower courts. At that point the IRS will get what it wanted: the ability to contest the pro-taxpayer law in a particular circuit court.

By citing the new mountain of paperwork as precedent the IRS will probably be successful in convincing the circuit court to reject the other circuit court’s pro-taxpayer ruling. If the IRS loses then it faces the decision of whether to appeal the decision to the Supreme Court. Whether the IRS pursues the Supreme Court option will depend on the language used by the circuit court in its judicial opinion. If it is favorable then the IRS might go for it; if not, then the IRS will probably reset its trap and wait for another unsuspecting taxpayer in another circuit.

Over time this process results in our tax laws being slanted against taxpayers and in favor of the government. The IRS sets its trap, it bides its time, and it slowly chips away at pro-taxpayer rulings. Eventually the law gains such an anti-taxpayer bias that either the courts or the Congress step in to reset the law to more of a middle position and the process begins anew.

This process plays out year after year, case after case, and IRS decision after IRS decision. Is this is the best way to establish our tax law? Can we not come up with a system that is fairer to taxpayers? Can we not come up with a system that is less wasteful of our limited resources? Somehow it just seems like we are missing the big picture here.

September 11th, 2005 | No Comments »