Tax Newletter 2001

Tax Simplificaton

The Republicans look to control the Presidency and both houses of Congress for the first time since 1953. Gore’s ongoing election contest is slowly losing strength, as of this writing. The Republicans have a razor thin majority in Congress. President Bush’s slim victory after divisive court battles have engendered deep political wounds. Bush will face the challenge of living up to his campaign slogans: to give the US a fresh start after a season of cynicism, and to be a uniter, not a divider

Tax simplification is an unintended consequence of the last elections. The Republican do not have enough votes in Congress to pass their wish lists. Still, a few bipartisan areas of tax agreement may break through the political gridlock and use some of our huge budget surplus to:

Reduce the marriage penalty. Washington started giving tax breaks to the traditional one wage earner family about World War II. Now two earner families are popular. The tax code treats married people differently in 63 separate sections. Unfortunately, Congress may not simplify by eliminating these differences. Congress has a very bad habit of complicating by adding new sections of law.

Expand the Estate tax exclusion, currently $675,000 (phasing in to $1,000,000 by 2006). The booming economy has increased the number of Estate tax returns by 79% since 1991. Some legislators say they want to eliminate death taxes altogether. Washington will more likely increase the estate tax exclusion, perhaps substantially.

Limit Alternative Minimum Tax (AMT). AMT is complex, yet it is Washington’s idea of flat tax reform. 9% of all taxpayers will pay AMT by 2008 (up from 1% now), an increase of 30% per year. Middle and low income taxpayers are paying AMT, as incomes have risen over the last few decades.

2001 Investment Tips

18/8% are the new, maximum, 5 year capital gains rates, depending on your regular tax bracket. The 5 year holding period begins January 1, 2001. Elect to pay tax now on the built in gain for assets you already own. The new 18/8% rates apply to any subsequent gain. This is a great deal for the right assets. California has no separate maximum capital gains rate.

The falling stock market is troublesome for most, potentially disastrous for those who exercised and held Incentive Stock Options (ISOs). You may owe AMT in 2000, unless you sell the ISO shares by December 31. Call me to estimate your 2000 and 2001 tax returns to determine how much AMT you might pay. 2000 actions to lessen your tax might include selling the ISO shares, and/or paying California tax by December 31.

Like kind exchange (also known as Starker, or section 1031 exchange) rules now allow you to buy the new property before you sell the old one. But you must have the free cash to finance both properties during the escrow.

Roth IRA conversions are hot, for the right people. Roth IRAs exempt income from taxation forever. The big savings are for younger people, whose IRAs will grow over many decades, and for those who will be in a higher tax bracket when they would distribute their regular IRA. Your adjusted gross income must be less than $100,000. Conversion is a great estate tax planning tool. Avoid estate tax on the income tax you will pay on conversion. Make all future earnings tax free, even to your heirs. Start your Roth IRA now to start the 5 year prohibition on withdrawals (even if you make more contributions later).

IRA mistakes are common and costly. Mistakes regarding beneficiaries and divisions due to death or divorce can lay hidden for years, until it is far too late to correct them. You must name beneficiaries and choose distribution methods timely and wisely. IRS recently announced rules to correct some mistakes. Review your IRA plans now, to correct mistakes before it is too late.

Tax Reform Update

Congress held sensational hearings in 1997-1998. Some politicians threatened to bury the IRS. Others bemoaned IRS’ harassment and incompetence. What has happened since?

Congressional hearings led to basic reforms of the IRS - the income tax system, not just the income tax. Washington’s last systemic reform was in 1952. This time around, Congress hoped to change the IRS’ culture of secrecy and isolation. It reorganized IRS’ management, outsourced computer modernization, and vastly increased taxpayer rights.

Taxpayer Rights

Congress slashed IRS’ budget, forcing IRS has to decrease its audit and compliance actions 30-40 percent over the last two years, says IRS Commissioner Charles O Rossotti. IRS collections decreased by only .1%.

Congress required IRS to stop seizing property indiscriminately. IRS’ use of seizure authority continues to produce mixed results in terms of targeting the most non-compliant taxpayers, is questionable in some cases, and is difficult to monitor because of woefully inadequate documentation, says Congress’ General Accounting Office (GAO).

IRS has not harassed taxpayers, nearly so much as accused in Congressional hearings. The Treasury Inspector General for Tax Administration has not upheld one of the first 830 complaints of taxpayer harassment filed under the new law. IRS did fire 4 (out of 16,000) auditors between July, 1998, and May, 2000, for improperly threatening to audit taxpayers. IRS fired one employee for destroying records to cover up a mistake. IRS fired 104 for failing to file tax returns and to report all their income. Numerous other independent probes have also cleared IRS of most of the harassment charges made in the hearings, and all of the most outrageous charges.

IRS is dragging its heals in abating interest, as Congress required. IRS sees interest as a charge for the use of money. National Taxpayer Advocate W Val Oveson has recommended that IRS: 1) expand IRS’ interest abatement authority for any unreasonable error or delay; 2) restrict compounding of interest to the underlying tax, not to penalty or additional interest; 3) limit interest to 200 percent of the tax liability; and 4) allow interest abatement for any significant hardship.

IRS is also dragging its heals in explaining and abating penalties. Congress intended penalties as a tool to increase compliance, not to raise revenue. Penalties have become almost as complicated as the underlying provisions they seek to enforce, says Charles W Shewbridge III, President of the Tax Executives Institute. Taxpayer Advocate Oveson ranks penalties fifth on his list of most serious IRS problems.

Congress mandated an IRS Oversight Board to advise the Department of the Treasury on strategic and budget issues. The members are largely from the private sector. Congress hopes the Board will provide continuity in the face of rapidly changing Treasury political appointees. President Clinton violated the Act by delaying over one year in nominating the initial Board members.

IRS controlling its Appeals office is like letting the wolf guard the hen house. Taxpayers need a truly independent chance to settle disputes, before they have to incur the expense of going to tax court. IRS has instituted formal procedures to separate the examination process from Appeals. But noone can police himself. Washington should move the Appeals office outside of IRS control.

Who will champion taxpayer rights, now that the two most important Congressmen in the passage of the 1997 and 1998 Acts are history? House Ways and Means Committee Chair William Archer (R-TX) retired in 2000. I want to tear the income tax out by its roots, said Archer. Voters ousted Senate Finance Committee Chair William V Roth Jr (R-DE). Roth said that [taxes are] a minefield for most Americans, and even too complex to be efficiently and consistently administered.

IRS Management

We are fundamentally changing the IRS, says the new IRS Commissioner Charles O Rossotti. Rossotti is the first commissioner with a five year term, making him independent of the President. He is a civil servant, not a political appointee. He is a highly experienced high tech manager, not a tax lawyer. We are working to put service first. We are trying to [put] at least as much emphasis on making sure taxpayer rights are preserved, and making enforcement a last resort rather than a first resort, says Commissioner Rossotti.

IRS cannot help you in real time over the telephone. Banks, airlines, even California’s Franchise Tax Board can, but not IRS.

IRS cannot return $67 million of refunds to 90,000 taxpayers. IRS’ multiple computer systems cannot talk to each other, and cannot keep track of people. California leads the list with 14,648 undelivered refunds. You can check by calling IRS at 800-829-1040.

Rossotti is reorganizing the IRS to be more market focused. The current jumble of 33 districts and 10 service centers will transform into four functional divisions for individuals, small business, big corporations, and non-profits.

IRS Modernization

The US tax administrations system, which collects $2 trillion in revenues each year, is critically dependent on a collection of obsolete computer systems developed by the IRS over the last 35 years. These Systems are fundamentally deficient. It’s almost amazing that the systems continue to operate, says Commissioner Rossotti.

Rossotti remains the most popular IRS Commissioner in history. He’s a smart, skilled manager. He’s got extraordinary respect on the hill, says Ronald A Perlman, Georgetown University law professor and former Treasury official. He is doing all the right things, says Paul Sax, American Bar Association Tax Section Chair. Barron’s concludes that Rossotti is leading IRS’ 98,000 employees to treat the 90% of taxpayers who file on time as valued customers.

Death and Taxes

Everything appears to promise that it will last; but in this world nothing is certain but death and taxes, wrote Benjamin Franklin. Tax records are in the earliest known writing by humankind, from 3300 BC to 3200 BC. Ceasar Augustus decreed that all the world should be taxed.

Washington imposed the first US Income Tax in 1862 to fund the civil war. The top rate was 10%. The income tax lapsed after the war, but the die was cast.

In 1894 Charles Pollock of Massachusetts sued to stop the second income tax. Widespread resentment of ultra wealthy business tycoons such as Carnegie, Morgan, and Rockefeller, prompted taxation of their income. The US Supreme Court found the income tax to be unconstitutional.

In 1909 Congress passed, and in 1913 the States ratified, the Sixteenth Amendment to the Constitution, which states: Congress shall have power to lay and collect taxes on incomes from whatever source derived.

The income tax code is a plaything for the rich, said Jimmy Carter in his 1976 presidential campaign. Tax Shelters kept most people from paying the top rates of 77% during World War I, and 94% during World War II. The top tax rate is currently 39.6%, and tax shelters are slowly becoming less effective.

Tax Shelters

Tax shelters are complex. Congress promotes certain segments of the economy by giving tax subsidies, also known as tax expenditures. Congress rarely authorizes IRS to pay the recipient directly, instead reducing the tax the recipient otherwise would owe. Sometimes the recipient must carry the subsidy back or forward to use it in another year. Non-profits pay no tax, so Congress allows investors or donors to claim indirect subsidies, Monitoring and enforcing these subsidies is complex and often inequitable.

The top ten 2001 tax expenditures are:

$92Billion Pension plans

$81Billion Medical payments, including insurance

$61Billion Mortgage interest (an itemized deduction)

$42Billion State and local income taxes (an itemized deduction)

$42Bllion Capital gains limitation

$33Billion Accelerated depreciation for business

$28Billion Step-up basis of capital gains at death

$27Billion Charitable contributions (an itemized deduction)

$23Billion Municipal bond interest

$23Billion State and local property taxes (an itemized deduction)

In addition to the top ten above, there are many other tax shelters that may reduce your tax. Some are:

The Earned Income Tax Credit (EITC) is a major tax subsidy for the working poor. The EITC is one of the few government programs to pay recipients directly through refundable credits. The EITC is so complex, requiring multiple worksheets, checklists, and forms, that many who qualify do not claim it. Some others claim the EITC when they should not. EITC fraud has cost $billions, which IRS cannot easily retrieve. The advent of electronic filing has made the refunds even quicker to get, and even harder for IRS to catch. IRS threatens criminal penalties, especially against tax preparers who collude with taxpayers to steal EITC refunds.

Estate tax shelters are popular and widely available. The Estate tax rises to 55% very quickly after an initial exclusion of $675,000 (rising to $1million in 2006). Common estate planning vehicles include bypass trusts, charitable gifts, and personal gifts less than $10,000 per year. Less common vehicles can save big taxes, including valuation discounts through entities such as family limited partnerships, prepayment of education expenses, annuities, charitable and insurance trusts, business buy-sell agreements, and life insurance. The insurance industry has historically received generous tax treatment for itself and for its investors.


Charitable giving of appreciated property is a popular tax shelter. Noone pays the capital gains tax, yet you can qualify for an itemized deduction on the full appreciated value. Nonitemizers cannot take charitable deductions, until they give enough to itemize. Big problems occur when charities and donors try too hard to milk deductions. IRS must exercise the wisdom of Solomon in deciding disputes regarding charities. IRS threatens penalties and loss of tax exempt status.

Some charities are willing to exaggerate the fair market value of non-cash gifts. One popular scam involves used car dealers and towing companies, who pay some charities only pennies on the donated dollar to use their names. A more sophisticated scam, outlawed last year, used charities to buy split dollar life insurance.

Business activities are nontaxable, but only so long as they directly serve the charities’ purpose. Taxpaying businesses complain that charities unfairly compete by not paying income taxes under the guise of their charitable exemptions. Congress should tax all business income.

Tax Shelters

Congress prohibits charities’ political activities, such as endorsing candidates. But what is the IRS to do to a Church which does not file returns nor pay taxes? IRS has penalized and withdrawn tax exempt status in egregious cases, such as political or profit making organizations that masquerade as churches and charities.

The Audit Lottery

The Audit lottery is the middle class tax shelter. IRS probably will never audit. If they do audit, they may overlook the issue. Beware penalties, even criminal sanctions.

Most individuals do not file and pay the Nanny Tax for household help. IRS does not try to find these people. If you do come to IRS’ attention, the payroll penalties plus interest can triple the original tax.

IRS may tax all your bank deposits in an audit. So you should report a side business, hobby, room rental, etc. IRS threatens criminal penalties for consistent underreporting of substantial income.

Alternative Minimum Tax (AMT) recognizes more income and disallows more deductions than the regular tax system. Many individuals who prepare their own tax returns ignore AMT, or err in the calculations. IRS’ computers catch some of the errors. IRS must audit in person to catch most AMT errors.

Nonexistent dependents and spouses are slowly becoming history. IRS matches names and numbers against the social security administration’s database. When IRS first required children’s numbers on tax returns, millions of falsely claimed dependents disappeared. Current matching programs vex women, who may change their names on marriage, and immigrants from countries with non-US naming conventions.

IRS threatens criminal penalties against abusive trusts, such as family trusts and some offshore trusts. They magically reduce your tax, without any real purpose. Do not confuse these abusive trusts with the many legitimate trusts, which are useful tax shelters.

Corporate tax shelters can also magically reduce tax, without any real purpose. Sophisticated investors, including corporations, use complex schemes in multi-million dollar transactions. Despite the fact that many of these shelters are technically correct, IRS complains that they have no economic substance.

International tax havens will always be available to shelter big money. Legitimate tax jurisdiction shopping is common. IRS requires withholding on interest, dividends, and gross proceeds of securities sales that are not carried out through qualified intermediaries, beginning Jan 1, 2001. IRS names non-cooperating countries with rigorous bank secrecy laws: the Bahamas, Caymans, Cook Islands, Dominica, Israel, Lebanon, Liechtenstein, Marshall Islands, Nauru, Niue, Panama, Philippines, Russia, St Kitts and Nevis, St Vincent and The Grenadines.


California makes your taxes even more complex, California makes many of its own tax laws, and has not conformed to most US tax laws since January 1, 1998. Major differences include no special capital gains rates, and no tax on social security income. There are hundreds of smaller differences.

California credits are great if you qualify for one of them. New individual creditees include long term care givers, teachers, and charitable donors of land and water rights.

California subsidizes the few charities that it puts on Form 540. They get $2million more in donations just because you can check a box on your tax return. Some of the lucky beneficiaries are the California Military Museum, Firefighters, and Mexican American Veterans.

California Independent Contractor Reporting begins January 1, 2001. CA is responding to Federal rules to collect child support. If you will owe a 1099 at the end of the year, you must report to CA within 20 days of paying or agreeing to pay. The general 1099 rule is that businesses must report those service providers whom they pay over $600.

This new reporting requirement expands the three year old employee reporting. Employee reporting is so problematic, that CA has not yet penalized anyone. Maybe CA will wait three more years to start penalizing people under the independent contractor reporting program.

William M West offers tax services to business, investors, and individuals. He is experienced with computer systems, and develops business computer solutions.

December 8, 2000 © William M West This Newsletter is an overview of the year’s tax news, and is not tax or legal advice. You should consult a tax professional regarding your situation. You may use any material herein if you credit me by name, telephone, address, and issue date; and send me a full copy of your publication.

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