Tax Newsletter 1999
We are fundamentally changing the IRS.
The ghost of taxes past is the incomplete Taxpayer Relief Act of 1997 (TRA97), which outlined many major tax reforms. The ghost of taxes present is the IRS Restructuring and Reform Act of 1998 (RRA98), which filled in these tax reforms, and which systemically reinvented IRS. The ghosts of taxes future are more tax reforms and simplification (see page 3) and continued close monitoring of IRS to control severe taxpayer abuse.
1998 Tax Planning
Tax planning is more important and lucrative than in years. Many provisions of the Taxpayer Relief Act of 1997 (TRA97) start to take effect in 1998. These rules are very fluid, as Washington is still correcting and refining these major tax changes, as usual. Even though TRA97 balanced revenues with tax cuts, critics bemoan the tax cuts as the biggest giveaways to wealthy taxpayers in decades. We cannot plan for many of these changes, such as the child and education credits. Here are some big planning issues:
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. Convert by December 31, 1998, and defer recognizing ¾ of the income until future years. Your adjusted gross income must be less than $100,000. Conversion is a great estate tax planning tool, since your heirs will not pay income tax, either. Start your Roth IRA now to start the 5 year prohibition on withdrawals (even if you make more contributions later).
The capital gains holding period is now 12 months, down from 18 months, retroactive to January 1. 1998. The maximum rate, 20% in most circumstances, has not been so low in decades.
Small company investment gains can be more easily deferred by investing into another small company. Just as we have been able to exchange investment real estate.
Systemic Tax Reform
Washington reformed the IRS - the income tax system, not just the income tax. Washington’s last systemic reform was in 1952. Congressional hearings sensationally aired some of IRS’ more egregious taxpayer abuses (see page 4). The IRS Restructuring and Reform Act of 1998 (RRA98) aims to change the IRS’ culture of secrecy and isolation, and to protect taxpayer rights:
IRS cannot be trusted to police itself. A new Oversight Board of Directors, including 6 public members, will review IRS policy and problems. A more independent Treasury Inspector General replaces IRS’ internal Chief Inspector. The National Taxpayer Advocate is stronger and more independent of IRS, and has enhanced powers to slice through IRS red tape and to fix bureaucratic bungling.
IRS employees will be more accountable to IRS management and to Congress. IRS and rogue agents will pay much bigger penalties when they act maliciously and vindictively. Employees will be more easily terminated and disciplined, instead of being protected by tenure, the culture of secrecy, and the old boys network.
Political influence will hopefully decline as the IRS Commissioner is appointed for a 5 year term. Charles O Rossotti is the first of a new breed of commissioners, a successful businessman and information technology expert; a manager, not a tax lawyer.
You are now innocent until proven guilty in Tax Court, if you cooperate with IRS in its initial investigations. Critics of this fundamental shift of the burden of proof claim that IRS’ loss of power will prompt it to become much harsher in its initial investigations.
Innocent spousesget tax relief, if you are separated from your spouse and you did not benefit from the income in question.
IRS penalties are much bigger when it errs, to $1 million and more. Wronged taxpayers can more easily recover attorney fees and other costs, and sue IRS employees individually. IRS will suspend your penalties for late payment unless it timely audits and proposes changes to your return.
IRS owes you more privacy in audits. It can no longer discover and use against you the tax planning your CPA or EA helps you to do. It cannot frivolously intrude into your personal life.
Tax court has more power. It can help you to correct many more IRS errors. It will use its simplified fast track rules for small cases (up to $50,000).
Health problems qualify you for extra time to file returns and to claim refunds. IRS must toll (ie, suspend) the statute of limitations in these hardship cases.
Regional discrimination has been the norm since Congress reformed IRS in 1952. IRS corruption was rampant and numerous IRS employees, including one commissioner, went to jail. As IRS returns to functional organization (for individuals, small businesses, and big businesses) Congress hopes that central computers will standardize tax collection around the country, and keep employees honest.
IRS must notify you in many more cases, including:
• Installment account balances.
• Liens, levys, and 3rd party notifications.
• Detailed interest and penalty computations.
Congress’ goal is that 80% of all tax returns will be filed electronically by 2007. IRS will save big money by transferring tax return input and edit responsibility to tax preparers. 80% is an ambitious goal, given the complexity of the underlying law. IRS has already announced pilot programs to use electronic passwords/PINs instead of paper signatures, and to allow online access to your account. Use credit cards: Mastercard, American Express, and Novus. You, not IRS, will pay a convenience fee. Visa will not work with IRS because cardholders may default on big tax bills. Electronic filing will continue to have many teething problems.
IRS must use many kinder and gentler audit procedures, including:
• IRS agents must identify themselves by name and telephone number. They have too often hid behind form letters.
• Multiyear audit changes will cost less by netting interest.
• Pass thru entities (partnerships and S corporations) can more easily choose their audit representative (aka Tax Matters Partner, or TMP).
[Taxes are] a minefield for most Americans, and even
too complex to be efficiently and consistently administered.
The Death of the Income Tax
Congress makes the tax laws, and Congress makes the tax laws complex. Complexity is slowly killing the income tax system as we know it. Senate Finance Chair William V Roth makes the eternal promise to simplify taxes in the near future.
Politicians loudly and publicly lower taxes, then limit many, mostly higher income, taxpayers from using these tax cuts. Tax laws are dull tools, and everyone pays for this complexity. Lower and middle income taxpayers do not deserve the relatively complex forms and worksheets they must complete to qualify for their tax cuts. Higher income taxpayers (my clients) lose many of the tax cuts.
Then they use hidden, complex limitations to prevent
Everyone sees the complexity as unfair. Our response to unfair taxes is to stop filing voluntarily. Voluntary reporting of cash, barter, and other income, has been on the decline for years. Income taxes collect a shrinking percentage of the government’s revenue, currently less than half. Washington has been increasingly substituting easier to collect taxes, such as payroll, excise, and sales/VAT taxes.
Any tax system is a money tree for Congressional reelections. Entrenched politicians use their power of taxation to collect campaign contributions. This system promotes complexity, and law abiding citizens stop filing voluntarily. This endless circle can best be stopped by instituting term limits, which will end the entrenched politicians’ endless grab for campaign contributions.
The Alternate Minimum Tax (AMT) is Congress’ stealth flat tax version of tax reform. AMT is a separate (but similar) tax system which adds much complexity for those who might pay it, instead of regular tax. Congress’ answer to many tax controversies over the last quarter century has been to allow disputed deductions for regular tax, but to disallow them for AMT. There are dozens of income and expense items disallowed for AMT, with many separate phaseout limits.
30% more taxpayers will pay AMT each year, increasing to 9% in 2008 from 1% now. Many more are close to paying AMT, and must plan for it, as is the case with most of my higher income clients. Many complain that AMT is an overly complex aberration that must be corrected.
AMT is probably here to stay. Politicians will continue to trade votes for promises to cut taxes. AMT is the ideal vehicle for politicians to talk tax cuts then to restrict higher income taxpayers from realizing the same benefits as lower income taxpayers. The problem in the middle will continue to be severe. AMT is a dull tool, and will continue to limit middle (and a few low) income taxpayers who were never intended to be limited.
Congress also uses phaseout limits to prevent higher income taxpayers from using the middle class tax cuts. There are hundreds of phaseout limits. Just a few of the common and simple ones effecting my clients include (for married taxpayers filing jointly, not including separate limits for other filing statuses):
Phaseout limits on education subsidies are so low that most of my clients will lose these benefits. The subsidy amounts are so low they are not worth planning for, which may have been Congress’ intent. My education solution for higher income clients is to give high growth, no dividend, stocks to your children. The kids may not even have to file returns. When they get to college they sell the stocks, and pay tax on the capital gains at their lower tax rate.
Most of my clients will be limited out of the $400/$500 (1998/1999) child tax credit for dependents to 16 years. This credit is one of the biggest tax subsidies of the recent major tax reform. The phaseout is very low ($110,000 joint, $75,000 single/head of household, $55,000 separate). You must complete a complex new form and worksheet.
Congress just put off an AMT problem for lower and middle income taxpayers by suspending AMT on the child and education credits for this year. Next year it plans to make a more permanent solution.
Other complexities, which Congress should simplify, include:
• Marriage penalty. It is just too expensive to equalize taxes for married and single filers, both economically and politically. Congress has been giving tax breaks to one income joint filers (at the expense of dual income joint filers) since 1948.
• Earned income credit. Electronic filing fraud has cost IRS $Billions.
• Capital gains. Many have failed to file the complicated 1997 form which calculates your tax based on numerous rates and holding periods, including AMT.
• Kiddie Tax. Every family must adhere to rules designed to limit a few wealthy families from saving tax with their children under 14 years.
• Employee/independent contractor status. Congress has prohibited IRS from making definitive rules for decades, but has not resolved these issues either.
IRS [is] struck in a 1950s and 1960s time warp. [It] is really an agency out of date(IRS Commissioner Charles O Rossotti). IRS’ computers are a joke, and all one can do is laugh.
It’s a damn miracle that we get through any tax season says Commissioner Rossotti. IRS uses seven different computer systems, many designed 50 years ago.
Most of IRS’ hardware has been obsolete for years. Some of its software is so old it is no longer used anywhere else, and is extremely expensive to patch.
Keep your fingers crossed says Rossotti. IRS’ Y2K patches are expensive, more than $1 billion. The Year 2000 problem is due to the myopic negligence of computer programmers who have ignored the march of time. Some computers will cough, some will fail. IRS has let its problem go so long that it will have many more Y2K failures than private industry.
IRS and Congress have known for years the sad state of the IRS computer system. Previous IRS management wasted $4 billion (of an $8 billion budget) in an aborted attempt to reengineer their computer systems. This fiasco was one of the reasons Congress systemically restructured IRS in 1998 and appointed Commissioner Rossotti.
We must hope against hope that Rossotti has the last laugh. With its computer systems so hopelessly obsolete, he has a clean slate to reinvent IRS’ computer systems for the 21st century.
Congressional hearings have exposed
a stunning confession of the sins of the IRS.
The IRS Restructuring and Reform Act of 1998 (RRA98) is Congress’ attempt to change IRS’ culture of secrecy and isolation, and to protect taxpayer rights. Here are some of the horror stories:
IRS rates just behind trash collectors, says the American Customer Satisfaction Index of the University of Michigan.
IRS employees have embezzled $5.3 million in the last two years. IRS’ internal cash controls are sorely lacking.
• Convicted felons have access to cash and checks in secure areas because IRS does not consistently use employment background checks.
• Secure areas are not secure.
• Bank messengers leave million dollar deposits unattended.
• Identity theft is also a problem, since these checks have your name, bank account, and social security numbers all in one place.
• J R Stevens was convicted of embezzling $77,218 while he was an IRS employee. He altered checks made payable to IRS to resemble his first two initials and his last name. His sentence was pretty light - restitution plus 7 months in a halfway house.
Overly aggressive, even vindictive collection is normal IRS procedure. IRS has been driven by statistics and quotas, contrary to long standing Congressional prohibitions.
• IRS promised to review 4,000 recent property seizures when studies showed ½ of them to have violated IRS procedures.
• IRS agents have failed to contact taxpayers before seizing assets; to consider health, business problems, and other hardships; and to compensate taxpayers fairly after selling assets at fire sale prices.
• IRS agents have stolen seized property for their personal use.
• IRS lied to and hounded 20,000 taxpayers to pay back taxes well beyond the 10 year collection deadline.
• IRS paid $3.5 million damages to Elvis E Johnson, its largest award to an individual. IRS improperly publicized confidential details of a tax penalty involving less than $3,500 in tax. IRS regularly stonewalls and uses its size and power to grind down taxpayers whom it has wronged. Johnson persevered for 15 years to get his award. House Ways and Means Committee Chairman Bill Archer called this a particularly compelling example of the breach of privacy rights.
• IRS agents have been virtually immune from discipline for these abuses. Many guilty employees, including one District Director, have been allowed to resign and to refuse to testify before Congressional hearings.
Armed raids on nonviolent taxpayers are another severe IRS abuse. I have great concerns that the police powers that are used by the IRS seem to be way beyond anything that they should have, given what they have done with them.(Senator Connie Mack) We have to be much concerned about the paramilitary performance of the IRS. (Senator Daniel Patrick Moynihan)
December 7, 1998 © 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 professional to determine how these new and rapidly changing topics affect you and 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.
William M West Certified Public Accountant
1905 Park Avenue, Suite 100
San Jose, CA 95126
Last Updated 1-12-01