Steven L. Jager, C.P.A.
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An Accountancy Corporation
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15250 Ventura Boulevard, Suite 1100, Sherman Oaks, California 91403 · (818)501-5797 · FAX (818)501-8560
Internet: http://www.cre8ivcpa.com
MEMORANDUM
TO: All Clients
DATE: August 17, 1998
FROM: Steven L. Jager, CPA
SUBJECT: Summary of Significant Changes
Internal Revenue Service Restructuring and Reform Act of 1998
Most recently, on July 22, President Clinton signed a new tax law, called the Internal Revenue Service Restructuring and Reform Act of 1998. As the name implies, much of the new law addresses taxpayer rights, IRS governance and tax procedure. Other parts of the new law make changes or "technical corrections" to the Taxpayer Relief Act of 1997. In all, the new law affects more than 200 sections of the Internal Revenue Code.
This memorandum will alert you to several items that could have a direct impact on you or your business. It is necessarily selective. By and large, I have tried to focus on information you probably will not get from newspapers, magazines or TV.
IRS PROCEDURE
Privileged Communications with Tax Advisers
The new law extends the attorney-client privilege to certain communications between a client and a "federally authorized tax practitioner," i.e., any person authorized to practice before the IRS, such as a CPA, enrolled agent, or enrolled actuary. The communications must be in connection with "tax advice" and must be such that they would qualify as privileged if made between a client and an attorney.
In effect, on the surface, the new rule incorporates the common law of attorney-client privilege. Accordingly, communications concerning the preparation of a tax return may not be protected. Also, the privilege can be waived inadvertently, such as by voluntarily disclosing information to a third party other than an agent of the attorney or client.
This new privilege applies ONLY to NONcriminal tax matters before the IRS and NONcriminal tax proceedings brought by or against the government in any federal court. It does not apply to prevent other agencies, from compelling disclosure. Also excluded from protection are written communications to a corporation’s officers or other representatives (which could include employees) in connection with promoting the corporation’s participation in a "tax shelter".
This privilege may only be illusory; DO NOT assume that any statement made to me as your CPA will be privileged.
As before, the only truly effective way to invoke privilege is to involve an attorney who appoints me as his/her agent PRIOR to making any statements which require privilege. In this way, our communications become an extension of his/her "workproduct" and are more likely to be protected. When in doubt, ask!
Innocent Spouse Relief and Joint Returns
Two provisions in the new law expand the availability of relief from liability on a joint return for items attributable to a spouse or former spouse. One provision makes "innocent spouse" status easier to obtain, primarily by removing the underpayment threshold and the "grossly erroneous" requirement. Also, it allows proportionate relief if the taxpayer was unaware of a portion of the underpayment.
A second provision permits a taxpayer to elect to be liable only to the extent a deficiency is attributable to items allocable to him or her. The election can be made up to two years after the IRS begins collection activities. In general, relief is available if, at the time the election is made, the parties are no longer married, are legally separated, or have lived apart for at least the preceding 12 months. Relief can be denied or limited because of certain property transfers between the parties or the taxpayer’s actual knowledge of an erroneous item.
The new provisions generally apply to tax liabilities arising after July 22, 1998, as well as existing liabilities to the extent they remain unpaid on that date.
Burden of Proof Shift
The new law adds a provision that may significantly reduce the IRS’s leverage against individuals and small businesses. Historically, taxpayers have had the burden to prove the IRS is incorrect in asserting a tax deficiency. Under the new law, if the taxpayer introduces "credible evidence" on a factual issue and satisfies several other requirements, the burden of proof on that issue will shift to the IRS.
The principal requirements concern substantiation, recordkeeping and cooperation with the IRS’s "reasonable requests" for additional information and the like. Significantly, "cooperation" does not require the taxpayer to agree to extend the statute of limitations (in fact, another new provision requires the IRS to advise taxpayers of their right to refuse to extend the limitations period.) The principal limit on the new provision is that a corporation, trust, or partnership with a net worth exceeding $7 million cannot benefit from it.
Under a second new provision, the burden of proof shifts to the IRS with regard to any item of an individual’s income that is reconstructed solely on the basis of statistical information on other taxpayers.
Finally, with respect to penalties on individuals, the IRS has burden of "production", i.e., it must present some evidence that such a penalty is appropriate. If it does so, however, taxpayers will still be required to establish defenses such as reasonable cause.
The new rules apply to court proceedings arising from examinations occurring after July 22, 1998, as well as to court proceedings in connection with events occurring after the date of enactment or taxable periods beginning after July 22, 1998.
Home & Business Seizures Restricted
Several provisions of the new law are aimed at making the seizure of an individual’s home or business a last resort for tax collection. For example, the IRS is prohibited from levying on a taxpayer’s principal residence without written approval from a judge or magistrate of a U.S. district court. Also, high-level approval is required in order to levy on tangible personal property or real property used in an individual’s trade or business. These provisions are effective on July 22, 1998.
Interest on Overpayments
Starting January 1, 1999, individuals and other noncorporate taxpayers will be entitled to receive interest on their tax overpayments at the same rate the IRS receives on underpayments. For the past several years, the interest rate on underpayments was one percentage point more than the interest rate on overpayments.
For example, under current law, if the underpayment rate for a calendar quarter were 7%, the overpayment rate would be only 6%. Thus, the IRS would pay 6% interest on amounts it owed taxpayers, but would receive 7% interest on amounts taxpayers owed it. Under the new law, the rate in this example would be 7% for both underpayments and overpayments.
Interest Netting
Although corporations do not benefit from the interest rate equalizing provision described immediately above, they will obtain relief under an interest netting provision in the new law.
In essence, the new rule eliminates any interest rate differential for any period to the extent a taxpayer’s underpayments and overpayments offset each other. For corporations having large underpayments (over $100,000), which are charged a higher interest rate, savings could be substantial whenever they also have offsetting overpayments--and especially if they have large (over $10,000) overpayments, which receive a lower interest rate. Noncorporate taxpayers can also benefit from this provision for periods before the interest rate equalizing provision described above goes into effect.
The new rule applies to interest for periods beginning after July 22, 1998. Also, if requirements are met, taxpayers may elect to have the rule applied to previous periods.
CAPITAL GAINS
Holding Period Reduced Retroactively
Retroactive to January 1, 1998, property held more than 12 months can qualify for the lowest capital gains rates -- generally 20% (10% for taxpayers in the 15% bracket for ordinary income).
Recall that the 1997 law reduced the maximum rate from 28% to 20%, but extended the required "holding period" to more than 18 months. Property held more than 12 months but not more than 18 months continued to be subject to the 28% maximum. Thanks to the new law, only the shorter "holding period" requirement again applies to post-1997 capital gains. (Note, however, that the maximum rate on certain gains will continue to be higher than 20% despite the reduced holding period... for example, the maximum rate on the sale of collectibles is 28%).
Principal Residence Sale Exclusion Clarified
The 1997 law allows taxpayers to exclude up to $250,000 ($500,000 for joint filers) of gain on the sale of a principal residence. One qualifying requirement is that the taxpayer must have owned and used the property as a principal residence for at least two of the five years preceding the sale. If a taxpayer fails to meet the full two-year requirement because of certain conditions (e.g., change of employment), an exclusion is still available, based on the fraction of the two-year requirement that was met. The new law clarifies that the fraction applies to the $250,000/$500,000 limitation, not the actual gain.
For example, suppose Mr. A, a single taxpayer, satisfied the requirement in only one (rather than two) out of five years because of an employment-related move. His maximum exclusion would be $125,000 (one-half of the $250,000 limitation), regardless of the amount of gain. Thus if A had a gain of $300,000, he could exclude $125,000, not $150,000 (one-half of the $300,000 gain), and would pay tax on $175,000. On the other hand, if A had a gain of $100,000, he would pay no tax because all the gain would be excludible, not jus $50,000 (one-half of the $100,000 gain).
ROTH IRAs
The 1997 law created the Roth IRA, a new type of investment vehicle. One cannot deduct annual contributions to a Roth IRA -- so it is funded with after-tax earnings -- but the earnings build up tax-free and there is no tax on withdrawals.
An existing IRA may be converted to a Roth IRA if the taxpayer’s adjusted gross income (AGI) does not exceed $100,000. The taxpayer must pay a price, however, by including the converted amount in income for the year of conversion. (Moreover, if a nondeductible IRA is converted, only the amount representing previously untaxed earnings is included in income.). For 1998 conversions, a special four-year averaging rule allows the taxpayer to include only one-fourth of the income each year from 1998 through 2001.
Distributions During Four-Year Period Accelerate Tax
The new law allows a taxpayer to elect not to apply the four-year averaging rule and instead take the entire amount into income in 1998. But if the taxpayer does use the four-year averaging rule and later withdraws any amount during that four-year period, the withdrawn amount is included in gross income, together with the amount, if any, includible for that year under the four-year averaging rule. Hence, the taxpayer will lose some or all of the benefit of the four-year spread.
Surviving Spouse Can Use Four-Year Rule
The new law adds a rule that if a taxpayer dies during the four-year spread period, any as-yet untaxed amounts are included in income in the year of death. But if the IRA passes to the surviving spouse, he or she may elect to continue reporting under the four-year averaging method.
Converted Amount Does Not Effect AGI Limitation
The new law clarifies that the actual converted amount is not included in determining the $100,000 AGI. For example, suppose Ms. B wants to convert a regular IRA containing $50,000 into a Roth IRA, and that she has AGI of $80,000 without counting the $50,000 from the regular IRA. The new law makes it clear that, even though the $50,000 may increase her AGI to $130,000 for other purposes (e.g., calculating taxable income), Ms. B will still be able to convert her regular IRA to a Roth IRA.
Conversion Benefits Restricted
To close a perceived loophole, the new law provides that the 10% early withdrawal penalty will apply if a distribution from a Roth IRA is allocable to a conversion from a non-Roth IRA and is made within the five taxable years beginning with the year of conversion.
Contribution Limit Clarified
The new law clarifies that an individual can contribute up to $2,000 to all IRAs in a taxable year. Thus, for example, suppose Mrs. C was unable to make a deductible IRA contribution and was limited to a $1,000 Roth IRA. She could still make a $1,000 nondeductible IRA contribution.
FAMILY BUSINESS ESTATE TAX BREAK REWRITTEN
The 1997 tax law added a provision aimed at reducing estate taxes on family-owned business interests, thus making it less burdensome for the family to continue the business. The new rule took effect this year (i.e., for estates of decedents dying after December 31, 1997), but has been widely criticized for being excessively confusing and complex. For example, because of a technical glitch in the way this provision interacted with a phased-in increase in the "unified credit" -- which is available to all estates -- the benefit of the new provision would actually decrease each year that the unified credit increased.
The new law is aimed at correcting that mistake, as well as others. To do that, Congress rewrote the provision -- to such an extent that it had to be renumbered and moved to a different location in the tax code.
The new law provides an estate tax deduction for "qualified family-owned business interests" of up to $675,000. It then coordinates the deduction with the unified credit, such that the combined benefit of the deduction and the credit will not exceed $1.3 million. (The combined effect may be less, of course, if the value of the qualifying business interests is less than $675,000.).
The new law makes several other changes that should make it easier to qualify for the benefit. For example, it clarifies that the decedent’s lifetime gifts of business interests are counted in determining whether the decedent’s business holdings were sufficient to qualify for the benefit, even if the gifts were excluded from tax because of the $10,000-per-donee annual exclusion. Another change is intended to clarify that a trust can be treated as a "qualified heir" if its only beneficiaries are "qualified heirs". Also, the new law clarifies that qualifying property can include property the decedent leased to family members on a net cash basis.
The new law is effective retroactively, superseding the 1997 law.
OTHER IRS PROCEDURAL REFORMS
The new law also does the following:
· Creates a nine-member oversight board; six will come from outside the Federal government;
· Prohibits the IRS from using records of tax enforcement results in evaluating IRS employees’ performance;
· Liberalizes the rules permitting taxpayers to recover administrative or litigation costs from the IRS;
· Expands the circumstances under which taxpayers can collect civil damages for wrongful IRS actions in tax collection activities;
· Permits the record owner of property to have a federal tax lien discharged as a matter of right by posting bond or depositing cash. Also creates the right to challenge the lien within 120 days after the certificate of discharge is issued;
· Suspends interest and certain penalties on individual returns if the IRS does not timely notify the taxpayer of the amount and basis for a tax liability. Notification must be within 18 months of the return’s due date or filing date, whichever is later. (The time for notification is reduced to one year for tax years beginning after January 1, 2004, or later.);
· Establishes formal procedures to insure due process when the IRS seeks to collect taxes by levy or seizure;
· Expands the circumstances under which a taxpayer may challenge IRS summonses to third parties in the course of investigating the taxpayer.
I hope that this selected overview is helpful. As always, please do not hesitate to contact me concerning any of the new law’s provisions or to make an appointment to discuss your tax planning issues.
Best regards,
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Steven L. Jager, CPA, An Accountancy Corporation