General Practice, Solo & Small Firm DivisionMagazine
Representing a Taxpayer Before the IRS
BY GEORGE E. MARIFIAN
© American Bar Association. All rights reserved. George E. Marifian is a principal in the Belleville, Illinois, law firm of Mathis, Marifian, Richter & Grandy, Ltd., where his practice is concentrated primarily in the areas of civil and criminal tax controversy and litigation, income, gift and estate tax planning, probate litigation, corporate and business law and litigation.
Almost 20 years ago when I worked in Caracas, Venezuela, preparing income tax returns for Americans living abroad, a well-to-do Venezuelan said, "You Americans are crazy! You voluntarily pay your taxes without the tax collector knocking on your door."
Americans for the most part do voluntarily file their income tax returns and voluntarily pay the amount of tax shown to be due. Yet the IRS regularly seems to be the target of criticism for its tax collection efforts when taxpayers don’t voluntarily pay their tax. But enforced collection activity is the last step in a process that began much earlier.
Our rules of professional conduct require that we provide competent representation to a client. The lawyer who represents clients before the IRS should possess a knowledge and understanding of the Internal Revenue Code (I.R.C.). But he should also have a working knowledge of tax procedure and how the IRS operates.
The IRS conducts two types of audits—office audits and field audits. Generally, the office audit is conducted by lesser experienced tax examiners and the office audit notices generally specify one or two audit issues. Some cases might even be resolved by correspondence. By contrast, field audits are conducted by revenue agents who are generally more experienced and who are assigned more complex returns.
Office audits. The normal response for a taxpayer who is notified that his return has been selected for examination should be to contact the return preparer. The return preparer should be well equipped to respond to the auditor. Let’s assume that you are the preparer. First, you must obtain a power of attorney from the client authorizing you to represent the taxpayer before the IRS. This is accomplished by the filing of a completed Form 2848 with the IRS.
After the return has been selected for examination, the office auditor will generally contact the taxpayer by telephone to schedule a time and will follow up by letter notifying the taxpayer of the examination and the items on the return for which the IRS seeks supporting documentation. This should allow you sufficient time to meet with the client, review the return, and focus attention on the agent’s areas of inquiry.
You should assemble necessary documentation to support the return position. If it appears that a technical tax issue will be raised, you might want to review relevant tax authorities, including IRS rulings and court opinions supporting the taxpayer’s position. Your response should be thorough and should be in writing so that the taxpayer’s position is documented in the auditor’s file.
Field examinations. More complex returns are generally assigned to a revenue agent for examination. Almost without exception, the examination should be scheduled at your office. You should obtain and furnish the power of attorney to the IRS, and notify the examining agent that the requested books and records will be made available to the agent at your offices. The agent should also be instructed that he is not to contact the taxpayer directly.
This should be done for several reasons. First, the taxpayer may simply not want to be bothered by the examination and is willing to pay you to represent him. Second, the presence of a revenue agent at the client’s place of business may be disruptive, especially to the client whose time may be better spent attending to the affairs of his business. Moreover, by examining the books and records at your office, the revenue agent is less likely to want to go on a "fishing expedition" through a random search of the client’s records.
Also, there is always the risk of the taxpayer talking too much. When a taxpayer meets with the tax examiner, all too often, he "opens mouth and inserts foot." If the agent has questions for the taxpayer, they can be reduced to list to which a written response can be made.
Case in point: Getting lucky. Last year, a client called to inform me that the IRS wanted to look at its worker classification of certain independent contractors and needed help. I faxed a power of attorney to the agent and advised that the examination would take place at my offices. When we met, the agent sought responses from the corporation’s president regarding the "twenty factors" test that the IRS then used to determine whether a worker was an employee.
Because my client heard through the grapevine that the IRS had recently raised the same issue with a competitor, I demanded that the agent furnish me with the authorization from the IRS’s National Office for this initiative. Further, having reviewed the availability of Section 530 of the Revenue Act of 1978, I responded that the taxpayer could raise the Section 530 defense without first having to concede employee status. The agent appeared a bit shellshocked and indicated that he would have to make some inquiry. Within a few days the worker classification issue was dropped. Moral of the story: Sometimes you are lucky and get an issue about which you have more knowledge or experience than the agent.
If you and the agent are unable to agree on the technical issue but you feel strongly about the merits of your position, you should request a conference with the agent’s group manager. If this still proves unsuccessful, you could request the revenue agent to obtain technical advice from the National Office of the IRS.
A point of caution: Don’t be surprised if the National Office indicates support for the revenue agent’s position. If you happen to have a question of first impression, don’t lose sight of the fact that the National Office might be reluctant to rule favorably for the taxpayer unless the issue clearly favors the taxpayer. Once an adverse ruling is issued both examination and appeals will be bound to follow it. In such case, litigation is the only other means of relief.
The "30-day letter": As an alternative to technical advice, you may want to take your chances in appeals by instructing the revenue agent to write report as unagreed. This will give rise to what is commonly referred to as the "30-day letter," which transmits a Revenue Agent’s Report (RAR) of examination changes to the taxpayer and advises him of his appeal rights.
Planning tip: Before the revenue agent submits his examination report for review, he will have to explain the taxpayer’s position in narrative form. It is imperative that you write a letter to the revenue agent setting forth the taxpayer’s position with appropriate analysis and authority so that quality review will have the benefit of your analysis as opposed to relying solely on the revenue agent’s statement of the taxpayer’s position. This technique has frequently resulted in favorable resolution of issues prior to the issuance of the 30-day letter or lays the foundation for favorable results at the appeals division.
The 30-day letter is the IRS’s official notification to the taxpayer of proposed changes to his income tax return. It informs the taxpayer of his right to protest the proposed changes to the appeals division within 30 days, generally by submitting a written protest. The function of the appeals division is to take a fresh look at a factual dispute. The appeals officer is not bound to the position taken by examination, but is required to make an independent analysis and conclusion with respect to the issues.
Planning tip: The lawyer has to make a tactical decision at this point. Does he merely prepare a skeletal protest? Does he "brief the issue"? There is no simple answer to this question. Because tax cases are so factually intensive, it is hard to come up with a rule of thumb. However, the lawyer should be guided by cost considerations. It is probably not cost justified to prepare a $2,000 protest of a proposed $5,000 tax deficiency. But the lawyer’s negotiating position could be enhanced by the presentation of a well-reasoned argument of the facts and the law.
Negotiating Your Case
The lawyer who appears before the IRS is the taxpayer’s advocate. His mission is to obtain a favorable result for his client. The impressions that the lawyer leaves with the appeals officer will undoubtedly influence his decision. The following tips will help.
Tip 1: Be prepared! Nothing will make a worse impression on an appeals officer than the lawyer who is unprepared. A well-prepared lawyer will: (1) thoroughly review the file in advance; (2) be able to clearly articulate the facts of the case, and in particular the facts at issue; and (3) be able to explain how relevant cases and rulings support your position. Approach the appeals conference as if it is a trial. Be sure to bring all of your exhibits that you want the appeals officer to consider. Don’t assume that an important document obtained during the examination has been reviewed or is even available to the appeals officer. The examiner might not attach the same significance to a document as you.
Tip 2: Be professional. The manner in which the attorney conducts his business with the appeals officer will set the tone for any settlement discussions. While I believe the following points are pretty much commonsensical, they bear repeating. First, don’t promise anything you can’t deliver. While it’s human nature to believe what our clients tell us, don’t place blind faith in a client’s statement and don’t offer it as hearsay evidence to the appeals officer. If the appeals officer asks you to substantiate an allegation and you are unable to do so either because a third party is unavailable or unwilling to cooperate, you have weakened your case.
Acknowledge request for production; don’t ignore it. Your silence could infer that the information is unavailable or adverse to your position. Unless a document is privileged, it will be discoverable anyway. If you believe the information is privileged, tell the appeals officer and go on. He will appreciate your forthrightness.
Adhere to time deadlines. The failure to meet agreed upon schedules will likely leave the appeals officer with one of two impressions (both of which are bad): the information doesn’t exist, or you are stalling. Be courteous in your face-to-face dealings. An argumentative tone or personal attacks on the appeals officer are unproductive. A case is seldom settled favorably if the lawyer tells the appeals officer that he doesn’t understand the law. Confine your comments to facts and the law, not to the person.
Tip 3: Document your position. If you choose to write a skeletal protest, be sure to follow up the appeals conference with a letter to the appeals officer setting forth the substance of your discussions, both with respect to the facts and the applicable law. Although the appeals officer will make notes of the conference, it is possible that he will not consider something as important as you do. A favorable outcome could turn on the appeals officer having a clear understanding of your arguments.
Tip 4: Be flexible. If you have a proposal for settlement, get it on the table. But after having done so, don’t dig in your heals. Be willing to compromise. Even if you believe your case is strong, don’t insist on a "no change" unless the facts or the law so overwhelmingly favor your position. The appeals officer might even think that his case is weak, but if he faces an inflexible lawyer who is unwilling to compromise, he may be forced to issue a statutory notice of deficiency.
If the appeals officer believes he has a weak case, he has to face the important decision of whether to recommend a statutory notice of deficiency. I.R.C. § 7430 allows the awarding of costs and certain fees in any administrative or court proceeding against the IRS unless it establishes that its position was substantially justified. The lawyer should expect that the IRS will evaluate whether its position is substantially justified. While the threat of a § 7430 claim probably will not enhance the likelihood of settlement, it probably doesn’t hurt to let the appeals officer know that you are at least familiar with that section and the relief potentially available.
Tip 5: Evaluate a request to extend the statute of limitations. The appeals officer is frequently under time constraints with respect to the expiration of the statute of limitations. Typically, he will ask for a waiver of the statute of limitations to permit settlement discussions to continue. Again, the lawyer faces a difficult decision. Does he extend the statute? Or does he force the IRS to issue its statutory notice of deficiency? Unfortunately, there is no rule of thumb.
If you believe that the prospects for a settlement are good, then it is probably to the client’s advantage to execute a consent to extend the statute. However, I do not recommend executing a blanket extension (Form 872—Consent to Extend the Time to Assess Tax). Rather, I prefer Form 872-A—Special Consent to Extend the Time to Assess Tax, because it gives me the flexibility of terminating the consent by filing a Form 872-T—Notice of Termination of Special Consent to Extend the Time to Assess Tax.
But you may want to force the IRS to take a position. If the taxpayer refuses to execute a consent to extend the statute, the appeals officer will have to decide whether his case merits the issuance of a statutory notice of deficiency or whether the case is capable of being settled on the terms proposed by the taxpayer.
Even if the appeals officer causes a statutory notice of deficiency to be issued, the parties could nonetheless continue to work toward a settlement. In a little known, and probably seldom used procedure, the IRS and the taxpayer can agree to rescind a statutory notice of deficiency. IRS Form 8626—Agreement to Rescind Notice of Deficiency is authorized under I.R.C. § 6212(d). The only prohibition on the use of this form is where the taxpayer has already petitioned the U.S. Tax Court to contest the deficiencies in the notice of deficiency.
The well-prepared lawyer should leave the appeals conference with an impression of the appeals officer’s knowledge and advanced preparation. If there is reason to believe that the appeals officer is not well prepared, this might tip the scale in favor of refusing to extend the statute of limitations.
Threat of litigation. The appeals division has the ability to settle a dispute based upon the hazards of litigation. If the taxpayer and appeals officer are unable to reach a settlement, the taxpayer then has two choices: pay the tax, or petition for redetermination with the U.S. Tax Court. In the latter, the appeals officer will trigger a statutory notice of deficiency or "90-day letter" in which the taxpayer is given 90 days to petition the Tax Court for redetermination of his liability.
We have been asked from time to time to assist CPAs in tax appeals because of the appeals officer’s unwillingness to reach a reasonable settlement with the CPA. Experience suggests that an appeals officer who knows of a CPA’s reluctance to involve tax counsel might offer less in settlement to the CPA than he might otherwise concede to the lawyer because the CPA doesn’t use the threat of litigation.
Case in point: The taxpayer, a physician, purchased an expensive yacht and immediately placed it in a rental pool. For income tax purposes, he claimed that he was engaged in the activity for profit and claimed deductions and credits, which were challenged by the IRS. The Appeals Division was unwilling to settle. The CPA brought us into the case and we promptly met with the same response. Therefore, we told the Appeals Officer to issue the statutory notice of deficiency so that we could file our petition with the Tax Court. Because of National Office policy, our case was referred back to Appeals for possible settlement.
Reluctantly, I took the client, to the appeals conference because he insisted on explaining all of the steps he followed in treating his yacht rental activity as a bona fide business venture. Unfortunately, as the appeals officer grilled him on the lack of a significant amount of revenue generated by the activity, the physician lost his composure and slammed his fist on the table saying: "What do you people want? My blood? I paid six figures in income tax that year!" Fortunately, we were still able to reach a monetary settlement based upon the hazards of litigation. Moral of the story: Don’t be afraid to file a Tax Court petition. Second moral of the story: Don’t take your client to the appeals conference.
If the taxpayer is unable to resolve issues in appeals, he will receive a 90-day letter" or statutory notice of deficiency. At this point, he has three choices: (1) concede the issue and pay the tax; (2) not pay the tax and petition the U.S. Tax Court for a redetermination of liability; or (3) pay the tax and sue for a refund either in the U.S. District Court or the U.S. Court of Federal Claims.
The "90-Day Letter" and Tax Litigation
Many factors will have to be weighed by the lawyer in making his recommendation regarding a choice of forum. For example, if the taxpayer does not want to pay the tax in advance of U.S. Tax Court. But if the taxpayer is concerned about the accumulation of interest on a potential deficiency, he could pay the tax and immediately file a claim for refund.
Once the refund claim is denied, the taxpayer can file a refund action against the United States either in the district court or Court of Federal Claims so long as the action is commenced within the applicable statute of limitations. (generally three years from the due date of the return or two years after the taxes are paid).
Prior to enactment of the IRS Restructuring and Reform Act of 1998, the taxpayer had the burden of persuasion or burden of proof regardless of the forum chosen. Following the effective date of the 1998 act, the burden of proof in tax litigation shifted to the IRS, provided the taxpayer has satisfied the requirements of I.R.C. § 7491.
A petition to the U.S. Tax Court tolls the statute of limitations; thus, any item on the return is subject to challenge by the IRS even after the expiration of the applicable statute of limitations. One need only look at annotations under I.R.C. § 6214 where the courts have allowed the Commissioner to amend his answer to assert additional deficiency in tax prior to entry of decision. If it is preferable to isolate the issue for litigation, the lawyer will probably opt to file a refund action as opposed to petitioning the Tax Court.
Statute of Limitations
The lawyer should be mindful of two periods of limitations in tax controversy matters. The better-known statute of limitations is the three-year limitations on assessments. Generally, the IRS must assess a tax within three years of the due date of the return or the date the return is filed, whichever is later. The statute of limitation is set forth in I.R.C. § 6501.
While three years is the general rule, I.R.C. § 6501(c) contains exceptions for the willful attempt to evade a tax, for the filing of a false return, or where no return has been filed. In each of these situations, a tax may be assessed without limitation. I.R.C. § 6501(e) also contains an exception to the general three-year rule in the case of a taxpayer who omits an amount which is more than 25 percent of the amount of gross income stated in the return. In such case, a deficiency may be assessed within six years after the return is filed.
The other familiar limitation statute is the limitation on collection of tax found in I.R.C. § 6502(a). That section permits enforced collection activity by levy or by a proceeding in court but only if the levy or proceeding has begun within ten years after the assessment of tax. This is commonly referred to as the ten-year collection statute. I.R.C. § 6502 also contains an exception to the ten-year rule for agreements between the taxpayer and the IRS to extend the ten-year period. However, under the IRS Restructuring and Reform Act of 1998, I.R.C. § 6502 was amended to eliminate the provision allowing for the extension of statute of limitations by agreement between the taxpayer and the IRS, except that extensions may be made in connection with the installment agreements.
The right of the IRS to pursue collection of a tax liability depends upon the existence of a valid assessment. An assessment can arise in the following ways: (1) through the voluntary self-assessment of a liability by the filing of a tax return; (2) by the taxpayer’s consent to the assessment of a deficiency arising from an examination; (3) from the taxpayer’s failure to file petition with the U.S. Tax Court pursuant to a 90-day letter within the time limits prescribed; and (4) from the assessment of a liability based upon a "substitute for a return" prepared by the IRS pursuant to I.R.C. § 6020(b) in the absence of a filed return.
The Collection Process
Simply because the IRS has a valid assessment does not necessarily mean that enforced collection activity will be taken. A delinquency in the payment of tax is first dealt with by the IRS Service Center through the issuance of a series of computer generated notices or letters asking for voluntary payment of the tax.
The length of the collection process depends upon how soon the taxpayer pays his obligation. Notices typically encourage the taxpayer to contact the IRS explaining why he is unable to pay the liability in full. If the taxpayer is unable to pay his tax bill in full, I recommend that you initiate contact with the IRS to avoid enforced collections.
Word of caution: The IRS does not want to be the taxpayer’s bank or finance company. When the taxpayer demonstrates his inability to pay the liability in full, but it appears that the liability can be paid in full over a period of time, the IRS will likely consider a deferred payment arrangement commonly referred to as an Installment Agreement. But if the taxpayer demonstrates to the IRS’s satisfaction that he does not have the ability to pay the liability in full, I.R.C. § 7122 allows the IRS to compromise the taxpayer’s liability.
(As this article went to print, it was rumored that the IRS was considering amending the Offer in Compromise rules to allow for deferred payment offers for the balance of the collection statute in those cases where the taxpayer does not have the ability to pay the liability in full within the limitations period.)
Before the IRS is willing to consider either an Installment Agreement or an Offer in Compromise, it must be satisfied of the taxpayer’s financial condition warrants relief and will require the filing of a Collection Information Statement. Form 433-A is a Collection Information Statement used for individuals and Form 433-B is a Collection Information Statement used for businesses and for individuals with sole proprietorships or other closely held entities. These forms are designed to disclose the taxpayer’s "ability to pay."
If the taxpayer has realizable equity in his assets, the IRS might insist, as a condition of any agreement, that the taxpayer either liquidate assets or borrow the equity out of the assets in satisfaction of his tax liability. Similarly, if the taxpayer’s net monthly cash flow exceeds his necessary living expenses, the IRS will generally insist that such excess be applied against his liability.
Ignoring the IRS
If the taxpayer repeatedly ignores requests from the IRS to voluntarily pay his taxes, the IRS will likely take one or more of the following actions: (1) file a Notice of Federal Tax Lien; (2) serve a Notice of Levy upon the taxpayer’s employer, bank or other holder of investment-type assets; and/or (3) seize and sell the taxpayer’s real, personal or business property.
Lien. A Notice of Federal Tax Lien is generally filed with the public recorder in the county where the taxpayer resides or conducts business. The filing of such notice is the means by which the IRS protects the government’s interest in the taxpayer’s assets and is the means by which the IRS gives public notice to the taxpayer’s creditors that it has a claim against the taxpayer’s property, including any property that the taxpayer might acquire after its filing of the lien. The filing of a Notice of Tax Lien is generally harmful to the taxpayer’s credit.
Levy. Levy is the most common means used by the IRS to collect taxes that the taxpayer has not voluntarily paid. The I.R.C. imposes three requirements on the IRS before a levy action can be made: (1) the IRS must assess the tax and send a Notice and Demand for payment; (2) the taxpayer must neglect or refuse to pay the tax; and (3) the IRS must send a Final Notice of Intent to Levy at least 30 days prior to the levy.
Offers in compromise. Even if the taxpayer has received the 30- Day Notice of Intent to Levy, he can still avoid enforced collection activity by the filing of an offer in compromise. As stated above, the I.R.C. authorizes the Commissioner to compromise a tax liability when it is in the best interest of the government. Generally, the IRS will suspend collection while an offer is being considered. Offers can be filed on two grounds: (1) doubt as to liability and (2) doubt as to collectability.
The Offer is filed on Form 656—Offer in Compromise and must be accompanied by Form 433-A—Collection Information Statement for Individuals or Form 433-B—Collection Information Statement for Businesses, or both in connection with a self-employed person or owner of a closely held entity. The Collection Information Statement is designed to disclose the taxpayer’s net equity in his assets, as well as his net monthly cash flow in excess of his necessary living expenses. In most cases, the IRS will require verification of the taxpayer’s assets, liabilities, monthly sources of income and necessary living expenses.
In 1995, the IRS established national and local standards with respect to the determination of certain necessary living expenses. The IRS Restructuring and Reform Act of 1998 Amendments to I.R.C. § 7122 permits the IRS to look beyond its published "allowable expense standards" if the effect of the application of the standards would be to impair the taxpayer’s ability to provide for his necessary living expenses.
National and local standards (now codified in I.R.C. § 7122) contain limitations on the amount of certain living expenses taken into account in determining a taxpayer’s ability to pay his liability. The IRS publishes annually national standards for determining the necessary personal expenditures for things like food, clothing, personal, and household care items and the like, determined in accordance with the taxpayer’s gross monthly income and family size.
Similarly, the IRS publishes annually local standards setting forth the amount of monthly transportation and housing costs that can be taken into account for purposes of determining the taxpayer’s ability to pay. These standards for monthly housing costs are based on countywide averages and the taxpayer’s family size and may not bear any rational relationship to the taxpayer’s particular facts and circumstances. As a result of the use of the national and local standards, a collection information statement might reveal the "phantom monthly cash flow" that the IRS takes at present value in helping to arrive at an acceptable offer.
• Don’t be afraid to argue for the allowance of monthly expenses in excess of the published standard where the circumstances justify it.
• Your success in obtaining an approved offer will likely depend upon your client’s offer being in excess of the amount the IRS could otherwise obtain by levy.
• The IRS Restructuring and Reform Act of 1998 imposed restrictions on the IRS’s ability to levy upon a principal residence. In addition to obtaining approval by the District Director, the IRS also has to obtain approval by a U.S. District Court or U.S. Magistrate Judge. This should foreclose personal residence levies except in the most egregious or abusive situations.
Following the congressional hearings that led to enactment of the IRS Restructuring and Reform Act of 1998, the IRS took steps to improve its image. One step has been the "Problem Solving Days," held on selective dates throughout the nation. These sessions have enabled taxpayers to resolve a myriad of issues, and not necessarily limited to tax collection matters. Lawyers should explore the use of the Problem Solving Day where it appears that the traditional approaches are not progressing to his satisfaction. CL