Report on the Internal Revenue Service Restructuring and Reform Act of 1998
This report to our clients summarizes the principal changes in the recently enacted Internal Revenue Service Restructuring and Reform Act of 1998. Significant changes were made in the areas of IRS administration and procedures.
The new law provides sweeping changes in the way the IRS will operate and enacts many new provisions that will affect your tax obligations. For your reference, we briefly discuss some of these new changes we believe may be of general interest. We would be pleased to discuss with you in more detail how the new law impacts you personally.
Because we offer only summaries here, you should not reach a conclusion about the application of the legislation to a particular situation without first reviewing the relevant provisions of the law itself and obtaining legal advice if needed.
Conversion of IRAs to Roth IRAs - An existing IRA may be converted to a Roth IRA so long as the taxpayer's adjusted gross income does not exceed $100,000 (not including the amount converted). The converted amount, however, must be included in income. Generally, for conversions made in 1998, a taxpayer includes only a quarter of the income each year from 1998 through 2001 under a four-year averaging rule. Under the new law, however, an individual may elect to include the entire amount in income for 1998. For taxpayers who anticipate being in a lower tax bracket in 1998 than in other years, this election is particularly advantageous because the taxpayer will have a lower tax burden on the amount rolled over. If a taxpayer dies during the four year period, any amount remaining must generally be included in the individual's final federal income tax return.
Reductions of holding period for capital gain - The Taxpayer Relief Act of 1997 (the "97 Act") reduced the maximum rate on the adjusted net capital gain of an individual from 28 percent to 20 percent for property held for more than 18 months. Under the new law, property held for more than one year (rather than for more than 18 months as required under the 97 Act) will be eligible for the lowest capital gain rates, thus entitling individuals to attain the more favorable tax rate by holding the property for a shorter period of time. This holding period change is effective for tax years ending after December 31, 1997 .
Burden of proof - Traditionally, in court proceedings the IRS' determination was presumed correct and the taxpayer had the burden to prove otherwise. This burden was particularly onerous on taxpayers. In an effort to expand the taxpayer's rights, the new law provides that, effective for court proceedings arising in connection with examinations beginning after July 22, 1998, the IRS has the burden of proof in any court proceeding with respect to a factual issue, provided the taxpayer satisfies the following conditions: (1) the taxpayer must substantiate any item by complying under statute and regulations; (2) the taxpayer must retain records as required by statute and regulations; (3) the taxpayer must cooperate with reasonable requests of the Secretary for access to information; and (4) corporate and trust taxpayers must not have net worth that exceeds $7 million. Although this shift in burden of proof in theory is taxpayer friendly, it remains to be seen whether such change has any practical significance. As in the past, a taxpayer must continue to preserve documentation and substantiate any positions taken on a tax return.
Payment of taxes to the U.S. Treasury - Under prior law, if a taxpayer paid taxes by check or by similar means (such as by money order), payment was made to the "Internal Revenue Service." Effective as of July 22, 1998, the new law provides that the IRS is to establish rules, regulations and procedures to allow payment of taxes by check or similar means to be paid to the "United States Treasury." In Congress' view, it was more appropriate that payment be made to the U.S. Treasury as opposed to the IRS. While this change might be purely semantic, taxpayers should exercise caution when paying taxes by check or similar means. Checks made to the IRS may not be honored and the taxes sought to be paid by such check might be deemed unpaid, possibly resulting in interest and penalties.
Privileged communications with tax advisors - At common law, communications between a client and his or her attorney are confidential with respect to legal advice given by the attorney. The new law, effective for communications made on or after July 22, 1998, provides that tax advice communicated in noncriminal proceedings between the taxpayer and the taxpayer's federally authorized practitioner are now accorded the same protections of confidentiality as a communication between a taxpayer and an attorney. A federally authorized practitioner is any individual who is authorized to practice before the Internal Revenue Service, such as a certified public accountant, enrolled agent, or enrolled actuary. This change should provide for fuller disclosure between a taxpayer and his or her advisor with respect to tax matters. The new privilege, however, does not apply to written communication in connection with corporate tax shelters and it is unclear whether states will also treat the communication as privileged. Nor does the new law affect the full protections provided by the attorney/client privilege in criminal matters.
Increase in size of cases permitted on small case calendar - Special small case procedures provide a quick and easy way for taxpayers to obtain an unappealable decision by the United States Tax Court. Small tax cases are conducted in an informal manner (i.e., neither briefs nor oral arguments are required and strict rules of evidence are not applied). Under prior law, disputes between a taxpayer and the Internal Revenue Service involving $10,000 or less could be administered under the special small case procedures. The new law, effective for proceedings beginning after July 22, 1998, increases the cap to disputes involving $50,000 or less. This increase in size is designed to allow more taxpayers to take advantage of the informal small case procedures and should provide relief to those taxpayers who have relatively small amounts in dispute. The IRS, however, may object to small case treatment if it believes that the case has potential precedential value.
Spousal election to limit joint and several liability - By signing a joint income tax return, all spouses agree to be jointly and separately liable for the tax liability. In some circumstances, this rule had particularly harsh effects on individuals who were not aware of their spouse's activities. Often when one spouse could not be found, the IRS demanded that the "innocent spouse" satisfy any outstanding tax liability. The "innocent spouse" could be relieved of paying the tax only if he or she satisfied a burdensome and difficult test. Effective for any tax liability arising after July 22, 1998, the new law provides some relief to "innocent spouses." Specifically, a spouse may elect to limit his or her liability for unpaid taxes on a joint return to the spouse's separate liability amount. In order to limit liability, the taxpayer must either no longer be married to, or be legally separated from, or have been living apart for at least 12 months from, the person with whom the taxpayer originally filed the joint return. Spouses who do not satisfy these requirements may still obtain relief under the more burdensome rules.
Rollover of gain from sale of qualified stock - The 97 Act provided that gain from the sale of qualified small business stock held by an individual for more than six (6) months can be "rolled over" tax-free to other qualified small business stock. Qualified small business stock is originally issued stock of a C corporation with assets of no more than $50 million. The new law provides that effective for sales after August 5, 1997, any taxpayer other than a corporation may now take advantage of the tax deferral. Thus, for example, under the new law, a partnership or an S corporation can roll over gain from qualified small business stock held more than six (6) months if at all times during the taxable year all the interests in the partnership or S corporation are held by individuals, estates, and trusts with no corporate beneficiaries.
Taxpayer protections -The new law provides numerous protections from unconscionable actions by the Internal Revenue Service. For example, effective for actions of IRS officers or employees after July 22, 1998, a taxpayer can collect up to $100,000 in civil damages if an employee of the IRS negligently disregards the law with respect to collecting a taxpayer's income tax and up to $1 million if an employee of the IRS willfully violates certain bankruptcy laws. Furthermore, effective for tax years ending after July 22, 1998, the new law suspends interest and certain time related penalties if the IRS does not provide a notice of tax liability within 18 months of the filing of a timely tax return. And, in a much anticipated change, the new law provides, effective as of July 22, 1998, for a reorganization of the IRS which will make the agency more responsive in addressing taxpayer concerns and providing a public service.
Deductibility of meals provided for the convenience of the employer - The value of meals furnished to an employee by an employer is excluded from the employee's gross income if the meals are furnished for the convenience of the employer and on the business premises of the employer. Additionally, if substantially all of the meals are provided for the convenience of the employer, the cost of the meals is fully deductible by the employer. Under prior law, it was unclear what was meant by "substantially all of the meals." The new law provides that "substantially all of the meals" means that the employer provides meals to more than one-half of its employees. By providing clarity in this area, both employees and employers now can determine with certainty how to treat employer provided meals. The new law is effective for tax years beginning before, on, or after July 22, 1998.
Mitigation of penalty for failure to deposit payroll taxes - Deposits of payroll taxes are allocated to the earliest period for which such a deposit is due. If a taxpayer misses or makes an insufficient deposit, later deposits will first be applied to satisfy the shortfall for the earlier period; the remainder is then applied to satisfy the obligation for the current period. Cascading penalties may result as payments that would otherwise be sufficient to satisfy current liabilities are applied to satisfy earlier shortfalls. Under the new law, the taxpayer is permitted to designate the period to which each deposit is applied. The designation must be made no later than 90 days of the related IRS penalty notice. For deposits required to be made after December 31, 2001, any deposit is to be applied to the most recent period to which the deposit relates, unless the taxpayer explicitly designates otherwise. The new law is effective for deposits to be made after the 180th day after July 22, 1998.