Archive for February, 2010
Federal Income Tax – Taxes and Divorce
Divorcing people find themselves very interested in several sections of the Internal Revenue Code. Where one spouse has substantial retirement benefits, the parties should examine the rules for a Qualified Domestic Relations Order, or QDRO, which can divide the retirement benefits between the parties. If one party will be making payments to the other, the parties are allowed to determine which of them will be taxable on the payments through the Alimony rules of Section 71 of the Code.
In property settlements between divorcing parties, no gain or loss is recognized. The parties should realize, however, that the “basis” (cost) of whatever property they receive will carry over from when the couple acquired it. This can make a large difference when a party later sells the property. They should make an effort to divide both the property and the basis fairly. There is a $500,000 exclusion of gain on selling a marital residence. The excludable gain is only half as much for a single person. Couples with a large gain on their residence must be careful to sell at the proper time, and under the right conditions to maximize the exclusion.
The custodial parent normally gets the dependency exemption for dependent children. Only if the custodial parent signs off on claiming the exemption is the non-custodial parent allowed to claim the child or children.
Legal fees incurred in getting a divorce are not deductible. Legal fees incurred in getting tax advice, or in obtaining or collecting taxable alimony, are deductible.
QUALIFIED DOMESTIC RELATIONS ORDERS
The legal instrument for dividing retirement plans between the divorcing parties is the Qualified Domestic Relations Order (QDRO).
Retirement Plans come in two flavors: (1) Defined Contribution Plans, where the current value can be determined at any time, but the retirement benefits are not determinable, and (2) Defined Benefit Plans, where the retirement benefit is pre-defined, but the value at an earlier date can only be determined by an actuary.
Most retirement plans are subject to the Employee Retirement Income Security Act (ERISA). Plans that are subject to ERISA must provide for Qualified Domestic Relations Orders (QDROs) to divide retirement benefits between the plan participant and his or her spouse or other dependents.
Before QDROs, retirement plans were taken into account in divorce settlements, but the non-participant spouse was often given additional property to “offset” the retirement plan value retained by the participant spouse. The offset method is still often used for simplicity where the value of the retirement assets is small. The offset method won’t work in all cases because parties often don’t have enough assets outside of the plan to offset the value of the plan.
QDROs allow plans to be divided by the “Deferred Division Method” or the “Shared Benefit Method”. “Deferred Division” implies that both spouses will use the plan assets for retirement, but they are not required to. Many QDRO divisions are immediately rolled over into an IRA, or simply cashed out. The early withdrawal penalty does not apply when cashing out a QDRO. There are rumors that people have divorced in order to receive QDRO funds which are usually not available under retirement plans, and to avoid the early withdrawal penalty.
The “Shared Benefit Method” assures that both spouses will use the retirement fund for their retirement. Shared benefit assigns a portion of each benefit payment to each spouse. The shared benefit method avoids the necessity of valuing the plan at the time of divorce. The shared benefit method is often used where withdrawals from the plan have already begun before the divorce.
Plan administrators are often available to assist with forms or wording of QDROs. A QDRO can’t increase a plan’s obligations; it can only divide existing obligations between the plan participant and his or her spouse or dependents. Plans can have a variety of benefits besides a normal retirement annuity—survivor benefits, augmented early retirement benefits. These benefits should be addressed in the QDRO. Both parties and their attorneys should read at least the Summary Plan Description to know what benefits are available to be divided.
QDROs can divide retirement plans in favor of children or other dependents as well as spouses.
QUALIFIED ALIMONY/SECTION 71 PAYMENTS: DEDUCTIBLE BY PAYOR, TAXABLE TO PAYEE
Qualified Alimony is defined in Section 71 of the Internal Revenue Code. The definition in Section 71 does not correspond to other definitions of alimony in the legal or real world. In Section 71, there is no requirement that Alimony be for support, or that it be paid in periodic payments. Section 71 Alimony that is taxable to the payee is deductible by the payor.
Section 71 requires that deductible alimony be paid in cash. Property or the use of property doesn’t count as alimony. Payments can be to a third party “on behalf of” the payee. Deductible alimony must be paid under a Court Order or Written Separation Agreement. The Court Orders mentioned in Section 71are: a decree of divorce; a decree of separate maintenance; a written instrument incident to a decree. The parties may write their own Written Separation Agreement calling for payments that will qualify as alimony under Section 71.
To qualify as deductible alimony the payments must not be designated as non-deductible/non-taxable in the governing instrument. The parties cannot be members of the same household at the time the payments are made.
To qualify as deductible payments, there must be no liability to make payments for any period after the payee’s death, and no liability to make any substitute payments. The lack of liability for continuing payments may (and should) be stated in the governing instrument (Decree or Separation Agreement), or it can be a feature of local law. In Michigan, “Alimony” does not survive the payee’s death. Note that “Qualified Alimony” does not necessarily correspond to alimony as defined in Michigan divorce law. There does not need to be any support element or Periodic Payments in “Qualified Alimony.”
If the alimony payee is concerned to receive a certain amount in from the dissolution of the marriage even if he or she should die, this would be an ideal place to use life insurance. The alimony payee can insure his or her death, but the alimony payor should not provide that insurance directly.
If you wish to describe “Qualified Alimony” be sure to state that the payments end in the event of the death of the payee, regardless of how unlikely that death is before the payment of the alimony—even if the payment is being made on the same day the agreement is signed.
Qualified Alimony payments cannot be treated as child support in the document, either directly, or by adjusting the “Alimony” payments as the children reach certain ages.
Excessive “front loading” of alimony payments in the first three years will cause a portion of payments to be recaptured in the third year. Front loading is the most complex requirement Qualified Alimony must meet, but it only tests the first three years, so the math is manageable. Front loading is only concerned with decreasing payments. If the payments stay level or increase, there is no front loading issue.
Excessive “front loading” is calculated as follows:
- Begin with the third year’s payment(s).
- Second year payments will not be excessively front loaded if they do not exceed third year payments plus $15,000.
- First year payments will not be excessively front loaded if they do not exceed the average of the second and third years’ payments plus $15,000.
It might be easier to apply two rules of thumb which avoid going through the calculations: You can have one $15,000 “step down” in the first three years, or you can have two $10,000 “steps down” in the first three years without excessive front loading. Note that years one, two and three are calendar years. If the first payment is near the end of year one, year two’s payment may be paid shortly thereafter.
Qualified Alimony need not be paid for support. It can be used to pay attorney fees, to equalize property settlements, to buy out a business interest, to divide a small or non-qualified pension plan, to make the “interest” portion of a property settlement deductible to the payor, or for any other reason the parties may have, so long as the requirements are met.
PROPERTY SETTLEMENT: NO GAIN OR LOSS IS RECOGNIZED ON TRANSFERS BETWEEN THE SPOUSES OR INCIDENT TO A DIVORCE
A transfer is “incident to a divorce” if it occurs within one year of the divorce, or if it is related to the cessation of the marriage. A right of first refusal granted in a property settlement was found to be “related to the cessation of the marriage” years after the divorce.
The transferee spouse takes the property as if received by gift from the transferor spouse—cost basis and date basis carry over. Divorcing parties (or their attorneys) should compare not only the current values of the property being divided, but also the basis of the property, so that one spouse is not burdened with excessive low-basis assets which will generate taxable gains in the event of sale. Cost basis can be adjusted in some cases by borrowing against the property before its transfer.
How should the parties take potential tax liability into account? Subtracting a calculated tax from the current value sort of assumes an immediate sale. Ignoring the potential tax sort of assumes the property is never sold. It seems appropriate to compromise somewhere in the middle. Michigan courts have seldom reduced property values for potential tax liability, generally finding that assuming a taxable sale of the property was speculative.
If property is to be disposed of in a divorce, it is important to transfer the property between the spouses (tax-free) before the sale to locate the tax liability where it is appropriate. The tax liability is determined by the ownership of the property when it is sold. If property is sold by husband and wife as joint owners in Michigan, it is reported one-half on each spouse’s tax return. If property becomes co-tenancy property under the divorce decree, it will be an equal co-tenancy unless the court specifies otherwise. The parties are free to divide property or the proceeds of sale of the property in another proportion; make their ownership interests proportionate to their sale proceeds, or someone will pay too much tax. If the property is to be sold and Husband is to receive ¼ of the proceeds, make him a co-owner of ¼, or he will be paying tax on1/2 of the sale proceeds, including part that goes to his EX.
While the parties can divide their property between themselves to control their tax consequences, they can’t “assign” taxable income earned by one to the other. An attorney who assigns half of an expected fee to his spouse will be taxable on the whole fee. Most adjustments of taxable income between the spouses can be solved using Section 71 payments.
A common problem of divorcing couples is buying out a business interest of a soon-to-be ex-spouse in a tax efficient manner. One way it is done is to “hire” the ex-spouse to pay her with deductible corporate dollars. A second way is to pretend to hire the ex-spouse, paying her for no services with deductible corporate dollars. If this sham is discovered by IRS, the result is no deduction to the corporation, and the taxation of a dividend to the owner. A solution is to pay the dollars to the continuing owner, who transfers them to the ex-spouse using Section 71 Qualified Alimony.
Another way to handle the buyout of the ex-spouse would be by the redemption of stock. Assume W owns 100% of Company X. W transfer 50% of Company X to H. H’s shares are redeemed by Company X over time. Company X’s obligation to H is guaranteed by W. This is all a perfectly acceptable way to have the business buy out the ex-spouse (with after tax funds), provided W has no “primary and unconditional obligation” to make the payments due H. If she does have a primary obligation, then the corporation is paying her obligation, which will be treated as a dividend taxable to her.
The parties might also arrange for the use of Qualified Retirement Plan funds to buy out the ex-spouse. A QDRO pays the ex-spouse (or soon-to-be ex-spouse) the buy-out value. This provides security to the spouse receiving the funds, it preserves the business owner’s cash flow, and the retirement fund might be replenished for the business owner over time.
MARITAL RESIDENCE GAIN EXCLUSION
Internal Revenue Code Section 121 provides for the exclusion of $250,000 of the gain on the sale of a residence for a single person, and an exclusion of $500,000 of gain for a married couple. Requirements are (1) that the home be owned and used as the parties’ primary residence for two years out of the last five years before sale, (2) that the parties have not used the exclusion in the last two years, and (3) that the couple file a joint return. Both parties must satisfy the two year use requirement, but only one needs to satisfy the two year ownership requirement. The two year ownership and use requirements are pro-rated if an early sale is caused by unforeseen circumstances—loss of job, health problems, or divorce.
Unmarried co-habitants—A & B, unmarried, have owned their home jointly and have lived in it for over two years. They are about to sell it for a gain of $256,000. By virtue of their joint ownership, the gain is attributed ½ to each of them. Each has an exemption of $250,000 available, so each of their gains are excluded. If only one had owned the home, there would be only one $250,000 exclusion.
Newly married—A & B marry and buy a new home. They each sell their previous homes, A’s for a gain of $300,000, and B’s for a gain of $200,000. Each had owned and occupied their respective homes for more than two years. A is allowed an exclusion of $250,000, and B is allowed an exclusion of $200,000.
If a single homeowner marries the spouse must reside in the home (and not sell another home) for two years before the couple qualifies for a $500,000 exclusion.
The date basis for purchase of the home transfers from one spouse to the other if the property is transferred in a divorce. Use by a spouse or former spouse which is specifically provided in the divorce decree or written separation agreement is attributed to the non-occupant spouse. Arrangements for the custodial parent to use a co-owned home while children are minors, then house to be sold, will qualify for the $250,000 exclusion for each co-owner, even though the non-custodial parent has not lived in the home for years.
HOME DEDUCTIONS
In joint ownership each party can deduct the interest and taxes that he or she paid.
In co-ownership each party can deduct the interest and taxes he or she paid only up to that party’s proportional interest in the property.
Tenancy by the entireties (marital joint ownership) converts into equal co-tenancy upon divorce, unless the divorce decree specifies otherwise.
The marital home can be a qualifying first or second home for the non-custodial parent (for the purposes of deducting mortgage interest) if his or her children live there.
With some planning, the parties can use the Alimony definition of Section 71 to assign the home deductions to whomever benefits from them.
CHILDREN’S DEPENDENCY EXEMPTIONS
The general rule is that the custodial parent gets a child’s dependency exemption UNLESS he or she agrees not to take the exemption on Form 8332. This general rule applies whenever the parents together provide more than half of the support for the child, and have custody of the child for more than one-half of the year.
Any substitute for Form 8332 must have all of the information contained on Form 8332. A letter of intent or a letter of agreement between attorneys or parties won’t serve as a substitute for Form 8332. The Form can be signed once to cover one year or many years into the future. Probably the best practice is for the custodial parent sign Form 8332 each year after all support payments are made. Assignment of the dependency exemption to the non-custodial parent in the divorce decree is not effective BUT Michigan courts can require the custodial parent to sign Form 8332 if that is equitable or conforms to a divorce judgment.
Either parent may deduct medical expenses paid for their dependent child.
LEGAL FEES
Legal fees that either spouse pays in a divorceare considered personal and non-deductible. Fees that either party pays for tax advice are deductible under Section 212(3) of the Internal Revenue Code which provides that all fees paid to plan or calculate taxes are deductible.
Legal fees related to the production or collection of taxable alimony are deductible. Fees for fighting against the award of alimony are not deductible.
FILING STATUS
If the parties are married on December 31, they are treated as married for tax purposes. They may file a tax return as “Joint”, or as Married Filing Separately. Joint return filing rates are the lowest of any filing method. Married Filing Separately rates are the highest.
There is an exception for a parent who has been separated from the other parent for the last six months of the year, and provides a home for one or more dependent children. The separated parent can file as “Head of Household”, with rates lower than Married Filing Separately, and even lower than Single filing. The other parent, unless he or she also provides a home for another child or children, must file as Married Filing Separately.
When the divorce is final, the custodial parent providing a home for the dependent children can file as Head of Household. The non-custodial parent can file as Single.
Resources:
Internal Revenue Code:
Section 71, Alimony and Separate Maintenance Payments
Section 121, Exclusion of Gain from Sale of Principal Residence
Section 152, Dependents Defined
Section 163, [Deduction of] Interest
Section 164, [Deduction of] Taxes
Section 212, [Deduction of] Expenses for the Production of Income
Section 215, [Deduction of] Alimony, etc., Payments
Section 414(p) Qualified Domestic Relations Order Defined
Section 1041 Transfers of Property Between Spouses or Incident to Divorce
Treasury Regulation:
Section 1.121-3, Reduced Maximum Exclusion for Taxpayers Failing to Meet Certain Requirements
Internal Revenue Forms:
Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents
Federal Income Tax – Appeal Your Audit
If you don’t agree with the results of a tax audit, appeal! The Appeals Division is the only place to appeal audit results within the Internal Revenue Service. The Appeals Division’s job is to reduce the number of unagreed cases. Move to Appeals, and you will get several chances to improve or correct the findings of the audit.
Appeals wants to settle cases. That is its reason for existence. Section 8.1.1.1-2 C of the Internal Revenue Manual states:
“Appeals accomplishes this mission by considering protested cases, holding conferences, and negotiating settlements in a manner which ensures the following:
As many non-docketed cases as possible are closed while in non-docketed status, and as many docketed cases as possible are closed without trial.”
Non-docketed cases are cases that have not yet been filed in Court. Appeals measures its success by how many cases it can settle without court filings.
Prepare, Prepare, Prepare
While you are appealing, you can further prepare your case. You prepared for the tax audit. Now you have just gone through the audit. You have been told which items the auditor accepts, and which he rejects and why. At the appeals level, you will be allowed to present ANY arguments or facts you have that will improve your position, even if you did not present them previously. (This is different from the court system, where you present your best case first, or you lose the opportunity.)
If you can get a letter from your employer to support your position, do it. If the connection between your expense and your business is questioned, work on that connection. If more supporting documents are needed, try to obtain them. Use your imagination. If detailed mileage logs are not available for all of your mileage, try to support your mileage for one month and convince the Appeals Officer to accept it as “typical.” Use your appointment book to show your travel. Concentrate on the areas the auditor did not accept.
Again, if you remember or find issues that are in your favor, you are allowed to raise them. If you forgot to deduct some business expenses, tell the Appeals Officer. The Appeals Officer is directed not to raise new issues on behalf of the government, but to accept any new information in the taxpayer’s favor. Inernal Revenue Manual Section 8.6.1.6.4-1 states:
“Appeals gives full, fair and impartial consideration to the merits of each new issue raised by a taxpayer. If such an issue is based upon important evidence, such evidence is ordinarily referred to IRS Compliance for verification.”
Opening an Appeal
The normal income tax examination involving less than $25,000 in tax can be appealed with a simple letter stating what issues you don’t agree with, and why, and requesting Appeals consideration.
If your tax controversy exceeds $25,000, or involves issues other than the normal income tax examination (retirement plan issues, partnerships, S Corporations, appeals of liens, levies, seizures, or installment agreements) you will need to file a formal “Protest” of Internal Revenue Service’s decision or action. A formal Protest is simply a letter identifying you, a statement that you want to appeal IRS’s findings to the Appeals Office, a copy of the notice of the IRS findings, the time periods involved, a list of the changes you don’t agree with, a statement of the facts that support your position, and a statement of the law that supports your position. The protest must be signed under penalties of perjury.
Mission Statement
Internal Revenue Service states the mission of the Appeals Office as follows:
“The Appeals Mission is to resolve tax controversies, without litigation, on a basis which is fair and impartial to both the Government and the taxpayer and in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the Service.”
Resolution of tax controversies, “on a basis which is fair and impartial” claims to be a place where you can receive “justice” in the tax system. You would assume that, in a “fair and impartial” system, if you had a better argument than IRS on a tax issue, IRS would back down and concede the issue. It doesn’t work out that way. The Appeals Officer, rather, is working for Internal Revenue Service. The Appeals Officer has the authority to compromise issues with taxpayers. The way in which the Appeals Officer evaluates issues is to calculate the government’s chance of winning each issue, and then offering a settlement to the taxpayer based on that chance of winning.
Hazards of Litigation
If the Appeals Office feels that you have a 60% chance of winning an issue in court, it will not concede the issue. Appeals Officers have the authority to split the issue. They may settle such an issue with the Taxpayer by having the taxpayer pay 40% of the tax IRS billed (in this example) in the examination process. This process is called taking into account the “hazards of litigation.” Examination level employees are supposed to raise all issues on which Internal Revenue Service has any chance of winning in court, and Appeals Officers are authorized to consider how strong the government’s case is.
As explained in Regulation 601.106 (f):
| “(2) RULE II. Appeals will ordinarily give serious consideration to an |
| offer to settle a tax controversy on a basis which fairly reflects the |
| relative merits of the opposing views in light of the hazards which would |
| exist if the case were litigated. However, no settlement will be made |
| based upon nuisance value of the case to either party. If the taxpayer |
| makes an unacceptable proposal of settlement under circumstances |
| indicating a good faith attempt to reach an agred disposition of the case |
| on a basis fair both to the Government and the taxpayer, the Appeals |
| official generally should give an evaluation of the case in such a manner |
| as to enable the taxpayer to ascertain the kind of settlement that would |
| be recommended for acceptance.” |
Taking the hazards of litigation into account should leave the taxpayer in a better position than if he accepted the examiner’s conclusions, where the examiner raised all issues on which Internal Revenue Service had any chance of winning. But from the taxpayer’s perspective, wouldn’t it be fairer if all cases where the taxpayer has probably interpreted the law correctly were dropped?
Correspondence Appeal?
As part of its efficiency drive, Internal Revenue Service would like to settle as many cases as possible with as little taxpayer contact as possible. Appeals are handled by correspondence, telephone or in person. If you can manage it at all, arrange an in-person conference. You will be more than a number to the Appeals Officer after you have conferred for an hour about your tax situation. You will have a better chance to explain your position, and especially to answer the Appeals Officer’s questions. You will be able to see where your arguments are not getting through, and be able to expand them.
Internal Revenue Service makes a big point of stating that interest and penalties continue while you are appealing their decisions. In point of fact, the tax audit usually doesn’t happen until all penalties have reached their maximum. Interest continues, but is calculated at a rate related to the Treasury borrowing rate, so is not severe.
The Appeals level can be skipped. If you don’t request to go to Appeals, you will receive a letter that states that you have 90 days to appeal the results of the audit to the Tax Court. Remember the examiner is supposed to raise all questions on which the government might win. The bill you get after the examination will be the highest you can possibly get in the system. Go to Appeals if you have any strong arguments, and you may get a better result.
Appeals Officers settle about 9 out of 10 cases they handle, so your chance of getting a result you can live with is pretty good.
If you skip Appeals, or if you don’t resolve your case in Appeals, you will receive a “90 day letter” which advises you that you have 90 days to appeal your case to the Tax Court. Pay attention to the due date for your filing with the Tax Court. If you miss the date, the Tax Court is deprived of jurisdiction, so you have lost your best chance to resolve your case in your favor in court.
When your case is “docketed” in Tax Court, the case is assigned to an attorney to prepare it for trial. The attorney’s job is to plan and gather evidence to present the case to the Tax Court. The attorney will gladly confer with the taxpayer, in an attempt to “narrow the issues” that the Court will have to address. The taxpayer can use this as another opportunity to resolve the case, short of going to Court, although the attorney will be working with the Appeals Officer that originally considered the case.
References:
Internal Revenue Code:
Section 7123, Appeals Dispute Resolution Procedure
Treasury Regulations:
Section 601.105, Examination of Returns and Claims for Refund, Credit or Abatement
Section 601.106, Appeals Functions
Internal Revenue Manual:
Part 4, Examining Process
Part 8, Appeals
Internal Revenue Publications:
No. 556, Examination of Returns, Appeal Rights and Claims for Refund
Federal Income Tax – Income Tax Audit
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Your tax return was selected for an income tax audit? IRS audits one tax return out of every hundred it receives. How could you be so lucky? Selection of returns for examination
Selection of Tax Returns for Audit The Internal Revenue Manual states, at 4.1.1.1-5.“The primary objective in selecting returns for examination is to promote the highest degree of voluntary compliance on the part of taxpayers.” How would returns be selected to “promote the highest degree of voluntary compliance on the part of taxpayers”? Wouldn’t a random chance have the greatest effect of keeping people honest? That is not the way returns are selected for audit. With so few returns being audited, IRS attempts to make every audit count. It wants to bring in as much revenue as possible from its audits. The most common source of tax returns selected for audit is the comparison of income shown on the return with the reports the payers have sent to IRS. Since IRS knows what it believes to be your error, it computes the increase in tax before you are even notified. These audits are usually handled by correspondence. You will not receive a letter that says “You have reported more income than we think you actually received,” as IRS’s computers are programmed to find underreporting on tax returns. (The computers couldn’t be programmed otherwise, unless all payers filed reports on all payments.) IRS records can be mistaken, and the information submitted to IRS can be erroneous. If you are notified that your tax return does not agree with records submitted to IRS, take the notice seriously, and check all the income IRS thinks you received. A second common way in which tax returns are selected for audit is by computer scores calculated for the return based on the information shown on the return. IRS has a program called the Discriminant Inventory Function System (DIF) which assigns a numerical score to every tax return based on the items shown on return and on previous returns for the same taxpayer. The DIF score is calculated to select returns where there might be errors or underreporting resulting in relatively large recoveries of tax. A self-employed person in a business that handles a lot of cash transactions, whose business does not show the sales IRS would expect, based on the expenses shown on the return, would make a good audit candidate. If the person consistently earns a small amount, but lives in an exclusive neighborhood, that might add to the DIF score. IRS does not disclose either how DIF scores are calculated, or the DIF scores of returns selected for audit. IRS also selects returns for audit based on information it collects from public records, newspapers and tips from individuals. Big Brother is watching; don’t brag about your tax exploits. IRS selects some returns for audit randomly, hoping to keep all of us honest. With a total of only 1% of tax returns audited, and large numbers accounted for by discrepancies with information submitted by third parties, and by DIF scores, there is room for very few random audits. How to avoid an audit Avoid an audit by fitting into the pack. If you have unusually large amounts of itemized deductions your chances of an audit are increased. Averages are published by IRS. Complex transactions, especially transactions that are designed to take advantage of tax loopholes increase your chances of being called in.. A self-employed person in a business that takes in a large amount of cash is more likely to be audited than a wage earner. Do you claim a large amount of charitable contributions? Have you bragged to others about a “clever” tax strategy? Claim all your legitimate deductions, but be aware that some deductions make an audit more likely. You are entitled to bring someone with you to assist you at a tax audit. The people you may bring are the persons authorized to represent taxpayers before the Internal Revenue Service—attorneys, Certified Public Accountants, enrolled agents (usually former IRS employees who have passed an exam), and the person who prepared your return. The Internal Revenue Code specifies that discussions between taxpayers and their professional advisors, attorneys, accountants or enrolled agents, are “confidential”. Confidentiality of conversations with attorneys is a tradition of long-standing, but confidentiality of communications with accountants is a new concept. How confidential are your communications with your accountant? The Internal Revenue Code provides that communications with your attorney, accountant or enrolled agent are protected as long as IRS is working on civil matters (How much tax is due?), but may have to be disclosed in criminal investigations. Why are you Nervous? What are the chances that you are going to end up owing IRS after your audit is complete? Look at the sources of how your return was selected for audit. Nearly all of the sources indicate that IRS has already determined that it is likely that you owe money: Comparison of your return with reports from payers of income; a DIF score that indicates that your return would likely yield additional tax; tips from individuals or public records that seem to contradict your declared income. A few returns are added at random, but generally you can expect that IRS has selected you because it sees some issues or feels it will find some issues that it would have a pretty good chance of winning, if they argued against you in court. You are likely to pay some money before this is over. Another reason you should be nervous is that the IRS employee you are dealing with has been told to challenge you on every issue that the government might win on, if the issue were taken to court. Examination level employees are not permitted to view your audit as a judge; their job is to spot the issues for higher-ups to settle or to argue in court. Examination level employees are the District Attorneys of the tax system. Their job is to raise the issues—someone else will decide them. The fact that examination level employees raise all issues on which the IRS has a chance of winning is not a bad thing, it is just a fact of life. If you want “justice”, you will have to appeal the audit up to a level where employees can take into account the chances of IRS winning an issue, and settling with you on that basis. The unfortunate part of raising all issues that favor the government is that, after the auditor has raised every issue the government might win, including strong issues, where IRS’s chance might be 80 or 90%, and including weak issues where IRS’s chances might be 25 or 30%, the auditor is instructed to try to get your agreement to his one-sided report. Is the auditor a judge, trying to dispense impartial justice? Absolutely not, but he tells you that he is just applying the law. Prepare, Prepare, Prepare If your return is selected for audit, prepare for the audit. It’s very easy to treat the letter from IRS as simply a notice of an appointment. Don’t do it. IRS tells you in its initial contact with you the areas it wishes to question. Take some time to try to reconstruct the figures shown in those areas. It has been months or possibly a couple of years since you completed work on the tax return being questioned. You’ve put your papers away, and it will take some time to recall the various sources of figures on the return. Put in the work. Your efforts will be justified. When you explain an item to the auditor, you will be much more convincing if you clearly recall how you arrived at the figure originally. If you have been audited on the same issues in the past two years with no changes, IRS will generally waive your audit. The audit itself is conducted informally. If it is a correspondence audit, you can gather and send any supporting documents you think would be helpful—receipts, invoices, letters you ask others to write to support your position. Send as complete an explanation as possible along with the documents. If your audit is in person, prepare the same kinds of things to bring to the audit, and you will have the added benefit of being able to talk to the auditor and explain the relevance of the documentation. If IRS disbelieves one or more deductions on the return, it is likely to disallow the deduction. If it disbelieves income figures on the return, it may contact third parties to get information to reconstruct your income. Before IRS contacts third parties about your tax return, it is supposed to notify you of its plans to do so. You are allowed to raise issues in your favor at the audit. If you forgot to deduct sales tax on a new car, bring it up. If you missed aa contribution to the Haiti earthquake victims, bring your proof. The auditor is directed to accept any new issues from the taxpayer whenever you bring them up. Conclusion of the Audit At the conclusion of the audit, the result will be either a “No Change” determination by the auditor, or suggested changes by the auditor. The suggested changes are usually in the government’s favor, for the reasons stated above: first, your return was selected because of the likelihood that there were errors in your favor, which the auditor has now uncovered, and second, the auditor is instructed to work for the government, raising its issues, not yours. The changes are reported to the taxpayer on a Statutory Notice of Deficiency (a 30 day letter). You can either agree with the auditor’s changes, or you can disagree. If you agree, you can sign your agreement on the Notice of Deficiency, and make arrangements to pay the additional tax. If you don’t agree with the results of the tax audit, there are several steps that you can take to try to get a more favorable result. First, you can ask for a conference with the auditor’s manager. The manager’s job, like the auditor’s, is to raise every issue on which Internal Revenue Service might win at trial. Neither the auditor nor the supervisor is supposed to be “fair” with the taxpayer; they are not supposed to be impartial judges. Examiners are to be the “prosecuting attorneys.” The manager is working under the same rules the auditor works under, but you do get a second look by a more experienced auditor. The manager may have more pressures to settle cases, and may offer to drop an issue if you can accept the remainder of the audit. This “Manager’s Conference” is easier to arrange and more productive after an in-person audit than after a correspondence audit. After an in-person audit you can usually arrange a face to face meeting with the auditor’s manager. After a correspondence audit you can generally only talk to the manager on the phone, a much less satisfying arrangement. Regardless of how the Manager’s Conference will be conducted, prepare for it. Prepare for the individual issues that the auditor has raised. Get additional documentation. Dig out more records. Get letters confirming your position from your employer or your doctor. This is your second chance to win arguments at the audit level—take advantage of it. The auditor’s job and his supervisor’s, is to raise every issue on which Internal Revenue Service might win at trial. Neither the auditor nor the supervisor is supposed to be “fair” with the taxpayer; they are not supposed to be impartial judges. Examiners are to be the “prosecuting attorneys.” But, of course, both the auditor and the supervisor wish to close as many cases as possible, making as few waves as possible. They will try to concede a little in order to resolve a minor issue, or occasionally they will trade issues, withdrawing one where IRS’s case is weak if the taxpayer agrees to accept an issue where IRS’s argument is stronger. You may resolve one or more issues in the Manager’s Conference, but still have more issues which were not resolved. Don’t despair. Even after the Supervisor’s Conference about 19 out of 20 cases are resolved before reaching any court. Beyond the Manager’s Conference, you can appeal the auditor’s findings to the only audit level within the IRS, the Appeals Division. See the topic “Appeal Your Tax Audit”. The Appeals Division’s job is to reduce the number of unagreed cases. Move to Appeals, and you will get several chances to improve the findings of the audit. |
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| References:
Internal Revenue Code: Section 7123, Appeals dispute resolution procedure Treasury Regulations: Section 601.105, Examination of Returns and Claims for Refund, Credit or Abatement Internal Revenue Manual: Part 4, Examining Process Internal Revenue Publications: No. 556, Examination of Returns, Appeal Rights and Claims for Refund |
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Medicare Part B Premiums – Fairness?
A separate article discusses increases in Medicare Part B Premiums due to the income levels of insureds Medicare Part B Premiums–High Income Individuals.
An interesting wrinkle in the Social Security Act protects beneficiaries from having their net monthly benefits reduced by increases in Medicare Part B premiums. This provision keeps the Medicare Part B premium assessed to Social Security recipients from being raised in years, like 2009, when there is no Cost of Living Adjustment to Social Security benefits. A second wrinkle specifies that estimated costs for 25% of Medicare Part B will be assessed against insureds, to limit the government’s contribution to 75% of costs.
About 73% of insureds are receiving Social Security benefits; these are the folks who can’t be assessed any increase in costs under the first “wrinkle” above.
Total medical costs for 2010 are expected to rise about 4% from 2009.
Under the second wrinkle above, the total increase in cost for 2010 is charged against the 27%of insureds who do not receive Social Security benefits; to cover the required costs, the premium increase for this 27% of insureds was 15%. The premiums for 25% of this 27% are paid by state welfare agencies, transferring most of the cost increase from the federal government to the state governments.
The final 2% of insureds have to pay four times the actual increase in Medicare costs to protect the other recipients from a reduction in their net benefit. This discrepancy will get worse annually as long as there is no COLA adjustment to Social Security benefits, which may be for years. How will the adjustment be made when COLA does return—will premiums be equalized, or will the medical cost increase be applied ratably to both the low and higher premiums?
Medicare insureds who do not collect Social Security benefits in 2010 are being treated unfairly, and will continue to be treated unfairly for life.
Federal Income Tax – Making Work Pay Credit
In 2009 Congress passed the “Making Work Pay Tax Credit”. This is a credit available in tax years 2009 and 2010 to taxpayers with earned income (income from jobs or from self-employment). The credit is calculated at the rate of 6.2% of earned income, until the credit reaches $400 for single taxpayers, or $800 for joint returns. The credit phases out for single taxpayers having adjusted gross income above $75,000, and joint filers with incomes above $150,000. The credit is not available to persons claimed as dependents on someone else’s income tax return, nor to non-resident aliens. The taxpayer must submit a Social Security number (not a taxpayer identification number) to claim the credit.
The 6.2% tax credit rate is exactly the rate of the employee’s portion of Social Security Tax. The $400 credit for an individual is equivalent to the employee’s share of Social Security tax on earned income of $6,450; the $800 credit allowed on joint returns is equivalent to the employee’s share of Social Security tax on $12,900. The modest amount of the credit and the relatively low “phase out” indicate that Congress was addressing the burden payroll taxes impose on low wage taxpayers.
The Making Work Pay Tax Credit was part of the American Recovery and Reinvestment Act of 2009, a part of the early 2009 stimulus package.
To get immediate buying power into the hands of consumers, Congress provided a $250 Economic Recovery Payment in early 2009 to every Social Security beneficiary (and other retirees on federal pensions) and reduced withholding from wages by amounts that hopefully approximated the tax credit. Congress was so anxious to get buying power into the hands of consumers that it reduced the withholding tax rate on pensions, even though pensions don’t qualify for the credit.
The final reckoning comparing the credit (and other tax computations) with the withheld tax occurs on the 2009 federal income tax return. Taxpayers who received the $250 Economic Recovery Payment must reduce their Making Work Pay Tax Credit by that amount.
References:
Internal Revenue Code:
Section 36A, Making Work Pay Credit
IRS Publication:
No. 4787, Catch a Break – Individual