Tax Problem Fundamentals: Phase I Considerations

In the last blog I provided an overview on how to approach a tax problem. That overview broke the approach down into two phases. This installment considers Phase I: What do I owe?

Most income tax obligations arise through the filing of a tax return that reports a balance owed. This situation is typically referred to as a “self-assessment” since the taxpayer is volunteering, under penalties of perjury, what he or she believes to be his obligation. Once a self-assessment is made, the amount owed can still be changed by the taxpayer or by the IRS. The taxpayer can seek a change by filing an amended return. The IRS does so through an audit. As a general rule, any such change must occur within three years of when the return was filed.

In the case of an audit, if the taxpayer does not agree with the proposed audit adjustments there are both administrative and judicial appeal rights. The vast majority of administrative appeals are resolved without the need to go to court. The audit and appeal process can take months, sometimes years. But as long as this process is ongoing, the taxpayer is still dealing with Phase I issues. It is only after the taxpayer has foregone or exhausted all of these options to determine whether and how much is owed, does the tax problem move to Phase II of the process (the subject of my next installment.)

As a general rule, as long as Phase I is open no collection activity can be taken by the IRS under Phase II. But that is not always the case. For example, if no tax return is ever filed the IRS has the ability to file a return based upon information that has been reported by third parties (for example, W-2s and Forms 1099). When a tax liability arises as a result of this process, it is said to arise out of a “substitute for return.” If the IRS prepares a substitute for return, an amount owed has now been determined so collection activity (Phase II) will commence. And yet, when the IRS prepares a return for a taxpayer, usually the amount determined to be owed is significantly higher than what would have been owed had the taxpayer filed the return himself. Under these circumstances it is usually very beneficial to prepare the actual return for the year in question so the correct tax debt can be determined (Phase I).

Another instance when Phase II collection activity may occur before Phase I ends is when the IRS imposes penalties for the late filing of a return or the late payment of the tax owed. There may be no question that the underlying tax obligation is due but the circumstances that caused the late filing or late payment may serve as a basis to have penalties abated. Penalty abatement requests need to be submitted in writing and the written request must demonstrate reasonable cause and not willful collect. There is considerable guidance on what will constitute reasonable cause and things like serious medical issues or catastrophic events usually qualify.

Each of these Phase I examples — the substitute for return and penalty abatement request – muddy the Phase I and Phase II distinction I have made. In these situations, we clearly have Phase I issues to be addressed but IRS collection activity may also be well underway. Therefore, Phase II issues are also going to be in play.

In summary, any time the IRS asserts a liability, the possibility of there being what I call a “Phase I issue” should be considered. After it has been determined that Phase I is over, it is time to consider Phase II — the topic of my next installment.

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Some Fundamental Considerations When Facing a Tax Problem

When a tax problem arises it is not uncommon to become overwhelmed and sometimes even paralyzed by the situation. No doubt much of the anxiety is due to the uncertainty of whether the problem can be solved and how to go about doing so. More and more self-professed tax experts advertise promising results with such individuals in mind. Many of these so-called experts, however, take a very narrow “one size fits all approach” when dealing with a tax problem. That is unfortunate; oftentimes there are many options that should be evaluated before a decision is made as to how best to proceed. My next few blogs will consider how, in my opinion, a tax professional should evaluate a tax problem. The discussion begins with an overview of how to approach a tax problem and then delves into some of the details regarding the different phases of a tax problem.

When I assist with a tax problem I always look at the situation as having two distinct phases. Phase I deals with how much is owed. Phase II deals with how to pay the amount owed. Most of the time you know whether you are in Phase I or Phase II of the process. For example, if you receive an IRS audit notice, you are clearly in the early stages of a Phase I situation. If you receive a collection notice after filing a tax return without full payment of what you agree is due, this is a Phase II issue. But what if you never filed a tax return reporting a balance due and now the IRS serves a wage garnishment on your employer? Where are you in the process? What are your options?

Faced with this scenario, a seasoned tax professional would rightfully want more information from both the taxpayer and the IRS before evaluating how best to proceed. The questions that come to my mind on hearing these basic facts include: Did you recently move and possibly not receive an audit notice? Is it possible the IRS prepared one or more returns for you (referred to as a substitute for return) based upon limited information reported to the IRS? Has there been an identity theft? Each of these inquiries relate to the Phase I question of whether a tax is owed in the first place, and if so, how much is really owed.

While sorting out these questions, additional consideration would need to be given to the impact of the wage garnishment that has now occurred. On that subject the questions that come to mind include: Was the wage garnishment issued from an IRS service center or out of a local office? Has there been any prior collection notice or action taken before the garnishment? Is a voluntary payment arrangement preferable? Is a bankruptcy filing something to be considered? All of these inquiries deal with Phase II aspects of the problem.

While there are often recurring themes and typical situations when tax problems arise, solutions are best when tailor-made for the specific taxpayer in question. Evaluating where the taxpayer is in the process helps determine what options are available. The “one size fits all” approach may result in a resolution, but it may not be the best solution under the circumstances.

Settling Large Tax Debts with the IRS Just Became Easier

It seems you can not watch TV, listen to the radio, or read the newspaper without seeing at least one of those ads for someone claiming to be a “Tax Specialist” who can fix your IRS problems.  Helping people with tax issues seems to be big business these days.  Most of these advertisements are pushing what is a rather longstanding program with the IRS known as the “Offer in Compromise.”  In my experience, the Offer Program is an excellent program with one significant caveat; you must meet the stringent requirements to qualify.  None of the ads bother to mention this important detail.

                Last month the IRS announced that in 2010 they accepted 27% of all Offers submitted.  In 2011 that number rose to 34%.  In my estimation, those numbers are too low.  Given how the Offer Program works, acceptance rates should be well over 80%.  What this means to me is that too many offers are being submitted by people that don’t qualify.  This would seem to reinforce my impression that too many people claiming to be “Tax Specialists” are really just salespeople.  Like anything that is important in life, if you need professional assistance make sure you find someone who knows what they are doing.

                There are a lot of details behind the Offer in Compromise process.  At the heart of it, the IRS is measuring a taxpayer’s ability to pay by quantifying both the taxpayer’s equity in assets and available cash flow.  Understanding the rules that underlie how this calculation is arrived at is critical.  Just this month, the IRS announced some very favorable changes to some of these rules which should show a significant improvement in the acceptance rates of submitted Offers.  In my practice, this will mean that a lot more people should now have the opportunity to settle substantial tax obligations for much less than what is owed.  This very recent change in a longstanding program is clearly an indication that the IRS would like to resolve more cases than recent statistics indicate. 

                The Offer in Compromise program is not for everyone.  If a taxpayer cannot settle with an Offer, there are always other options ranging from convincing the IRS that you cannot afford to pay anything to setting up payment arrangements over as much as four or five years.  Experienced tax practitioners should be able to assess key information relatively quickly and steer individuals and businesses to the best solution available.

Some Thoughts Before You Pay the IRS

Anytime you make a voluntary payment to the IRS, you have the absolute right to tell the IRS how to apply the money.  For most taxpayers, this may never be an issue because they only owe one type of tax for one tax year.  But for some, there may be a number of unpaid tax obligations.  If that is the case, how the money is applied may be important.  For example, if some tax debts are joint obligations with a spouse and others are not, you may want to pay off the joint obligations so your spouse’s assets are no longer exposed to collection efforts.  If you owe money for a number of years and some of the years can be discharged in bankruptcy and some can not (a topic for another day), you will want to pay the taxes that can’t be discharged first. 

You may think this payment strategy could be used when you file a tax return with an overpayment.  If so, you would be wrong.  If you file a tax return that reports an overpayment of tax, you generally lose the right to tell the IRS how to apply that overpayment.   Most people know that if they file a tax return with an overpayment, rather than ask for the money back in a refund they can check a box on the return and apply the overpayment towards their tax liability for the next year.  For individuals that need to make estimated tax payments, this is often a mechanical choice since otherwise they are asking the IRS to send them a check the same time they are mailing in their estimated tax payment.  This is a good system as long as there aren’t other unpaid tax obligations, and sometimes nontax obligations, outstanding. 

If you owe other taxes, whether income tax, employment tax or excise taxes, the IRS is going to override your election to apply an overpayment to the next tax year and, instead, use the money to pay your other outstanding tax obligations. The overpayment will be applied first to the tax, then to penalties and then to interest for the oldest obligation. Certain kinds of other obligations such as child support and student loan payments may also be satisfied with a tax overpayment.  If you have these sorts of obligations, you need to be very careful when doing your estimated tax payment planning for a subsequent year.  If you think your overpayment is going towards your estimated tax payment and it doesn’t, you may now be underpaid in your estimates which will result in penalties. 

A good tax preparer can help you think through this situation, but they need to know that you have these outstanding obligations.  Once a return that reports the overpayment is filed, it is too late.  If you don’t want your overpayment to be used to pay off another tax obligation, then the best advice is to plan in advance not to have the overpayment.

Tax Lien or Tax Levy: Which is Worse?

If you owe the IRS money and arrangements are not made for payment, eventually you are likely to see one or more tax levies and be impacted by the filing of a tax lien.  What is the significance of these two collection activities?  Let’s start with some basic definitions.  A tax levy is the means by which the IRS compels someone (typically a bank) that is in possession of the taxpayer’s property to turn that property over to the IRS.  A tax lien is the means by which the IRS encumbers property owned by the taxpayer (most importantly real property) and establishes its position as a secured creditor in relation to other creditors of the taxpayer.  A tax levy is either mailed or hand delivered to the person/bank that has the taxpayer’s property.  A tax lien (which technically arises automatically when a tax is due) is asserted by the filing of a Notice of Federal Tax Lien in the county clerk’s office where the taxpayer resides.

So which of these collection devices is most significant?  It depends.  In my estimation, the tax levy is the more powerful and disruptive tool as it requires the third party holding the taxpayer’s property to turn that property over to the IRS in rather short order.  But if the third party doesn’t have any property of the taxpayer when the levy is served, then the tax levy has no effect.  One good thing about a tax levy is that it is not a public action.  That is to say, no one other than the third party is ever made aware of the fact that the taxpayer owes money and that collection activity is underway. 

 A notice of federal tax lien, on the other hand, is a very public act.  When a notice of federal tax lien is filed, all the world is now on notice of the unpaid tax debt.  The taxpayer’s credit will immediately be impacted because credit agencies, lenders, and other financing services will see the tax debt when searching the county records where the taxpayer resides.  Notwithstanding these negatives, a tax lien does not require the taxpayer (or anyone else) to do anything with the property encumbered by the lien.  The filing of the tax lien notice simply secures the debt.      

So which is worse?  There is no right answer to that question; both are very powerful tools in the IRS’ arsenal of collection devices.  There are ways to navigate around, or in spite of, a tax lien and tax levy but it is always best to avoid them if possible.  If you are facing collection issues with the IRS, the assistance of an experienced tax practitioner may help you do just that.

An Interesting Change in Strategy Because of Interest Rates

The New York State Department of Taxation and Finance has released their new interest rates for the second quarter of 2012.  Although these rates have not changed from the prior quarter, this announcement is a reminder of the significant interest charges that New York State is now charging when there is an unpaid tax.  The “basic” underpayment rate on most types of unpaid taxes 7.5%.  If that isn’t bad enough, the underpayment rate for sales and use taxes is a whopping 14.5%!  A sliver of good news:  if the State determines that the failure to pay sales tax is due to reasonable cause and not willful neglect, it will use the 7.5%.  Perhaps all of this would be more palatable if the State was as generous when they owed you money.  No such luck.  If you overpay your taxes, the State pays you 2% interest.

Clearly none of these interest rates are tied to current market rates.  What these rates reflect is the State’s determination to increase revenues from delinquent taxpayers.  If these rates were imposed only on those who chronically underpaid their legitimate tax debt, the higher rates could be an effective compliance tool.  But these rates also apply when there is a bona-fide disagreement over whether a tax debt is owed.  In that instance, these exorbitant rates can result in a very costly (dare I say punitive) price to pay to exercise the right to question whether a tax is really owed.

If someone has a dispute over whether a tax is owed, there are still two basic options:  contest the liability without paying anything until all appeal rights are exhausted or, pay the tax and then seek a refund.  Traditionally, no one ever wanted to pay the tax when they didn’t think it is owed, so the first option was almost always taken.  But now with the State’s high interest charges coupled with the fact that your money is not earning much interest sitting in a bank, the economics of how to approach a tax dispute have changed. 

Consider a simple scenario.  If the liability at issue is $20,000 and the dispute goes on for two years, at least $3000 of interest (using the 7.5% rate) could be added to the bill if you are unsuccessful.  (The cost would be $5,800 if sales taxes are involved and the 14.5% rate applied).   Even if the appeal is partially successful and you settled for $10,000, the two-year interest charge of $1,500 is an expensive price to pay to dispute the bill.   If instead you paid the $20,000 and then were unsuccessful on appeal, at least the cost has been held to $20,000.  If you resolved the matter for $10,000 of tax, the State would then refund you $10,000 plus 2% interest for two years (a total of $10,400); thereby reducing the tab from the original $20,000 to $9,600. 

There may still be good reasons not to pay disputed taxes before pursuing a tax appeal, and it is best to understand all of your options, and their implications, when you face a tax problem.  These higher interest rates now add another important consideration in the process.

Can I deduct the interest I pay on student loans that are in my parents’ names?

For most college graduates, paying back student loans is part of growing-up.  A portion of those payments is, of course, payment of interest.  While most personal interest is not deductible for income tax purposes, the Internal Revenue Code (the “Tax Code” or “Code”) provides a special exception for student loan interest.  The Code, in Section 221(a), provides:

Allowance of deduction.  In the case of an individual, there shall be allowed as a deduction for the taxable year an amount equal to the interest paid by the taxpayer during the taxable year on any qualified education loan.

The Code limits this potential deduction in several ways, and this post discusses one such limitation.  Many parents help pay for their children’s college by obtaining Parent PLUS Loans, which are government loans that recognize parents (and some others) are generally in a better credit-position to borrow than their children.

In addition to Parent PLUS Loans, students often take out loans in their own name to cover the remaining expenses.  After graduating, students quite often pay back their loans and the Parent PLUS Loans as all of the debt went to pay for their education.  As long as the student meets the Tax Code’s conditions, he or she can deduct the student loan interest paid on loans in their own name up to a certain amount.  But can they deduct the interest they paid on the Parent PLUS Loans?

The answer is no – even when the student is the one actually making the loan payments from they own funds.  The reason comes down to the Code’s definition of a “qualified education loan,” which reads as follows:

. . . any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses . . . . 42 U.S.C. § 221(d)(1) (emphasis added).

With a Parent PLUS Loan, only parents are legally obligated to pay the loan and the loan’s interest.  The student takes on no legal obligation, and therefore, no indebtedness where his or her parent utilizes a Parent PLUS Loan.  IRS publications agree this is the case.  Click the following link for the student loan interest portion of IRS Publication 970 with Joshua Werbeck’s notes.

Furthermore, students cannot simply execute an agreement with their parents obligating them to pay the interest.  The Tax Code’s definition of qualified education loan exempts indebtedness to related persons and some business entities.  See 42 U.S.C. § 221(d)(1) (“flush language” at the bottom of the subsection).

If you’d like, you can read the law yourself.  Here is a link to Section 221(a) of the US Tax Code covering the student loan interest deduction with Joshua Werbeck’s notes.

But what happens to the potential deduction if the person actually paying the loan is not entitled to utilize the deduction.  The person legally obligated to pay the qualified education loan, the parents in my example above, are entitled to the deduction even if they never actually made a loan payment.

Some payment options with the IRS just got a little kinder and gentler!

When you owe the IRS money and you can’t pay everything right away,  typically there are three  options:  (1) convince the IRS you can not currently pay anything and have your account marked as “currently not collectible;” (2) set up a payment arrangement; or (3) seek to settle through the offer in compromise program.  Each option has its pros and cons.  The IRS recently announced some helpful changes if you want to pursue the second option of setting up a payment plan.

 Rules for IRS payment plans have always been classified based on how much is owed.  These rules generally address the length of time that can be given for payment, the amount of financial disclosure required before a monthly payment amount will be accepted, and whether a tax lien will be filed.  The significant thresholds of balances owed are $10,000, $25,000, $50,000 and over $100,000.   As you would expect, the more you owe the more involved the rules become.  Therefore, as a threshold consideration,  before approaching the IRS about a payment plan, consider whether a partial payment can be made to move you down a tier or more in the escalating set of rules.   

 The recent changes relate to the “streamline installment agreements” for taxpayers owing less than $25,000 and those owing between $25,000 and $50,000.  In each instance, taxpayers may now be given up to six years to pay an obligation (increased from five years).  Taxpayers owing between $25,000 and $50,000 now need to make monthly payments by direct debit from a bank account.  Also, at this higher level some financial disclosure will be requested but the sole purpose for gathering this information is to ensure that the payments can be maintained for the life of the plan, not to glean the highest monthly payment that can be made.  Generally a tax lien will not be filed at either of these levels under the streamline rules.

 If a payment plan is the best option to resolve a tax debt, all of these changes should make setting up a payment plan easier.

Is the IRS Going Out of Business?

Very recently the IRS Taxpayer Advocate warned Congress that the IRS’s workload continues to increase while its funding is decreasing.  The Taxpayer Advocate is concerned that under these circumstances, the IRS is not able to do the job it is tasked with doing.  While some may smile when hearing such news and think–  “Good, the less IRS the better!”– be careful what you ask for. 

As the funding for IRS operations is reduced, services that we have come to expect from the IRS are vanishing as well.  Reaching a local IRS agent by telephone is fast becoming a thing of the past.  More and more often, matters are being assigned to 800-number call centers where you can be on hold for 30 minutes or more before reaching a live person.  If you need to call back with more information, you endure the same wait and end up with a different person.

Delays are part of the process when dealing with a tax problem but now those delays seem longer than ever.  With outstanding obligations accruing interest and sometimes penalties, delay can be costly.  The IRS always encourages voluntary payments while an issue is being reviewed and given these delays, sometimes that can make  sense.

As the IRS faces the same economic challenges of any other business, having an experienced advocate that knows where to go, knows how to streamline the process, and knows how to manage the ever changing bureaucratic landscape is important.   

 

I Haven’t Filed My Tax Returns…Is There Hope?

              I am often asked:  “If I can’t pay the tax due with my return, am I better off not filing until I have the money to pay?”  While the situation presents some complexities, the advice is simple:  it is always best to file your tax returns on time even if you can’t pay.  Such filing eliminates the failure to file penalty (which, along with the failure to pay penalty, can grow to as much as 25% of the tax due) and the possibility of the much more serious criminal consequences for not filing.  (These are the IRS consequences; each state has similar rules for their returns as well.)

            But what happens if I didn’t file a tax return, or worse yet, several returns?  Here’s the good news, it’s not hopeless.  Many people don’t file their tax returns.  The reasons for non-filing can run the gamut from serious medical or personal issues, natural disaster, economic reversal, business failure, and so on.  (I intentionally exclude illegitimate reasons for non-filing as the consequences for those are much different.)  In my experience, if someone hasn’t filed for one year, typically they haven’t filed for several years.  This prolonged period of non-filing typically starts with one of the reasons listed above, but the repeated failure to file results from the uncertainty – – really the fear — that “coming back into the system” will be too costly and potentially devastating.  Those that do not file one or more returns very often find themselves in what seems an inescapable and unsolvable predicament. 

            Fixing a non-filing situation is not always pain-free but there are options for non-filers and certain choices are much better than others.   Most importantly, for at least 25 years it has been the IRS’ policy not to press criminal charges for non-filers who voluntarily file their past due returns.  Returns are considered filed “voluntarily” as long as the IRS hasn’t commenced any investigation or contacted the non-filer before the returns are filed.  So the best option for the non-filer is to get the returns filed – before the IRS asks you to file them.  (Even when the IRS asks for unfiled returns, it is not automatic that criminal charges will be asserted.)

            What if you haven’t kept your records (W-2s, 1099s, etc.) to prepare your returns?  Don’t let that be an excuse.  All of that information is available from the IRS.  In fact, if you plan to file returns for the past several years it is a good idea to request that information before filing just to be sure you report everything that the IRS already knows about.   Once the return(s) have been filed, there are three basic options to then consider in dealing with the amount due:  full payment (all at once or over time), settlement through an offer in compromise, or having the debt found to be “currently not collectible.”     If penalties are been imposed after the return is filed, which is very likely to be the case, those additional charges may be removed if the taxpayer can demonstrate that the late filing was due to reasonable cause and not willful neglect.

            Nonfilers that I have worked with are almost universally relieved to learn that the heavy burden of not being in noncompliance can be resolved, often with consequences much less severe than ever envisioned.