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Tax Law

Tax Law

Understanding Tax Law

There is a saying that the only two sure things in life are death and taxes. Tax laws affect all people and touch most areas of life, so it would be helpful if tax laws were simple, clear, and easy to understand. Unfortunately, the tax system that exists has none of these characteristics. Many tax laws are unclear from the time they are written. Often, writing tax legislation involves so much compromise and redrafting that by the time a tax bill becomes law, even its author and sponsors do not fully understand what they have created. Other tax laws might be perfectly clear as written, but it may be difficult to know how to apply the law to a particular taxpayer. Finally, different courts in different jurisdictions can apply the same law to similar fact situations and reach completely different interpretations, each interpretation valid in that particular jurisdiction. Tax collectors have an important task because they collect taxes and help ensure that everyone pays his or her fair share. One of the most effective ways to encourage people to pay their fair share of taxes is to give them the impression that cheating will be noticed and punished. Simply put, the system would not work if the threat of a possible audit did not hang over every tax return submitted

Given the complexity of tax law, this chapter cannot describe all aspects of tax law. Instead, this chapter explains how consumers can manage tax disputes with the federal or state government.

Avoidance Versus Evasion

There simply are not enough resources for the government to calculate everyone's taxes or to audit every return filed. The tax collection system assumes that most taxpayers will be honest when reporting their income and calculating their tax obligations. The government has many ways of checking the accuracy of information the taxpayer provides. Employers provide the IRS with information on how much employees earn and financial institutions report the interest income their investors and depositors receive. Still, there is a tension built into the system. Taxpayers want to pay as little tax as legally possible but tax collectors want to ensure that taxpayers pay as much as they are legally obligated to pay. The terms "tax evasion" and "tax avoidance" are frequently used interchangeably to describe this tension, but the terms have different meanings.

To avoid taxes is to use legal means to limit one's tax liability. It is perfectly acceptable for a taxpayer to try to avoid taxes. Federal and state tax codes describe many ways a taxpayer can lower his or her tax burden. There are many ways to structure income to pay a minimum of taxes. There is nothing illegal in taking advantage of loopholes or shelters to avoid paying taxes. Tax evasion is using illegal means to get around paying one's taxes. It is illegal to evade paying legitimately owed taxes. Most taxpayers are tax avoiders. It is the job of tax collectors to find the tax evaders.

Federal Tax Disputes

The Internal Revenue Service (IRS) is the arm of the federal government charged with collecting federal income taxes. For most consumers, the federal income tax is the largest federal tax paid. The federal government collects taxes on a variety of different items including telephone calls, airplane tickets, cigarettes, and imported goods, but most consumers never challenge these taxes. For this reason, this section focuses on disputes with the IRS over the federal income tax.

IRS Audit

Pity the poor IRS agent. It is a safe bet that no one looks forward to being audited. Even if a taxpayer does nothing wrong, an audit, also called an examination by the IRS, can be confusing, frustrating, disruptive, and time-consuming. IRS employees know their task is not a popular one, and they do not try to aggravate taxpayers on purpose. They, too, struggle with a huge bureaucracy and must make do with outdated computers and a complex tax code with many gray areas of law.

The IRS audits approximately three million returns annually. About two million of those taxpayers end up paying more taxes to the IRS. Getting an audit letter from the IRS is not an indication that the IRS believes the taxpayer is a cheater; it usually means that there is some irregularity in the return or that the taxpayer has been selected for a random audit. The taxpayer usually winds up paying Uncle Sam more money.

Who is Audited

The IRS has three primary methods of selecting which returns to audit. The first method is random selection. By choosing to audit some returns at random, the IRS promotes better voluntary compliance with the tax code. Because every return has a chance of being selected for an audit, taxpayers are more likely to be honest. Relatively few of the returns selected this way contain significant errors, but the IRS uses the results of the random audits to measure compliance with the law and to update and improve the overall tax collection system.

The second method is a computerized process whereby the IRS separates out returns that it believes may contain errors or be fraudulent. The computer program is fine-tuned each year based on the experience IRS gains from applying the tax code. Most of the returns selected this way have some unusual characteristic that raises a red flag for auditors. For example, if the IRS determines that many taxpayers claiming very large deductions for entertainment expenses are trying to defraud the government, the computer can be programmed to separate out returns with unusually large entertainment deductions. If the IRS learns from its random audits that many people misunderstand a particular application of the tax code, the computer can be programmed to separate out all returns relying on that application.

An important point to know about this second method of selecting returns is that it is completely impersonal -- any return raising a particular red flag is tagged by the computer. Thus, if a taxpayer has an unusual circumstance that gives him or her an unusually large, yet legitimate deduction, the computer will select the return for audit every year. IRS auditors try to avoid repeat examinations for the same issue. Thus, if the IRS examined a taxpayer's return for the same issue in either of the previous two years and found in favor of the taxpayer, the taxpayer should call this to the attention of the IRS. Often in these cases, the audit is terminated without further investigation.

The third method for selecting returns for audit compares information provided by the taxpayer with information from other sources. For example, if someone reports less income on his or her return than is reported on the W2 form provided by the taxpayer's employer, the IRS can seek to clarify the discrepancy.

Audit Process

The audit process begins as soon as the taxpayer receives a letter from the IRS stating that his or her return has been selected for further examination. The audit may be done entirely by mail if the IRS has only a few questions, or it may be at an IRS office or at the taxpayer's home or business if the IRS has more substantial questions. The taxpayer can request that the audit interview be transferred to another IRS district if a different location is more convenient for the taxpayer.

Time Limits

Under normal circumstances, the IRS cannot audit tax returns filed more than three years ago. For example, the deadline for the IRS to audit a 1995 tax return, filed at the latest on April 15, 1996, is April 15, 1999. Under certain circumstances, the three-year limit is extended. The IRS can demand records as far back as six years if an audit reveals that the amount of income the taxpayer failed to report on his or her latest return exceeds by 25 percent or more the income reported. Also, the IRS has no time limit if the taxpayer fails to file a return or if it determines that the taxpayer deliberately filed a false or fraudulent return.

Records

IRS auditors almost always want to see financial records that relate to the return they are examining. This raises a commonly asked question: How long does a taxpayer need to keep records relating to income tax filings? The answer is generally three-and-a-half years because after that time, the IRS typically cannot audit the taxpayer. A taxpayer should keep financial documents longer than three-and-a-half years if they might affect any future returns. Thus, a person should keep records of any stocks purchased until they are sold, because only then can profit or loss be determined and reported on the next income tax return.

Taxpayer Rights in an IRS Audit

Some taxpayers claim they are made to feel like criminals in IRS audits. In fact, the audit procedure differs significantly from a criminal proceeding and may provide fewer procedural safeguards for the taxpayer. Unlike a criminal trial in which a defendant is presumed innocent until proven guilty, in an IRS audit the taxpayer must prove to the IRS's satisfaction that the information on a return is correct and legal. For example, if the IRS questions a deduction for business-related travel expenses, the IRS does not have to show that the travel was entirely for pleasure or that the taxpayer never traveled during the year of the return. The burden is on the taxpayer to show that he or she really did incur the amount of travel expenses claimed. If he or she cannot document the expenses, the IRS can disallow the deduction without offering any evidence at all.

A person has the right to ask the IRS to cancel a penalty if he or she can show his or her actions were the result of bad advice from the IRS. Thus, if someone pays less tax than owed, and the IRS discovers and penalizes the taxpayer for it, the taxpayer might have the fine canceled if he or she reasonably followed IRS advice in calculating taxes.

The first step in proving that bad advice from the IRS caused a mistake is to document what an IRS employee said in person, over the telephone, or by letter. It is important to write down any tax advice received over the telephone or in person, and to note the time, the date and the name of the IRS employee giving the advice. The second step is to show that reliance on that advice was reasonable. Just because someone says what the taxpayer wants to hear is not sufficient reason for the taxpayer to rely on that information; reliance must be reasonable. Determining reasonableness is tricky, but the taxpayer should be aware that if a piece of advice seems too good to be true, it may not be true. If a reasonable person would seek a second opinion, then the taxpayer should also seek another opinion. Although the IRS may cancel a penalty for relying on bad advice, it is not obligated to cancel the interest accumulated on any additional tax the taxpayer may owe.

The taxpayer need answer only the questions that the auditor asks. The taxpayer should not commit perjury, but he or she need not make the auditor's job easier by volunteering damaging information. If the taxpayer is instructed by the IRS to make documents available during an audit, it is best to have all these documents available for inspection in an organized and logical manner. In an audit conducted at home or at a place of business, called a field audit by the IRS, the taxpayer need not give the auditor access to a copying machine or allow the auditor to take original documents back to IRS offices. The taxpayer should, however, make copies of the documents that the auditor specifically requests and make a note of which documents the auditor gets copies of. If an audit is by mail, the taxpayer should send to the IRS only copies of those items specifically requested. Documentation should always be sent to the IRS via certified mail with a return receipt requested.

Many taxpayers are concerned about the privacy of information they provide on a tax return or in an audit. The government is obligated to respect the confidentiality of information a taxpayer provides in the tax collection process, and anyone who prepares a return or represents the taxpayer is also obligated to respect the client's privacy. In limited circumstances, the IRS is allowed to share some taxpayer information with state tax agencies, the Department of Justice, or other federal agencies. During an audit or at any time the IRS asks for information, the taxpayer has the right to know why the agency wants the information, how the information will be used, and what may happen if the taxpayer chooses not to give the information.

The taxpayer has the right to take someone along to an IRS audit interview. This could be an attorney, a certified public accountant, the person who filled out the tax forms, or an enrolled agent. Another person may represent the taxpayer in his or her absence during an audit interview, as long as the taxpayer files with the IRS a power of attorney form or a similar document.

The taxpayer has the right to tape record the audit interview. To do so, the taxpayer must inform the IRS in writing of the intention to tape the interview at least ten days in advance, and must supply the tape recorder. If the IRS decides to tape record an interview, it must inform the taxpayer at least ten days in advance. The taxpayer has a right to a copy of the IRS tape, but must pay for the copying expenses.

If at any point in the audit process the taxpayer feels that the proceeding is not going well, he or she always has three options. First, the taxpayer can agree with the IRS, pay additional taxes, and vow to be more careful when filing future tax returns. Second, the taxpayer can ask the IRS for a notice of deficiency and take the case to a federal tax court. Third, the taxpayer can pay the disputed amount, file a claim for a refund, and then take the case to the federal district court, the federal tax court, or the federal claims court.

Result of an Audit

A minority of taxpayers who are audited receive from the IRS a no-change report, a letter stating that the IRS accepts an audited return without changes. Only about 30 percent of the people audited get a no-change letter. In even rarer situations, the IRS owes the taxpayer money after an audit. However, in most cases, the IRS determines that the taxpayer owes more money.

If the taxpayer owes more money, the IRS sends the taxpayer a 30-day letter and a copy of the audit report outlining the additional taxes owed. If the taxpayer agrees to the changes detailed in the audit report, he or she can sign the enclosed form and send it back within 30 days to the IRS with a check. If the taxpayer sends a signed form back without a check, the IRS sends the taxpayer a bill, which must be paid within ten days. Either way, the taxpayer pays interest on the extra tax, calculated from the due date of the audited return to the billing date.

Another option outlined in the 30-day letter is the IRS's internal appeals process, which can be initiated by submitting, within 30 days, a written protest to the IRS requesting a conference with an appeals officer. If the amount of the additional tax is less than $2,500, the protest does not need to be in written form.

If the taxpayer ignores the 30-day letter, the IRS sends a notice of deficiency, sometimes called a 90-day letter, because it notifies the taxpayer that he or she has 90 days to either settle the matter with the IRS or to file suit in one of three federal courts.

Appealing an Audit

If a taxpayer disputes the results of an audit, he or she can appeal the auditor's decision to a regional IRS appeals office or directly to a federal court. Appealing within the IRS is relatively straightforward and generally less expensive and time-consuming than going to court. If taxpayers go to federal court and win there, they can sometimes recover from the IRS some or all of their administrative and litigation costs, but only if they first use the IRS appeals process.

Appealing Within the IRS

A taxpayer can start the IRS appeals process by requesting a conference through the IRS's local district director. The district director then arranges a meeting with one of the IRS's appeals officers, located in most major cities. The request for an appeals conference should state the exact elements in the auditor's report with which the taxpayer disagrees, the elements of tax law that support the taxpayer's case, and any facts that support the taxpayer's position.

As in any dealings with the IRS, the taxpayer can be represented or advised by an attorney during the appeals conference and can bring along witnesses to support statements of facts. These conferences are informal, and they represent a last chance to resolve a dispute before going to court. There is no guarantee what will happen, but quite often the IRS officers make some concessions at this point in order to avoid going to court.

Going to Court

If a taxpayer decides that the IRS's decision is unfair, unjust, or unreasonable, he or she can take the dispute to one of three federal courts, all of which operate independently of the IRS. Deciding whether to file suit in tax court, claims court, or district court depends on a number of legal and personal factors. Each court is guided by the previous cases that it has decided. As a result, a taxpayer's odds of success may be better in one court than in another. Most cases, no matter which court first hears them, can ultimately be appealed to the U.S. Supreme Court. The only exception to this rule is for cases heard under the small tax case procedure in tax court.

A taxpayer may go to any one of three courts without first going through the IRS appeals process, but quite often a tax court judge will not hear a case unless it has been considered for settlement by a regional IRS appeals office. If a taxpayer goes to tax court without first going through the IRS appeals process and loses his or her court case, the tax court judge may fine the taxpayer up to $5,000 if he or she determines that the lawsuit was a tactic to delay paying the IRS or that the suit was otherwise frivolous. In all three courts, the taxpayer has the burden of proving that the IRS is wrong. In other words, the court assumes that the IRS correctly interpreted the tax laws as they apply to a case, and the taxpayer does not win unless he or she convinces the court otherwise.

U.S. Tax Court

Tax court hears only tax cases. In order to go to tax court, a taxpayer need not pay the disputed tax amount first, unlike the other two courts where he or she must pay the disputed amount before filing suit. In tax court, the taxpayer does not have a right to trial by jury, so cases are heard by a judge who is experienced in tax law, rather than by a group of peers who might be swayed by emotion. If a taxpayer wants to take a case to tax court, he or she must file suit within 90 days after the IRS mails a notice of deficiency to the taxpayer's last known address. In general, tax court rules are less strict than those used in the other two courts.

If a dispute with the IRS is for an amount under $10,000, the taxpayer can go through the tax court's small tax case procedure, which is generally quicker and even less formal than the court's standard procedure. However, the decision of a judge who hears cases under the small tax case procedure is final, so if a taxpayer chooses this procedure, he or she loses the right to appeal the court's decision. Because the taxpayer does not need to be represented by an attorney in this procedure, it may be a good option in a dispute regarding smaller dollar amounts in which any money won would be wiped out to pay attorney's fees.

Finally, a taxpayer should be aware of what is often called the "tax court trap," which describes the ability of the IRS to impose even more fines based on any new information that it discovers about the taxpayer during a tax court proceeding.

Tax court is the most popular route for taxpayers, in large part because it does not require that the disputed tax be paid first. But tax court can also be a very unsuccessful route. IRS statistics show that only about five percent of the taxpayers who bring their cases in tax court win. The taxpayer success rate in the other two courts, however, is only marginally better at about 11 percent.

U.S. District Court

Of the three courts that hear taxpayer disputes with the IRS, only in federal district court is there a right to a trial by jury. To bring suit in district court, the taxpayer must first pay the disputed tax to the IRS and then claim a refund for that amount by filing the proper form with the IRS. If the IRS denies the refund request, the taxpayer can sue the IRS in district court. The taxpayer can sue for any amount of refund in district court, no matter how small. However, because the taxpayer is usually represented by an attorney in district court, going to district court may make sense only for larger monetary disputes.

If the IRS does not make a decision on a refund claim in six months, the taxpayer can file suit in district court. The taxpayer has up to two years after the IRS rejects a refund claim in which to file suit in district court.

U.S. Claims Court

The federal claims court follows the same rules as the district court regarding filing lawsuits for refunds from the IRS. A taxpayer must first pay the disputed amount and then file a lawsuit in claims court for a refund of that amount. There is no minimum limit to the amount of a refund claim that can be litigated in claims court. However, the taxpayer cannot file suit in claims court if the claim is for a refund of a penalty relating to tax shelter abuse. Also, a taxpayer cannot file suit in claims court to recover a penalty assessed by the IRS for fraudulently preparing someone else's tax return.

Illinois Tax Disputes

The State of Illinois assesses taxes for income, sales, excise, motor fuel, property and gambling. Illinois offers free tax help during the tax season (January through April 15). For information about the nearest one-stop shop available to you, call or write to: Taxpayer Information, Illinois Department of Revenue, P.O. Box 19001, Springfield, IL 62794-9001, 1-800-356-6302.

The state relies less on income taxes for revenue than does the federal government. Illinois' income tax is far less elaborate than the federal government's and there are fewer disputes over it. When the state does audit a taxpayer's state income tax return, the procedure is much like the procedure used in IRS income tax audits. An Illinois taxpayer who is audited may question the audit through an informal conference, followed by an administrative hearing and final review by the Illinois Board of Appeals. If you have questions regarding the specific process of an Illinois audit and appeal, contact the Board of Appeals, Illinois Department of Revenue, 100 West Randolph Street, Chicago, IL 60601-3274, phone: (312) 814-3004.

Property taxes, which are levied, collected and spent locally, are discussed in the Real Estate Chapter. The Illinois Department of Revenue has no direct involvement in the appeal process of assessed value of property, upon which the property tax is based.

The rights that Illinois taxpayers have against the Department of Revenue closely parallel the rights against the IRS. For example, the taxpayer has a right to have an attorney, accountant, or other person represent him or her at any meetings, and the taxpayer has a right to record meetings. The department must provide taxpayers with written information on their rights when they deal with the department. Illinois taxpayers have a right to sue the department. If a taxpayer wins, he or she may be able to collect damages if a court finds that the department knowingly or recklessly disregarded a state law or knowingly or recklessly failed to release a lien.

Resources

Internal Revenue Service, Kansas City, MO 64999, phone: 1-800-829-3676. Free tax publications are available.

Internal Revenue Service, phone: (708) 435-1040, (312) 435-1040, 1-800-829-1040, TDD: 1-800-829-4059. Free tax help information.

How to Cope with the IRS, Randy Bruce Blaustein, Retirement Living Publishing Co., New York, NY, 1991.

Keys to Surviving a Tax Audit, D. Larry Crumbley and Jack P. Friedman, Barron's, New York, NY, 1991.

Tax Procedure and Tax Fraud in a Nutshell, Patricia T. Morgan, West Publishing Co., St. Paul, MN, 1990.

Illinois Department of Revenue, P.O. Box 19468, Springfield, IL 62794-9468, phone: 1-800-732-8866, (217) 782-3336, TDD: 1-800-544-2304. For information and free bulletins.

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