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National Taxpayer Advocate Urges Tax Simplification and Compassionate Treatment of Taxpayers Hit by Recession

WASHINGTON — National Taxpayer Advocate Nina E. Olson today released
her annual report, urging Congress to greatly simplify the tax code and recommending
measures to reduce the burden on taxpayers who are struggling to pay their tax

The report takes note of the serious financial difficulties facing many Americans
in light of the ongoing economic downturn. “It is imperative for the IRS
to consider the circumstances of taxpayers facing economic hardship before initiating
enforcement actions,” Olson wrote.

When the IRS contemplates taking an enforced collection action such as a levy,
a lien or an asset seizure, both the tax code and IRS procedures require that
IRS personnel consider whether the collection action will impose an economic
hardship on the taxpayer. Despite these requirements, “current IRS guidance
provides little direction to help IRS employees identify taxpayers who are experiencing
economic hardship and prevent undue economic burden,” Olson wrote.

Call for Tax Simplification

The report designates the complexity of the tax code as the most serious problem
facing taxpayers. According to data compiled by Olson’s office, U.S. taxpayers
and businesses spend about 7.6 billion hours a year complying with tax-filing
requirements. “If tax compliance were an industry, it would be one of
the largest in the United States,” the report says. “To consume
7.6 billion hours, the ‘tax industry’ requires the equivalent of
3.8 million full-time workers.”

The report estimates that U.S. taxpayers spend $193 billion a year complying
with income tax requirements, an amount that equals 14 percent of the total
amount of income taxes collected. One count shows the number of words in the
tax code has reached 3.7 million, and over the past eight years, changes to
the tax code have been made at a rate of more than one a day – including
more than 500 changes in 2008 alone. Individual taxpayers now find the tax rules
so overwhelming that more than 80 percent pay transaction fees to help them
file their returns – about 60 percent pay a preparer to do the job and
another 22 percent purchase tax software.

Two examples of tax law complexity:

The Alternative Minimum Tax (AMT) effectively requires taxpayers to compute
their taxes twice — once under the regular rules and again under the AMT
regime — and then to pay the higher of the two amounts. Absent repeal
or continuing AMT patches, the AMT will affect 33 million taxpayers in 2010.
Although the AMT was originally conceived to prevent wealthy taxpayers from
escaping tax liability through the use of tax-avoidance transactions, 77 percent
of the additional income subject to tax under the AMT today is attributable
to the disallowance of deductions otherwise allowed for state and local taxes
and personal and dependency exemptions. “Few people think of having children
or living in a high-tax state as a tax-avoidance maneuver, but under the unique
logic of the AMT, that is essentially how those actions are treated,”
the report notes.

The tax code provides tax breaks to encourage taxpayers to save for education
and retirement. However, the number of such tax incentives has grown to at least
27 and the eligibility requirements, definitions of common terms, income-level
thresholds, phase-out ranges and inflation adjustments vary among the provisions.
This complexity undermines the intent of the incentives, as taxpayers can only
respond to incentives if they know they exist and understand them.

Olson recommends that Congress substantially simplify the tax code. The report
includes a series of recommendations, including recommendations to repeal the
Alternative Minimum Tax; streamline education and retirement savings tax incentives;
simplify the family status provisions of the tax code; simplify the rules under
which workers are classified as employees or independent contractors; reduce
sunset and phase-out provisions and revise the overall penalty structure. More
broadly, Olson recommends six core principles on which fundamental tax reform
should be based. (For details, see Most Serious Problem: The Complexity of the
Tax Code and corresponding items in the Legislative Recommendations section
of the report.)

Working with Taxpayers Who Are Experiencing Financial Difficulties

The report makes three principal recommendations to reduce burden on financially
struggling taxpayers:

1. Make greater use of collection alternatives when economic hardship
is present.
While enforced collection actions like levy and seizure
authority are important collection tools that allow the IRS to address serious
incidents of noncompliance, a review of IRS historical enforcement data show
that more enforcement actions do not translate into commensurate increases
in revenue collection. One example: The number of levies issued by the IRS
increased by 1,608 percent from FY 2000 to FY 2007 — from 220,000 levies
to about 3.76 million levies — yet the increase in the total collection
yield during the period was slightly less than 45 percent. By contrast, historical
enforcement data indicate that collection alternatives, such as offers in
compromise and partial-payment installment agreements, may be more effective
at collecting liabilities from taxpayers having difficulty paying their tax
debts. (For details, see Most Serious Problem: The IRS Needs to More Fully
Consider the Impact of Collection Enforcement Actions on Taxpayers Experiencing
Economic Difficulties.)

2. Simplify the “cancellation of debt” minefield that
many taxpayers who default on debts must navigate
. Most financially
distressed individuals who lose their homes to foreclosure or cannot pay off
their car loans, credit card balances, student loans, or medical bills probably
do not realize that their delinquency may increase their tax liabilities,
but it often does. If a creditor writes off a debt, the tax code generally
treats the amount of the canceled debt as taxable income to the debtor. Congress
has carved out a number of exclusions, including an exclusion for “insolvency”
and a recently enacted exclusion to help some (but not all) homeowners whose
mortgage debts are canceled when their houses are foreclosed upon and sold
or whose loan balances are reduced as part of a mortgage loan modification.
However, taxpayers do not receive the benefit of these exclusions automatically.
A taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge
of Indebtedness (and Section 1082 Basis Adjustment), to claim an exclusion.
Form 982 is extremely complex, and very few taxpayers or preparers are familiar
with it.

IRS data show that approximately two million Forms 1099-C, Cancellation of
Debt, are issued to taxpayers and the IRS each year reporting canceled debts.
In an economic downturn, the number of taxpayers defaulting on credit card
bills, car loans, home mortgages and other debts can be expected to rise.
Olson estimates that tens of thousands and possibly hundreds of thousands
of taxpayers who qualify to exclude canceled debts from gross income do not
file Form 982 to claim allowable exclusions. Instead, some of these taxpayers
unnecessarily include the amount of the canceled debt in gross income, and
other taxpayers who fail to include it unnecessarily face IRS examinations
and tax assessments.

Olson recommends that Congress change the law to remove taxpayers with modest
amounts of debt cancellation from the cancellation of debt income regime,
and she recommends that the IRS develop an insolvency worksheet that taxpayers
can file with their returns and create a centralized unit dedicated to handling
cancellation of debt issues. (For details, see Legislative Recommendation:
Simplify the Tax Treatment of Cancellation of Debt Income, and Most Serious
Problem: Understanding and Reporting the Tax Consequences of Cancellation
of Debt Income.)

3. Implement a “screen” to protect low income Social
Security recipients from continuous, automated tax levies
. Under
the Federal Payment Levy Program, the IRS is authorized to “levy”
(or withhold) 15 percent of any federal payment made to a delinquent taxpayer.
Using this authority, the IRS levied against 1.8 million payments to Social
Security recipients in 2008. TAS estimates that more than 25 percent of these
taxpayers had incomes below the poverty level and more than one-third would
likely be classified by the IRS as unable to pay if their cases were subject
to human review. However, the automated levy system does not use built-in
screens to identify and shield these taxpayers. The report contains a research
study recommending the implementation of such a screen. (For details, see
Research Study: Building a Better Filter: Protecting Lower Income Social Security
Recipients from the Federal Payment Levy Program.)

Finally, taxpayers who are unable to make their tax payments and face enforced
collection action will generally qualify for assistance from the Taxpayer Advocate
Service (TAS), which Olson heads. (See information below about contacting TAS.)

Other Issues

Olson reiterates her longstanding recommendation that Congress regulate unenrolled
tax preparers to protect taxpayers from preparer errors and exploitation. She
notes that 62 percent of taxpayers use preparers, yet anyone can now be a “preparer”
— with no training, no licensing and no oversight required.

The report also proposes a comprehensive framework for reforming the penalty
provisions in the tax code, which have increased from about 14 in 1954 to more
than 130 today. More specifically, the report recommends quick congressional
action to remedy particularly harsh consequences of a penalty enacted in 2004
to combat tax shelters. Section 6707A of the tax code imposes a penalty of $100,000
per individual per year and $200,000 per entity per year for failure to make
special disclosures of a “listed transaction.”

The penalty creates what Olson calls “unconscionable” results
and may have the effect of bankrupting middle class families who had no intention
of entering into a tax shelter. Under the law, the IRS must impose the penalty
where a taxpayer fails to make the special disclosures – even if the taxpayer
had no knowledge that the transaction was listed or even questionable, even
if the taxpayer derived no tax savings from the transaction, and even if the
transaction is not “listed” until years after the taxpayer entered
into it and filed a return reflecting the transaction. A taxpayer who does business
through a wholly owned S corporation is subject to a penalty of $300,000 ($200,000
at the entity level and $100,000 at the individual level) for each year in which
the transaction is reflected on a return. The IRS is currently considering this
penalty in hundreds of cases.

Overall, the report discusses 21 problems facing taxpayers, makes dozens of
recommendations for administrative change, proposes 17 recommendations for legislative
change and analyzes the 10 tax issues most frequently litigated in the federal
courts during the past fiscal year. It also contains a second volume that presents
in-depth studies on three subjects — the penalty regime in the tax code,
the development of a “filter” to protect low income Social Security
recipients from automated levies and strategies to improve tax compliance by
tax preparers and their clients.

More information about the IRS Taxpayer Advocate Service is at