INTERNAL REVENUE VOLUME 1 SERVICE This page intentionally left blank. This report is dedicated to our friend and former colleague, Henry O. Lamar, Jr., former Deputy National Taxpayer Advocate and former Commissioner, Wage & Investment, who served as a tireless advocate for taxpayers and IRS employees alike, and whose dignity and grace in the face of adversity serve as a model for us all. This page intentionally left blank. PREFACE PREFACE H ono RAB L E M E M BER S O F Con GRE ss : I respectfully submit for your review the National Taxpayer Advocate’s 2005 Annual Report to Congress. This is the fifth such report I have submitted as the National Taxpayer Advocate. More than anything else, this year’s report is a call for tax reform. Our tax code has grown so complex it creates opportunities for taxpayers to make inadvertent mistakes as well as to game the system. As the Code gets more complex – especially for individual taxpayers and small businesses – it becomes more difficult for the IRS to provide comprehensive, quality taxpayer service. As taxpayers become confused and make mistakes, or deliberately “push the envelope”, the IRS understandably responds with increased enforcement actions. The exploita- tion of “loopholes” leads to calls for new legislation to crack down on abuses, which in turn makes the tax law more complex. Thus begins an endless cycle – complexity drives inadvertent error and fraud, which drive increased enforcement or new legislation, which drives additional complexity. In short, complexity begets more complexity. This cycle can only be broken by true tax simplification, followed by ongoing legislative and admin- istrative discipline to avoid subsequent “complexity creep”. Our own contribution to the tax reform debate, though modest, is taxpayer-centric. Among the legislative recommendations included in this report, we first set out some general principles for tax reform, from the perspective of taxpayers. We then submit nine further legislative proposals – some substantive, some procedural, but all involving issues that impose significant burden on taxpayers. Our proposals run the gamut from reform of the Code’s six “Family Status” provisions and repeal of joint and several liability for taxpayers who file returns under married-filing-jointly status, to proposals to protect Social Security benefits from IRS levy action. However diverse these proposals may be, we advocate in each for simplification and reduced compliance burdens. Our report also highlights some significant contrasts. These contrasts are illustrated by the first three issues we identify as Most Serious Problems for taxpayers – trends in taxpayer service, criminal investigation refund freezes, and the cash economy. I am con- cerned that the IRS is decreasing the level of resources it dedicates to taxpayer service, including lowering the level of service on its toll-free lines and restricting the types and amount of service provided in its walk-in sites. The IRS justifies this reduction in service funding by the need to dedicate more resources to IRS enforcement functions. Yet the IRS is doing little to address the largest component of the tax gap – the cash economy.1 Meanwhile, the IRS is expending significant resources on a Criminal Investigation pro- gram that probably freezes over 300,000 refunds each year (the IRS doesn’t keep track of the number), classifies taxpayers as “criminals” without providing them an opportunity to produce exculpatory evidence, continues to automatically freeze those taxpayers’ refund claims for years into the future, and causes financial hardship for tens of thousands of 1 For purposes of this report, we use the term “cash economy” to mean payments for transactions that are not reported to the IRS by third parties. 2 0 0 5 A NNU A L REP O R T ◆ TA X P AY E R A DVOCATE SERVICE v PREFACE taxpayers whose claims are legitimate but are nonetheless forced to wait 8 ½ months or longer to receive their refunds. While the first two issues raise questions of resource allocations and organizational priorities, the last issue raises significant taxpayer rights and due process concerns. Even where there are real successes, we see contrasts. Take the Earned Income Tax Credit (EITC), for example. Although we identify the EITC as a Most Serious Problem, the EITC Program Office and Examination staff have, in fact, been working hard to improve the program by analyzing and redesigning its procedures, learning about the characteristics and limitations of the EITC’s target population, and applying that learn- ing to its processes. EITC personnel are open to stakeholder and Taxpayer Advocate Service suggestions and engage them in dialogue. Thus, we identify many significant improvements even as we recommend additional steps. It is important that the EITC program is making significant improvements, because 48 percent of IRS individual examinations involve the EITC despite the fact that only 17 percent of individual tax returns claim the EITC. This disproportionate attention is driven, in part, by the mandates of the Improper Payments Improvement Act. Here is another contrast: the IRS is vigorously attacking improper payments to taxpayers in the EITC but not pursuing equally vigorously the improper nonpayment of tax by taxpayers in the cash economy. The IRS is overly focusing on $9 billion of the annual tax gap attributable to low income taxpayers, while inadequately focusing on the estimated $100 billion-plus of the annual tax gap attributable to the cash economy. We have tried, in our report, to point out alternative approaches to problems, both administrative and legislative, that are taxpayer-friendly and cost-effective, particularly in PREFACE the long run. Over the next year, the Office of the Taxpayer Advocate will advocate for these positions and thereby seek to help the IRS fulfill its mission of serving taxpayers. But to return to my initial premise, there comes a time when the only effective systemic change is tax reform grounded in simplification. There is a big constituency for tax sim- plification, after all – the taxpayers themselves. They are speaking up for reform daily, through the phone calls they make and the letters they send to the IRS, through the number of errors they make on tax returns, through the reluctant decision of a majority of them to pay professionals to prepare their tax returns for them, through their growing awareness of the Alternative Minimum Tax. We encourage Congress to listen to these folks and take action. I hope this report will assist in that endeavor. Respectfully submitted, 31 December 2005 vi PREFACE TAB L E O F Cont E nts T AB L E O F C DEDICAT I O N PAGE ont PREFACE E nts TAB L E O F C ONT E NTS TH E M O S T S ERI O U S PR O B L E M S E N C OUNT ERED BY TAXPAYER S Introduction / Methodology . 1 1. Trends in Taxpayer Service . .2 2. Criminal Investigation Refund Freezes. .25 3. The Cash Economy. 55 4. Training of Private Debt Collection Employees. 76 5. EITC Exam Issues. .94 6. Levies on Social Security Payments. .123 7. Appeals Campus Centralization. .136 8. Refund Anticipation Loans: Oversight of the Industry, Cross-Collection Techniques, and Payment Alternatives . 162 9. Identity Theft. 180 10. Complexity of the Employment Tax Deposit System. .192 11. Automated Collection System Levy Releases. .209 12. Regulation of Electronic Return Originators. 223 13. Limited Scope of Backup Withholding Program. 238 14. Accessibility of E-Services For Tax Practitioners. .249 15. Mandatory Briefings for IRS Employees About the Taxpayer Advocate Service. 260 16. Allowable Expense Standards for Collection Decisions. 270 17. Inadequate Taxpayer Service to Exempt Organizations Resulting In Unnecessary Penalties. .292 18. Direct Deposit of Income Tax Refunds. 315 19. Innocent Spouse Claims. .326 20. Limitations of Collection Account Databases. .345 21. Reasonable Cause Assistant. .357 K EY L EGI SL AT IVE REC OMM E N DAT I ONS Introduction . .369 1. A Taxpayer-Centric Approach to Tax Reform. 375 2. Measures To Reduce Noncompliance in The Cash Economy . 381 3. Tax Reform For Families: A Common Sense Approach. .397 4. Another Marriage Penalty: Taxing the Wrong Spouse . 407 5. Requiring Brokers to Track and Report Cost Basis for Stocks and Mutual Funds. 433 6. Tracking Cost Basis as a Result of Estate Tax Repeal. 442 7. Restructuring and Reform of Collection Due Process Provisions. 447 2 0 0 5 A NNU A L REP O R T ◆ TA X P AY E R A DVOCATE SERVICE vii nts E ont F C ADDI T I ON A L L EGI SL AT IVE REC OMM E N DAT I ONS O E 1. Direct Deposit of Income Tax Refunds. 464 L AB 2. Social Security Levies . .466 T 3. Debt Collection Techniques on EITC Benefits By The Refund Anticipation Loan Industry. 468 TH E M O S T L I T IGAT ED I SSU E S Introduction. .471 1. Appeals from Collection Due Process Hearings Under Internal Revenue Code Sections 6320 and 6330. 474 2. Gross Income Under Internal Revenue Code Section 61 and Related Sections. 488 3. Failure to File Penalty Under Internal Revenue Code Section 6651(a)(1). 498 4. Trade or Business Expenses Under Internal Revenue Code Section nts 162 and Related Code Sections. 503 5. Frivolous Issues Penalty Under Internal Revenue Code Section 6673 . 510 E 6. Negligence Penalty Under Internal Revenue Code Section 6662(b)(1). 514 7. Family Status Issues Under Internal Revenue Code Sections 2, 21, 24, 32, And 151. 519 8. Relief From Joint and Several Liability Under Internal Revenue Code Section 6015 . .530 9. Summons Enforcement Under Internal Revenue Code Section 7604. 536 10. Trust Fund Recovery Penalty Under Internal Revenue Code Section 6672 .