WASHINGTON — National Taxpayer Advocate Nina E. Olson today released her annual report to Congress, identifying the need for tax reform as the number one priority in tax administration. The Advocate expressed continuing concern that the IRS’s increasing use of hard-core enforcement actions, particularly tax liens, is inflicting unnecessary harm on financially struggling taxpayers. The report also examines challenges the IRS is facing in implementing the new health care law.

TAX REFORM

“There has been near universal agreement for years that the tax code is broken and needs to be fixed,” Olson said in releasing the report. “Yet no broad-based attempt to reform the tax code has been made.  This report documents the burdens the tax code imposes on taxpayers and explores why many taxpayers may nevertheless feel wedded to key aspects of the current system, undermining efforts at reform.”

Compliance Burdens.  A TAS analysis of IRS data shows that taxpayers and businesses spend 6.1 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 6.1 billion hours, the ‘tax industry’ requires the equivalent of more than three million full-time workers.”

Individual taxpayers find return preparation so overwhelming that about 60 percent now pay preparers to do it for them.  An additional 29 percent use tax software, with leading software packages costing $50 or more.  IRS researchers recently estimated that the annual monetary tax compliance burden of the median individual taxpayer (as measured by income) is $258.

Tax Reform Challenges and Public Awareness.  The report discusses why efforts at tax reform – which usually focus on eliminating tax breaks in exchange for lower rates – have not succeeded.  “It is sometimes suggested that taxpayers are looking for a free lunch – that they want to see lower tax rates but keep their tax breaks and retain their government benefits, all while balancing the budget,” Olson said.  “But this perspective overlooks the fact that federal tax and spending policies are complex, and most people don’t have the time to study these policies in detail.  Our aim is to improve public knowledge of the trade-offs involved and to help policymakers and the taxpaying public conduct a more informed conversation about tax reform alternatives.”

The report attempts to improve awareness of the extent to which taxpayers benefit from tax breaks by discussing the subject in detail.  The report attempts to improve awareness of the connection between taxation and spending by recommending that the government provide all taxpayers with a “taxpayer receipt” each year that presents a breakdown showing how their federal dollars are spent.

“The Special Interests Are Us.” The report notes there is a widespread belief that the influence of entrenched “special interests” is the biggest roadblock to comprehensive tax reform.  “There is no doubt that many provisions in the tax code benefit narrow groups of taxpayers,” the report says.  “But the dirty little secret is that the largest special interests are us – the vast majority of U.S. taxpayers.  Virtually all of us benefit from certain exclusions from income, deductions from income, or tax credits.”

These tax breaks (known as “tax expenditures”) now total $1.1 trillion a year.  Among the largest are the exclusion of employer contributions for health care, the exclusion for retirement plan contributions and earnings, the mortgage interest deduction, reduced tax rates for dividends and capital gains, exclusions for Medicare benefits, the earned income tax credit, and the deduction for state and local taxes.  Other popular benefits include the child and dependent care credits; the deductions for charitable donations and contributions to traditional IRAs; and exclusions for distributions from Roth IRAs, for distributions from Section 529 education savings plans, for contributions to Flexible Spending Accounts (both medical and dependent care), and for public transportation subsidies.

Tax Breaks Reduce Average Tax Liability by About $8,000 Per Return.  A TAS analysis found that, on average, the tax liability of each individual who files a federal tax return is reduced by about $8,000 a year due to these tax breaks.  Moreover, since tax is computed as a percentage of income, a taxpayer who pays a 25 percent tax rate could be benefiting from deductions or exclusions from income worth $32,000.  The report presents an example of a fairly typical taxpayer who faces a 25 percent marginal tax rate on his “taxable income,” yet ends up paying an average tax rate of 9 percent on his “gross income” because of tax breaks.

“If tax rates are to be substantially lowered, many existing tax breaks will have to be eliminated immediately and others will be phased out,” Olson said.  “But I believe most taxpayers will conclude this is a worthwhile trade-off.  If tax reform proceeds on a revenue-neutral basis, the average taxpayer’s liability will not change, and we will end up with a tax system that is simpler, more transparent, and easier and cheaper for taxpayers to navigate.”

The report acknowledges that Congress may at some point raise tax revenues to address the nation’s long-term fiscal challenges.  However, the report suggests that Congress first enact structural tax reform on a revenue-neutral basis and keep separate the decision whether to adjust tax rates.

“Zero-Based Budgeting” Approach Recommended.  The report recommends that Congress approach tax reform in a manner similar to zero-based budgeting.  The starting assumption should be that all tax breaks would be eliminated; a tax break would then be retained only if a compelling case can be made that the benefits of providing the tax break outweigh the complexity burdens it creates.  The report suggests additional core principles for tax reform and summarizes key simplification proposals the Advocate’s office has made in past reports, including repealing the Alternative Minimum Tax for individuals and consolidating the number of incentives that encourage taxpayers to save for education and retirement.

Tax Reform Suggestion Box.  The National Taxpayer Advocate is today launching a web page to solicit taxpayer suggestions regarding tax reform.  “What would taxpayers be willing to give up if they knew that others are giving up their breaks and the end result would be a much simpler system?” Olson asked.  “What particular provisions of the existing tax system are especially burdensome or seem particularly unfair?” Suggestions may be submitted at http://www.TaxpayerAdvocate.irs.gov.  TAS will track suggestions and post results periodically.

IRS USE OF HARD-CORE ENFORCEMENT TOOLS, ESPECIALLY TAX LIENS

The report describes the Advocate’s continuing concern that IRS collection practices inflict unnecessary harm on financially struggling taxpayers and fail to achieve the IRS’s overriding objective of increasing long-term voluntary compliance with the tax laws.

“Tax collection requires a delicate balancing of the government’s interest in collecting revenue and ensuring that all taxpayers pay their fair share of tax, on the one hand, and protecting financially struggling taxpayers from unnecessary harm, on the other,” Olson said.  “Current IRS policies do very little balancing.  For example, IRS lien filing policies are all about ‘protecting the government’s interest’ and don’t consider the impact on the taxpayer.”

Financial Impact of Tax Liens.  In FY 2010, the IRS filed liens against 1.1 million taxpayers.  When the IRS files a notice of federal tax lien, the taxpayer’s creditworthiness can be badly damaged for the long term.  Lien filings are picked up by the three credit rating agencies and remain on the taxpayer’s credit report for seven years from the date a tax liability is resolved, or longer if it is not resolved.  ”Increasingly, employers, mortgage lenders, landlords, car dealerships, auto insurance companies, and credit card issuers utilize credit reports, so a tax lien has the potential to render someone unemployable, unable to obtain housing (owned or rented), and unable to obtain car insurance or a credit card, at least at reasonable rates, for many years into the future,” Olson said.  A tax lien can be particularly devastating to small businesses, as it often cuts off their access to credit.

Several Million Taxpayers Affected.  Over the past seven years, the IRS has filed more than five million tax liens.  The report says that despite the high unemployment rate and the unusually large number of Americans who are experiencing financial difficulties, the IRS is continuing to ramp up the number of tax liens it files each year.  The 1.1 million liens filed in FY 2010 compare with 168,000 in FY 1999, an increase of 550 percent.

Revenue Benefits of Tax Liens Unknown.  The IRS does not have data that show whether, or to what extent, liens further revenue collection.  A TAS study conducted in 2009 suggests there is a possibility that lien filings may reduce long-term tax collection.  Notably, over the same period that lien filings have increased by 550 percent, annual revenue collected by the IRS’s Collection function on an inflation-adjusted basis has remained flat.

“By filing a lien against a taxpayer with no money and no assets, the IRS often collects nothing, yet it inflicts long-term harm on the taxpayer by making it harder for him to get back on his feet when he does get a job,” Olson said.  “Absent data that show liens make a meaningful contribution to revenue collection and especially in this economy, I find it unacceptable that the IRS continues to torment financially struggling taxpayers in this way.”

Broader Use of Collection Alternatives Recommended.  The report states that the IRS has taken steps in the last year to reassess its collection policies but concludes that more steps should be taken quickly.  The report reiterates the Advocate’s longstanding suggestion that the IRS make greater use of collection alternatives, such as offers in compromise, when dealing with taxpayers who cannot afford to pay their liabilities in full.  A comprehensive assessment of the IRS’s collection policy and a suggested roadmap toward a more effective approach are presented in Volume 2 of the report.

IRS CHALLENGES IN ADMINISTERING BENEFITS PROGRAMS, INCLUDING HEALTH CARE REFORM

IRS as Tax Collector.  Historically, the IRS’s mission has been to collect taxes, but in recent years, Congress has directed the IRS to administer an increasing number of social benefits programs, including Economic Stimulus Payments, the First-Time Homebuyer Credit, and the Making Work Pay Credit.  The recent directive to administer major aspects of the new health care law will add significantly to the IRS’s workload.  “I am confident the IRS can succeed in its implementation of health care reform,” Olson said.  “But a comprehensive assessment of the issues and challenges that lie ahead is a prerequisite for success.”

IRS as Benefits Administrator.  The IRS will administer four key provisions of the new law: the Small Business Tax Credit, the Premium Assistance Credit, the Individual Responsibility Requirement, and the Employer Requirement.  Among the challenges the IRS faces is determining the types of new information it needs to gather, determining the new entities it needs to work with, resolving privacy issues, and implementing a new definition of income, the report says.

“From an organizational standpoint, there are substantial differences between benefits agencies and enforcement agencies in terms of culture, mindset, and the skill sets and training of their employees,” Olson said.  “As the IRS prepares to administer large portions of the health care legislation, it will have to shift from being an enforcement agency that primarily says, in effect, ‘you owe us’ to an agency that places much greater emphasis on hiring and training caseworkers to help eligible taxpayers receive benefits and work one-on-one with taxpayers to resolve legitimate disagreements.”

Revision to IRS Mission Statement Recommended.  The report points out that the IRS has a “mission statement” that should serve as its foundation and around which its strategic plan, operational priorities, budget, and performance measures should be built.  In light of the IRS’s expanded responsibilities, the report recommends that the IRS revise its mission statement to recognize explicitly its dual roles as tax collector and benefits administrator.  Greater recognition of this dual role will enable the IRS to plan more effectively to handle health care and will make explicit to Congress that the agency will require sufficient funding to perform both of its functions effectively, the report says.

*   *   *   *   *

Federal law requires the National Taxpayer Advocate to submit an Annual Report to Congress that identifies at least 20 of the most serious problems encountered by taxpayers and makes administrative and legislative recommendations to mitigate those problems.  Overall, this year’s report identifies 21 problems, provides updates on four previously identified issues, makes dozens of recommendations for administrative change, proposes 11 recommendations for legislative change, and analyzes the 10 tax issues most frequently litigated in the federal courts.

About the Taxpayer Advocate Service

The Taxpayer Advocate Service is an independent organization within the IRS.  TAS employees help taxpayers who are experiencing economic difficulties, such as not being able to provide necessities like housing, transportation, or food; taxpayers who are seeking help in resolving problems with the IRS; and those who believe an IRS system or procedure is not working as it should.  If you believe you are eligible for TAS assistance, you can reach TAS by calling the TAS toll-free number at 877–777–4778 or TTY/TDD 800-829-4059.    For more information, go to http://www.TaxpayerAdvocate.irs.gov.

IR-2011-2, Jan. 5, 2011

It's customary for this column to start the year with a roundup of what's new for taxpayers. Given last December's theatrics in Congress, some items on our list may seem familiar unless you were out mapping the tributaries of the Amazon.

But keeping tax details straight is tough—even for tax reporters. Our mailbox is full of queries from bewildered readers trying to sort out issues such as which Roth IRA conversion rules expired last year, how the new payroll tax cut works, or at what income level the zero rate on long-term capital gains ends.

The most important point to remember is that last year's 11th-hour tax changes, though favorable for most, are temporary. After 2012, many provisions are set to snap back to what they were before 2001, and a few even expire this year.

That raises the dreary possibility that in less than two years we will be in a replay of last year's tax debates, but in the middle of a presidential campaign. Once again tax rates on both pay and investment income will be set to spike, especially for those at the bottom, and the estate tax will revert to a $1 million-per-individual exemption and a 55% top rate.

Tax strategists like Robert Gordon of Twenty-First Securities in New York see this year as a lucky reprieve for those who didn't get around to planning for higher taxes earlier, especially on investments with long-term gains and stock options. "It's not a question of whether investment tax rates are going up, but when," he says. He already is meeting with clients who escaped a 2011 increase but are determined to get ready for 2013.

Meanwhile, here are important changes for this year:

• Income taxes. This year's rates carry over from last year, but the brackets are a bit higher than last year's due to inflation adjustments (see table). Expires: end of 2012.

• 'Stealth' income taxes. Affluent taxpayers won't have deductions clipped by the so-called Pease and PEP limitations. The Pease limit cut 3% of itemized deductions and PEP eroded the personal exemption, which is $3,700 for 2011. Expires: end of 2012.

• Investment taxes. Rates continue at historic lows for both long-term capital gains and dividends. For taxpayers in the 15% income tax bracket and below, the rate is zero. For those in the 25% bracket and above, the rate is 15% (see table). Expires: end of 2012.

• Estate and gift taxes. The system has been overhauled, with a top rate of 35% and one exemption of $5 million per individual for estate, gift and generation-skipping taxes alike. For those who can stand to part with assets, it's now possible to shift large amounts of wealth. Expires: end of 2012.

The annual exclusion for tax-free gifts remains $13,000 per donor. A giver may make an unlimited number of $13,000 gifts, as long as they are to different individuals. Gifts of tuition and payments for medical care also are exempt.

• Payroll taxes. Last year's big surprise was a temporary two-percentage-point cut in the employee's share of Social Security taxes, saving a maximum of $2,136 per worker. There is no phase-out, and each partner of a married couple can get the rebate. Expires: end of 2011.

For most workers, this cut will come as an automatic adjustment to withholding. For the self-employed (whose tax rate falls to 10.4% from 12.4%), it will be built into a quarterly withholding worksheet the IRS hopes to release soon, says IRS spokesman Eric Smith.

• Alternative Minimum Tax (AMT). The "patch" enacted by Congress sets the AMT exemption at $47,450 for single filers and $74,450 for married couples, slightly higher than for 2010. Expires: end of 2011.

• Roth IRA conversion. The income limit for conversions has been permanently removed, so this year all taxpayers may still convert ordinary IRAs into Roth IRAs. But taxpayers who convert to Roth IRAs in 2011 no longer have the option of deferring conversion income into later years, as was true for 2010 conversions. Those who converted in 2010 do have until next Oct. 17 to decide whether to use this deferral.

• Foreign-account reporting. A little-noticed provision enacted last year imposes a new IRS reporting requirement on those with foreign financial assets above $50,000 in 2011. This form is different from the foreign asset report known as the FBAR. It will also apply to some, such as hedge-fund investors, who have been exempt from the FBAR filing, according to Michelle Koroghlanian of the American Institute of CPAs. Details remain unclear, as the IRS hasn't yet issued regulations.

• Medical expenses. Workers with Flexible Spending Accounts (FSAs) may no longer use pretax funds to pay for many over-the-counter medicines—aside from insulin—without a prescription. But FSA funds may still be used for other, nonprescription medical items such as crutches, contact-lens solution or a wig after chemotherapy, if the individual plan allows it, notes Melissa Labant of the AICPA. For a list of what is allowed by law, see IRS Publication 502.

• Cost-basis reporting by brokers. As of 2011, brokers must track clients' purchases of stock, real-estate investment trusts and foreign securities, and report the original cost to the IRS when the asset is sold. This is an effort to improve tax compliance by investors. The rules for investments in mutual funds, bonds, options and many exchange-traded funds don't kick in until after 2011. (See Tax Report, Oct. 23, 2010.)

• Energy tax credits for homeowners. As part of the December changes, lawmakers extended the "25(C)" credit for energy-efficient improvements, but in a way that will be useful to few. The amount of the credit has shrunk to a maximum of $500 per taxpayer per lifetime, so those who took last year's $1,500 credit under this provision don't qualify. The current version expires at the end of 2011, and builders and remodelers may push either to expand it or drop it altogether.

• Other changes. Also renewed at the last minute were the $250 deduction for teacher classroom expenses; a deduction for state sales taxes in lieu of the state income tax deduction; and the tax-free donation of IRA proceeds to charity. (See Tax Report, Dec. 18, 2010.) They expire at the end of 2011. The American Opportunity Tax Credit of up to $2,500 for education expenses was renewed for 2011 and 2012.

WASHINGTON — The Internal Revenue Service today opened the 2011 tax filing season by announcing that taxpayers have until April 18 to file their tax returns. The IRS reminded taxpayers impacted by recent tax law changes that using e-file is the best way to ensure accurate tax returns and get faster refunds.

Taxpayers will have until Monday, April 18 to file their 2010 tax returns and pay any tax due because Emancipation Day, a holiday observed in the District of Columbia, falls this year on Friday, April 15. By law, District of Columbia holidays impact tax deadlines in the same way that federal holidays do; therefore, all taxpayers will have three extra days to file this year. Taxpayers requesting an extension will have until Oct. 17 to file their 2010 tax returns.

The IRS expects to receive more than 140 million individual tax returns this year, with most of those being filed by the April 18 deadline.

The IRS also cautioned taxpayers with foreign accounts to properly report income from these accounts and file the appropriate forms on time to avoid stiff penalties.

“The IRS has made important strides at stopping tax avoidance using offshore accounts,” said IRS Commissioner Doug Shulman. “We continue to focus on offshore tax compliance and people with offshore accounts need to pay taxes on income from those accounts.”

The IRS also reminded tax professionals preparing returns for a fee that this is the first year that they must have a Preparer Tax Identification Number (PTIN). Tax return preparers should register immediately using the new PTIN sign-up system available through www.IRS.gov/taxpros.

Who Must Wait to File

For most taxpayers, the 2011 tax filing season starts on schedule. However, tax law changes enacted by Congress and signed by President Obama in December mean some people need to wait until mid- to late February to file their tax returns in order to give the IRS time to reprogram its processing systems.

Some taxpayers – including those who itemize deductions on Form 1040 Schedule A – will need to wait to file. This includes taxpayers impacted by any of three tax provisions that expired at the end of 2009 and were renewed by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act Of 2010 enacted Dec. 17. Those who need to wait to file include:

• Taxpayers Claiming Itemized Deductions on Schedule A. Itemized deductions include mortgage interest, charitable deductions, medical and dental expenses as well as state and local taxes. In addition, itemized deductions include the state and local general sales tax deduction that was also extended and which primarily benefits people living in areas without state and local income taxes. Because of late Congressional action to enact tax law changes, anyone who itemizes and files a Schedule A will need to wait to file until mid- to late February.
• Taxpayers Claiming the Higher Education Tuition and Fees Deduction. This deduction for parents and students – covering up to $4,000 of tuition and fees paid to a post-secondary institution – is claimed on Form 8917. However, the IRS emphasized that there will be no delays for millions of parents and students who claim other education credits, including the American Opportunity Tax Credit extended last month and the Lifetime Learning Credit.
• Taxpayers Claiming the Educator Expense Deduction. This deduction is for kindergarten through grade 12 educators with out-of-pocket classroom expenses of up to $250. The educator expense deduction is claimed on Form 1040, Line 23 and Form 1040A, Line 16.

In addition to extending those tax deductions for 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act also extended those deductions for 2011 and a number of other tax deductions and credits for 2011 and 2012 such as the American Opportunity Tax Credit and the modified Child Tax Credit, which help families pay for college and other child-related expenses. The Act also provides various job creation and investment incentives including 100 percent expensing and a two-percent payroll tax reduction for 2011. Those changes have no effect on the 2011 filing season.

The IRS will announce a specific date in the near future when it can start processing tax returns impacted by the recent tax law changes. In the interim, taxpayers affected by these tax law changes can start working on their tax returns, but they should not submit their returns until IRS systems are ready to process the new tax law changes. Additional information will be available at www.IRS.gov.

For taxpayers who must wait before filing, the delay affects both paper filers and electronic filers. The IRS urges taxpayers to use e-file instead of paper tax forms to minimize confusion over the recent tax law changes and ensure accurate tax returns.

Except for those facing a delay, the IRS will begin accepting e-file and Free File returns on Jan. 14. Additional details about e-file and Free File will be announced later this month.

Many Ways to Get Assistance

The IRS is also continuing to focus on taxpayer service. Taxpayers with questions should check the IRS website at www.IRS.gov, call our toll-free number or visit a taxpayer assistance center.

This is also the first filing season that tax packages will not be mailed to individuals or businesses. There are still many options for taxpayers to get paper forms and instructions if they need them. In recent years, fewer and fewer taxpayers received these mailings. Last year, only 8 percent of individuals who filed tax returns received tax packages in the mail. Taxpayers can still get any forms and instructions they need online at www.IRS.gov, or they can visit local IRS offices or participating libraries and post offices.

In addition, individuals making $49,000 or less can use the Volunteer Income Tax Assistance program for free tax preparation and, in many cases, free electronic filing. Individuals age 60 and older can take advantage of free tax counseling and basic income tax preparation through Tax Counseling for the Elderly.

IRS Free File provides options for free brand-name tax software or online fillable forms plus free electronic filing. Everyone can use Free File to prepare a federal tax return. Taxpayers who make $58,000 or less can choose from approximately 20 commercial software providers. There’s no income limit for Free File Fillable Forms, the electronic version of IRS paper forms, which also includes free e-filing.

Check for a Refund

Once taxpayers file their federal return, they can track the status of their refunds by using the “Where's My Refund?” tool, located on the front page of www.IRS.gov. Taxpayers can generally get information about their refunds 72 hours after the IRS acknowledges receipt of their e-filed returns, or three to four weeks after mailing a paper return.

Taxpayers need to provide the following information from their tax returns: (1) Social Security Number or Individual Taxpayer Identification Number, (2) filing status, and (3) the exact whole dollar amount of your anticipated refund. If the U.S. Postal Service returns the taxpayer’s refund to the IRS, the individual may be able to use “Where’s My Refund?” to change the address the IRS has on file, online.

Also, taxpayers may complete a Form 8822, Change of Address, and send it to the address shown on the form. They may download Form 8822 from www.IRS.gov or order it by calling 800-TAX-FORM. Generally, taxpayers can file an online claim for a replacement check if more than 28 days have passed since the IRS mailed their refund.

IR-2011-1, Jan. 4, 2011