TAX CODE REFORM
The most serious problem facing taxpayers – and the IRS – is the complexity of the Internal Revenue Code (the “tax code”). A simpler, more transparent tax code will substantially reduce the estimated 6.1 billion hours and $168 billion that taxpayers (individuals and businesses) spend on return preparation; reduce the likelihood that sophisticated taxpayers can exploit arcane provisions to avoid paying their fair share of tax; enable taxpayers to understand how their tax liabilities are computed and prepare their own returns; improve taxpayer morale and tax compliance – and perhaps even the level of connection that taxpayers feel with the government; and enable the IRS to administer the tax system more effectively and better meet taxpayer needs.

The National Taxpayer Advocate believes fundamental tax reform is essential and urgent. We believe that taxpayers will support tax reform by wide margins if they better understand the trade-offs involved and can be part of an informed dialogue. The report recommends that Congress approach tax reform in a manner similar to zero-based budgeting. Under this methodology, the starting assumption would be that all tax expenditures would be eliminated. A tax break would then be retained only if a compelling case can be made that the benefits of providing that tax break outweigh the complexity burdens it creates. At the same time, Congress can separately consider how much revenue it wants to raise, and then it can marry up our optimally designed tax system with our revenue needs by setting tax rates accordingly.

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“To alleviate taxpayer burden, the National Taxpayer Advocate urges Congress to simplify the tax code. In general, this means Congress should look at each provision in the code and ask questions like: ‘Does this government incentive make sense?’; ‘If it does, is it better administered through the tax code or as a direct spending program?’; ‘However well intentioned, is it doing what it was intended to do?’; and ‘If yes, can it be administered without imposing unreasonable burdens on taxpayers or the IRS?’. A tax benefit should be retained only if Congress determines that the public policy benefits of keeping it outweigh the complexity burden it imposes.”

– Nina Olson, National Taxpayer Advocate

THE IRS FAILS TO HELP HUNDREDS OF THOUSANDS OF IDENTITY THEFT VICTIMS

Tax-related identity theft wreaks havoc on the lives of its many victims, who not only must cope with an emotionally exhausting crime, but may have to deal with the IRS for years to untangle their account problems.

Identity theft cases in the IRS and the Taxpayer Advocate Service are rising at an alarming pace. The IRS has nearly 650,000 such cases in its servicewide inventory, and may take six months or longer to resolve them. TAS’s identity theft caseload has soared more than 650% since fiscal year 2008, with TAS providing relief to 88 percent of the affected taxpayers in FY 2012.

While the IRS has adopted some of the National Taxpayer Advocate’s repeated suggestions for resolving the problem, it has not done enough to relieve the victims’ burden. A particular concern is the IRS’s effort to decentralize its approach to helping victims. The National Taxpayer Advocate firmly believes the IRS needs a single, central “traffic cop” unit to handle complex identity theft cases with multiple issues.

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“Identity theft wreaks havoc on our tax system in many ways. The impact on victims is significant. More than 75 percent of taxpayers filing returns are due refunds, which average some $3,000 and are not paid until the IRS fully resolves a case. That now takes more than 6 months.”

– Nina Olson, National Taxpayer Advocate

ALTERNATIVE MINIMUM TAX CONTINUES TO BURDEN TAXPAYERS

As our Annual Report went to press on December 31, it appeared an agreement has been reached to patch the Alternative Minimum Tax (AMT). For taxpayers and the IRS, that is good news.However, even if a permanent patch is enacted, the AMT is still extremely burdensome for taxpayers, and will continue to affect many middle and upper-middle income taxpayers, who presumably were not its intended target. At the same time, the AMT does not affect many wealthy taxpayers, who still manage to pay no income tax. One projection estimated that about 7,000 millionaires reportedly paid no income tax in 2011.Taxpayers spent about 18 million hours for the 2000 tax year (the most recent year for which we found data) completing and filling out AMT tax forms and determining whether they owed the tax. The AMT requires millions of taxpayers to essentially compute their tax liabilities twice – once under the regular tax rules and once again under the AMT rules – and then pay the higher of the two tax amounts.The National Taxpayer Advocate reiterates her longstanding recommendation that the individual AMT be repealed.

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“The AMT does not achieve its original purpose. Many middle and upper-middle class taxpayers pay the AMT, while most wealthy taxpayers do not, and thousands of millionaires pay no income tax at all. At the same time, the AMT adds significant complexity to tax computations, requiring millions of taxpayers essentially to compute their tax liabilities twice – once under the regular tax rules and again under the AMT rules – and then to pay the higher of the two tax amounts.”

– Nina Olson, National Taxpayer Advocate

ADOPTION CREDIT DELAYS HARM TAXPAYERS

Congress created the adoption tax credit to help low and middle income families afford the costs of an adoption, which are estimated to run as high as $40,000. Yet the IRS, partly using income-based rules, selected 69% of returns claiming the credit during the 2012 filing season for audit, as compared with one percent of tax returns overall. These audits imposed significant burden on the affected taxpayers for several reasons, notably because the median refund claim constituted nearly one-quarter of the taxpayers’ adjusted gross income for the year, and the audits on average took over four months. Despite the burden, the payoff was relatively small. The IRS denied only about 10% of the amounts claimed in Tax Year 2010, and as of mid-November, the IRS had denied only about 1.5 percent of the amounts claimed in Tax Year 2011.

Many affected taxpayers came to TAS for assistance, with 83% receiving full relief. The excessive focus on returns claiming the adoption credit burdened many taxpayers and could have the effect of negating Congress’s intent to encourage adoptions.

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“The IRS’s misguided procedures, and its failure to adequately adjust these processes when it learned its approach was seriously flawed, have caused significant financial harm to thousands of families who are selflessly trying to improve the lives of vulnerable children.”

– Nina Olson, National Taxpayer Advocate

IRS UNDERFUNDED TO SERVE TAXPAYERS, COLLECT TAX

The significant, chronic underfunding of the IRS poses one of the most significant long-term risks to tax administration today, including reduced revenue collection, impaired taxpayer rights, and greater taxpayer burden. Because of funding shortages, the IRS cannot answer millions of taxpayers’ telephone calls or timely process their letters; the amount of tax due but uncollected stands at nearly $400 billion each year; taxpayers believe the tax laws are not fair; and the federal deficit is unnecessarily large.

The IRS serves as the de facto Accounts Receivable Department of the federal government. On a budget of about $11.8 billion, the IRS collected about $2.52 trillion in FY 2012 for an average return-on-investment of about 214:1, yet the appropriations process treats the IRS like any other discretionary spending program. Some taxpayer problems result from poor IRS planning or execution, but the lack of sufficient funding is the sole or significant cause of many of these problems.

The National Taxpayer Advocate recommends that Congress consider revising the budget rules so that the IRS is “fenced off” from spending ceilings and is funded at a level designed to maximize tax compliance, particularly voluntary compliance, with due regard for protecting taxpayer rights and minimizing taxpayer burden. She also recommends that Congress keep in mind in allocating IRS resources that tax compliance requires an appropriate balance between high-quality taxpayer service and effective tax-law enforcement.

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“Because the IRS is the federal government’s accounts receivable department and generates a substantially positive return on investment, it is self-defeating to treat the agency like a pure spending program. With most spending programs, a dollar spent is simply a dollar spent from a budget perspective. With the IRS, a dollar spent generates many dollars in additional revenue, and conversely, a dollar not spent translates to a greater decrease in revenue collection, thereby adding to the budget deficit.”

VICTIMS OF RETURN PREPARER MISCONDUCT NEED MORE HELP FROM THE IRS

Unscrupulous tax return preparers sometimes change their clients’ returns without the clients’ knowledge or consent to obtain inflated refunds and divert the extra money into their own bank accounts. The taxpayer is unaware of the preparer’s actions and receives no financial gain from them, but is left to deal with the IRS when the discrepancy is found.

Even though the IRS will remove the preparer’s inaccurate return from its systems and process the correct original return from the taxpayer, it will not issue a second refund to the taxpayer if the preparer absconded with the initial refund from the falsified return. When a taxpayer is victimized by a preparer who receives such a refund by paper check, the IRS will issue a replacement refund to the taxpayer, but the IRS will not issue a replacement refund when a taxpayer is victimized by a preparer who receives the refund due by altering the bank routing number on a direct deposit request, even though the IRS has received legal advice that it may do so. In other words, the IRS appears to be emphasizing budget concerns over legal principles.

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“When a taxpayer is victimized by a tax return preparer who receives a fraudulent refund in the taxpayer’s name by altering the bank routing number on a direct-deposit request, the IRS will not issue a replacement refund. The National Taxpayer Advocate believes the taxpayer-victim is legally entitled to receive the refund and the IRS has no legal basis to withhold it.”

OFFSHORE DISCLOSURE PROGRAMS DISCOURAGE TAX COMPLIANCE

U.S. law requires citizens and residents to report foreign bank accounts so the government can better detect “bad actors” engaged in tax evasion, terrorism, and money laundering. The IRS launched a series of offshore voluntary disclosure (OVD) programs to settle with taxpayers who had failed to report offshore income and file information returns. The IRS has sought to increase enforcement of Foreign Bank and Financial Accounts (FBAR) reporting requirements in recent years and has offered a series of voluntary disclosure programs designed to settle with taxpayers who had failed to file required FBAR forms. However, the report says, the programs generally applied a “one-size-fits-all” approach that required the payment of significant penalties and did not distinguish between “bad actors” and “benign actors.” These “benign actors” include those who have dual citizenship but have never lived or filed tax returns in the U.S., people who inherited an overseas account or opened one to send money to friends or relatives abroad, refugees or immigrants from totalitarian countries who felt compelled to conceal their assets from the governments they fled, and Holocaust survivors and their children who are frightened that persecution based on national origin could happen again.

The National Taxpayer Advocate also is concerned that the IRS has increased the cost and burden of correcting past violations, increased the burden of reporting foreign accounts in the future, and discontinued programs that provide account holders with information about reporting requirements. The IRS has reduced the burden of correcting errors somewhat. However, the combination of the reporting statute and the way the IRS administers it creates the potential for such draconian penalties that many taxpayers agree to pay unwarranted penalties to avoid the possible risk of having to pay even larger penalties if they opt out of the settlement initiative.

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“The IRS should promote voluntary compliance by reducing compliance burdens and expanding its targeted outreach and self-correction options for benign actors.”