Inside the IRS: What You Need to Know About IRS Operations
- IRS Inefficiency
- Communicating With the IRS
- Rules of the Game—Tax Laws
- Interpreting the Tax Code
- Self-Assessment of Income Taxes
- Winning the IRS Game
Let’s take a look at the Internal Revenue Service, or IRS. The IRS’s stated mission is to “Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.” A chart of the main IRS divisions appears below. Here is a description of the divisions and offices you are most likely to encounter. National. The IRS is a branch of the U.S. Treasury Department, with headquarters in Washington, DC, and is ruled by a commissioner appointed by the president. About 1,900 folks work at the national office. The IRS brain is contained in the National Computer Center. The national IRS office sets tone and policy, while procedures—especially audits and collections—are left to the regional and local offices. The IRS is divided into four operating divisions, but only two concern most of us: the Wage and Investment division and the Small Business/Self-Employed division. IRS campuses. IRS campuses (formerly called service centers) annually process over 200 million tax filings, including over 125 million individual income tax returns. IRS campuses collect over one trillion dollars in tax payments each year. Regional campuses are located in Andover, Atlanta, Austin, Cincinnati, Fresno, Holtsville, Kansas City, Memphis, Ogden, and Philadelphia. They mail out tax notices, collection notices, or bills; tax return problem notices; and tax forms. Contacts with the IRS campuses are usually by mail or fax, or occasionally by telephone. Automated Collection System, or ACS. This program communicates with taxpayers who owe the IRS. It is a highly computerized collection system staffed by personnel working by phone and mail. You may talk to an ACS person, but you will never meet one. Local Offices. Local IRS offices sit in major cities with suboffices in smaller cities. You can bet one is near you. Each local office is divided into several departments, four of which you may encounter: examination, collection, criminal investigation and Taxpayer Advocate Service. Let’s look at these departments in more detail:
- Examination personnel perform audits, or examinations in IRS-speak. The people who audit tax returns are either tax auditors working inside the local IRS office or revenue agents if they come to your home or business, which is called the “field.” The term auditors in this book refers to both.
- Collection personnel collect tax dollars from people who haven’t voluntarily and timely paid. Local IRS collectors are called revenue officers. If your case goes to collection, you or your representative will meet with a collector face to face. The IRS campuses and automated collection system are also part of the collection apparatus, but they do not employ revenue officers.
- Criminal Investigation is the police force of the IRS, and its employees are called special agents. If you ever meet an IRS criminal investigator, it means that you or someone you know is under investigation for a tax crime.
- Taxpayer Advocate Service has the IRS troubleshooters to call on when you can’t get tax problems solved through normal IRS channels. These officers are found at IRS campuses and local IRS offices. Taxpayer advocates hold powers to cut through red tape and get things done quickly.
Tax Return Processing
From January to May, regional campuses operate around the clock, processing income tax returns, extension requests and tax payments. Many temporary workers are hired, trained on the job and paid little more than the minimum wage. IRS officials admit that many processing mistakes are caused by these seasonal employees. First, machines open tax return envelopes and remove tax returns and checks. Human transcribers scan the returns for completeness and enter the key tax return data into a computer; the computer then checks for arithmetic accuracy. Asecond transcriber double checks the first transcriber’s work-up by re-inputting the same information into the computer. Tax return data is sent to the National Computer Center, where each return is computer scored for its “audit potential.” About 10% of all individual (nonbusiness) income tax returns are selected by the National Computer Center for further review. These files are sent back to the regional campuses. There, IRS classifiers (human beings) weed out most of the 10% scored for audit, based on their opinion of the most problematic tax returns. So, roughly ½% to 1% of all individual tax returns filed are selected for further taxpayer contact. (For more information on how returns are selected for audit, see Chapter 3.) The total number of IRS permanent and seasonal employees at all levels is approximately 95,000, making it our largest federal bureaucracy. Auditors make up 25%, collectors 15%, and criminal investigators 3%. The other 57% make policy, run the computers, answer taxpayer inquiries, and God only knows what else. The IRS has been downsized by one-third since 1988. The explanation is the increased reliance on IRS electronic data processing. If you’re confused about the structure of the IRS, don’t worry—you’re not alone. The following example, shows how the various divisions work.
- On April 15, Arnold and Aimee Tyson file their income tax return by mail with their IRS campus.
- The information on their return is transmitted to the National Computer Center for analysis and given a potential audit score. If the score is high enough (it is), the return is screened at the IRS campus. If the return is then deemed to have a high enough audit potential (it does), it is sent to their local office.
- At the local office, the Tysons’ return is scrutinized again and selected for examination (audit). An IRS agent calls the Tysons or sends them an examination notice.
- The Tysons make an appointment with a tax auditor at the local IRS office. (Or alternatively, a revenue agent comes to the Tysons’ business to conduct the audit.)
- The auditor looks at the Tysons’ records and suspects fraud. He refers their file to Criminal Investigation for handling by an IRS special agent. The audit is temporarily suspended. A criminal investigation is very rare.
- The special agent concludes that the Tysons made many errors, but they were not serious enough to be criminal acts. He sends the file back to the auditor.
- The auditor concludes the audit and sends the Tysons an examination report. The report states that they owe the IRS additional taxes, interest, and penalties. The Tysons disagree with the report.
- The Tysons file an appeal, or protest of their audit.
- The appeal is heard at the nearest Appeals Office. The appeals officer upholds the auditor, and the Tysons file a petition in tax court. Tax court is independent of the IRS. The Tysons win a partial victory in tax court.
- After their tax court hearing, the Tysons still owe the IRS. Taxes, interest, and penalties are formally entered, or assessed, in the Tysons’ IRS computer records.
- The Tysons receive their first series of computerized collection notices from their IRS campus. They don’t pay or make only a partial payment.
- The IRS campus eventually gives up. Next, collection notices and telephone calls come from an IRS call center.
- The Tysons still don’t pay. The IRS call center sends the file to a revenue officer at the local office.
- They try to work out a payment plan, but the collector is unreasonable and threatens to take their wages and property. The Tysons seek help from the Taxpayer Advocate Service.
- With the help of a taxpayer advocate, they arrange a monthly installment plan. Assuming the Tysons make the payments on time, the case will be closed.
If you have never dealt with a bureaucracy, the IRS will give you a lesson in how one operates. The IRS machinery moves slowly and often breaks down. Internally, the IRS is very specialized, which can create problems right at the outset. Often, your first challenge is to locate the right department and person to talk to. Because most IRS employees don’t know or care how the IRS operates outside of their own small area, IRS personnel often don’t know where to direct you. Here are the major challenges you will encounter in dealing with the IRS. Bureaucracy. Civil servants in the IRS bureaucracy are not usually self-starters. For many, the IRS provides an escape from the long hours and competitive pressures of the private business world. Others are gaining work experience or biding their time until a better job comes along. All this results in a paint-by-the-numbers approach which can drive any taxpayer nuts. In contrast, you are highly motivated in IRS dealings—it’s your pocketbook at stake. What’s important is that you hang in there. Success with the IRS is possible, especially if you are armed with the information and strategies suggested in this book. Computers. The IRS loves its computers, and would replace all its people with machines if possible. Sometimes your file gets lost in the computer—usually through human error. Often this is good—for example, if you want to delay dealing with the IRS. In many cases, however, it is better to get your file out of the computer and into human hands. Every individual taxpayer’s IRS file is electronically stored by tax year or period and is computer accessed by Social Security number (SSN), not by name. Returns filed by a business with employees are accessed by the business’s employer identification numbers (EIN). The ultimate computerization goal of the IRS is totally paperless tax returns. The IRS reasons that if all your income, deductions, exemptions, and credits were electronically reported, a paper tax return would be unnecessary. Information returns, such as W-2 and 1099 forms filed by employers, banks, and the like, on paper and electronically, already make it possible for the IRS to prepare tax returns for nonfilers. And electronic tax filing allows tax refunds to be processed quickly without a paper filing. Complexity. Americans have the dubious honor of having the most complex income tax laws in the world. The IRS was created to see that we follow the rules. But nobody, including the IRS, understands all of them. It’s no wonder—given that the tax code is full of contradictions and hopelessly unclear provisions. Blame Congress. It is far easier to pass a tax law than to administer it, or to teach a taxpayer or tax professional how to apply it. Each major tax revision produces unworkable tax provisions which are revised or repealed in the next term of Congress.
IRS Organizational Chart (Short Version)
The IRS structure is far more complicated than the chart below indicates. Only the top-level divisions you are most likely to encounter are included. The IRS publishes its own chart showing the entire organizational scheme, but you’ll probably be more confused than educated if you try to read it.
Communicating With the IRS
If you need to communicate with the IRS, try the telephone first. A specific IRS number should be on the notice that’s causing you concern. If not, call 800-829-1040, the IRS’s toll-free number. If calling doesn’t work, get out your pad and paper. However, be warned: Letters, which the IRS refers to as white mail, are not the best way to communicate with the IRS. The IRS gets millions every year from earnest, well-meaning taxpayers with legitimate IRS concerns (in addition to letters from cranks). IRS employees are trained to respond to IRS forms, not letters.
Before contacting the IRS, find out if there is an IRS form for your problem. The IRS has a form for just about everything. For example, you can request a payment plan on Form 9465, Installment Agreement Request. The clerk who opens the mail will route the form to the proper department right away, but may leave a letter with the same request to languish in a pile. To find out if the IRS has a form for your concern, call 800-829-1040, ask a tax advisor, or check the IRS website at www.irs.gov.
Obtaining Your Computer File
The IRS computer includes statements of accounts of all taxpayers—individuals and businesses. These accounts show the dates the IRS claims you filed your tax returns, any assessments of penalties and interest, and payments credited to your account. You can obtain a copy of your IRS accounts by calling and asking for your Master File Transcript, or MFTRA. If you are a business, also request a Business Master File, or BMF, transcript. Call the IRS Taxpayer Service (800-829-1040), visit your local IRS office, or write to your regional IRS campus where you file your tax returns. Give your Social Security number (and your spouse’s if you’re married) or your federal employer identification number (if you have a business), as well as the tax years requested. Include your telephone number and mailing address and a photocopy of some form of identification, such as your driver’s license. Within days or, more likely, weeks, you’ll receive a copy of your MFTRA or BMF. Don’t be discouraged if you can’t easily decipher it. It’s replete with IRS codes. Read it carefully and note all items you don’t understand. Then call the 800 number (800-829-1040) and ask for explanations, or report any mistakes you found, such as payments not credited to your account. If that doesn’t work, contact a taxpayer advocate (see Chapter 8) or a private tax professional.
Obtaining Income Information
Your MFTRA won’t show income reports the IRS has in its computer on you—that is, any 1099 and W-2 forms reporting how much you were paid by employers, banks, and the like. Income data is available, however, if you know how to ask for it. Call 800-829-1040 and ask for an Information Returns Program (IRP) transcript for each year of concern. IRP data is helpful if you have lost W-2 or 1099 forms and need to prepare a tax return. The information also lets you match your records against what others have reported to the IRS to let you check for discrepancies. Also, if you are ever audited, the auditor will have this IRP data in hand.
Obtaining Tax Return Information
If you can’t find a tax return and need the information on it quickly, contact the IRS and ask for a Tax Return Transcript. The transcript can prove that you filed a tax return and shows payment reports from banks, escrow companies, stock brokerages, and the like. The transcript is a free summary of your tax return, without the expense and four- to eight-week wait you’d encounter in getting a copy of the return itself. The cost of obtaining a complete copy of your tax return and any attached schedules is $39 per tax return. In addition to a transcript, there are three ways to obtain the information on your missing tax return:
- visit your local IRS office, and ask a clerk to access it on the IRS computer
- send in Form 4506, Request for Copy or Transcript of Tax Return Information, to your IRS campus where you file your return (you check a box on the form to indicate that you want a transcript of a complete copy ($39 per year); a copy can be downloaded off the IRS’s website at www.irs.gov), or
- call IRS Taxpayer Service (800-829-1040).
The surest way to get the information is by completing Form 4506, but calling may be faster.
Rules of the Game—Tax Laws
Congress writes the tax laws, which become part of the Internal Revenue Code, IRC, or tax code for short. The tax code is amended every year. The present tax code is over 8,500 pages long. It’s hard to keep up, even for a tax advisor. Thankfully, most of the tax code isn’t applicable to the average citizen taxpayer. Part of the problem is that many tax laws are passed for purposes other than raising money. For example, tax laws can have a social goal, such as attempting to alleviate the housing problem by giving tax breaks to those who invest in low-income housing. Or there might be an economic goal to stimulate manufacturing by allowing rapid tax write-offs to buyers of new business equipment. And there are purely political reasons for tax laws. Many special interest groups, such as oil companies, horse breeders, broadcasters, insurance companies, and even major league baseball clubs, have gotten tax laws passed designed to give them special treatment. These special provisions of the tax code outnumber the laws of general application.
Access to Tax Data Under the FOIA
All federal governmental agencies, including the IRS, are subject to the Freedom of Information Act, or FOIA. This law guarantees access to all data the IRS has in its files about you and about internal IRS operations in general. You are not entitled to information about other taxpayers, which is protected from disclosure by the Privacy Act. And sensitive information, such as how the IRS conducts criminal investigations and whether you are under investigation, is exempted from the FOIA. The most practical application of the FOIA gives you access to the contents of your IRS files, such as notes of IRS agents, workpapers, computations, and opinions. This information is particularly useful if you are contesting an IRS decision, including an audit or a bill. Getting information under the FOIA involves making a simple written request. (A sample letter is in Chapter 4.) If you are lucky, the IRS will respond to your request within 30 days. Unfortunately, however, the IRS gives a very low priority to complying with FOIA requests; after all, this is not a function that brings in money. Typically, the first response you receive is a letter stating that the IRS needs more time to get the materials. Delayed responses are not the only problem; the IRS edits out materials it doesn’t think you are legally entitled to—which may be exactly what you are looking for. Frequently, a person who doesn’t understand the FOIA, such as an auditor or collector, is given the file to decide what you will get. Often, you have no way of knowing what was left out. The form letter accompanying what is sent to you routinely states that materials were withheld under certain statutes. Occasionally, you’ll get all the materials with blackouts on the pages. I have seen some documents 90% blacked out! This is usually the case if you have been the subject of an IRS criminal investigation. You can appeal, but the FOIA Appeals Office in Washington, where you must appeal, is several years behind in deciding appeals. Thus, many taxpayers are forced to proceed without having the IRS provide all documents as required under the FOIA. A sure way to counter the IRS’s disregard of the FOIA is to file a lawsuit against the IRS in federal court. Going to court is prohibitively expensive for most people. But nine times out of ten, the IRS complies with your original FOIA request within days or weeks of your filing the lawsuit, without your having to get near a courtroom.
The Income Tax: Past and Future
Our income tax has its roots in the Civil War when Honest Abe asked Congress for money to finance the war effort. Enacted in 1862, the first tax law lasted until 1872. The Supreme Court struck the second income tax law down, which led to the passage of the 16th Amendment to the Constitution, which led to the basic law we have today. In 1913, the tax rate was just 1% on all corporations and individuals. But few people paid income taxes, because the standard exemption was $3,000 for single people ($4,000 for married couples), and almost no one earned this much. In fact, only one out of every 271 Americans paid any income tax the first year. By 1919, another war had broken out, and the maximum rate soared to 77%. Today, the highest federal income tax rate is 35%, but through the subtle workings of the tax code, it is actually several percentage points higher for top earners. With Social Security, Medicare, and various state income taxes added on, the total tax can be as high as 50% for individuals. The one-size-fits-all flat tax is a constant political issue. The flat tax is simple, pure, and has a lot of appeal. Is it likely to become law? My guess is that Congress knows that even small changes to the tax code have widespread repercussions—to the banking, real estate, housing, manufacturing, and charitable industries—affecting just about everyone. Once the big money special interest groups gear up to protect their niches in the tax code, things won’t change all that much. I don’t see the IRS going out of business or the tax code ever becoming comprehensible.
Interpreting the Tax Code
Congress has given the IRS the power to interpret the tax code. This is done primarily through a series of IRS regulations and other pronouncements. The regulations are expanded versions of some tax code provisions, with illustrations of how the law is applied in different situations. The regulations are about four times the length of the tax code itself. The IRS also publishes revenue rulings, revenue procedures and letter rulings, which provide guidance to taxpayers. There are thousands of situations where it is not clear exactly how the tax law should be applied. In these gray areas, disputes often arise between the IRS and the taxpayer. This is where the tax professionals earn their keep—by fitting the tax code most advantageously to a client’s case. Or put another way, if the tax case is analogized to the fence around Farmer Brown’s cabbage patch, the perimeter has gotten so long and twisted that a self-respecting rabbit may have a decent chance of finding enough room to wiggle through or under it. The IRS is not the final word on interpreting the tax code. The federal court system, composed of the U.S. Tax Court, federal district courts, the U.S. Court of Federal Claims, and U.S. Bankruptcy Courts, all have the power to decide, on a case-by-case basis, how Congress intended the tax laws to be applied. Any taxpayer or the IRS, unhappy with a court’s tax decision interpreting the tax code, can appeal to a circuit court of appeal, and in rare cases to the U.S. Supreme Court.
Self-Assessment of Income Taxes
The U.S. income tax system is based on a self-assessment theory. You are responsible for reporting your income and telling the government how much tax you owe. You assess your own income tax every time you file a tax return. This doesn’t mean that the system is voluntary or that you have a legal choice whether or not to assess taxes against yourself. Despite what some tax protestor organizations contend, you must file a tax return if you earn above a specified annual minimum income amount. The IRS’s job is to determine whether or not you obeyed the self-assessment principle and the tax code by:
- reporting all your income
- stating the correct amount of taxes due, and
- paying the taxes due.
If the IRS suspects that you have violated your self-assessment obligation, you may be audited and billed for an additional assessment. If you do not file a tax return, the IRS is empowered to calculate and assess the tax for you.
Winning the IRS Game
If you file and pay your taxes on time and never get an IRS notice, then you are already winning the IRS game and probably don’t need this book—at least not yet. The rest of us who encounter the IRS up close and personal still have a chance to win, or at least to not lose disastrously. This means keeping your income and assets away from the IRS and staying out of jail. And this is one game where, despite your coach having told you “It’s not whether you win or lose, it’s how you play the game,” you darn well want to win. Great, but you won’t win the IRS game unless you know the rules. This book tells you the most important rules—written and unwritten—and helps you develop a game plan. Let’s call the IRS team the Goliaths and your team the Goodguys. On paper, the Goliaths look unbeatable, but on the playing field it comes down to the strengths and weaknesses of the individual players. Here’s an analysis of the teams and players. Goliaths have experience. You are a rookie, so even the weakest IRS team member is ahead of you. But he or she probably can’t make it a runaway—the IRS is characterized by low morale and a high rate of employee turnover. Score seven for the Goliaths in the first quarter, 7-0. Goodguys have motivation and the advantage here every time. Coaches say that motivation is the key to winning. The Goliath player gets the same pay, win or lose, while the Goodguys are playing to keep their money. Score seven for the Goodguys in the second quarter. It’s tied at the half, 7-7. The game will be decided in the second half. You have to be prepared to go the distance. Know what you are doing and show strength and perseverance to the IRS. Keep your cool and don’t beat yourself. Remember the words of Pogo, the comic strip philosopher: “We have met the enemy and he is us.” A Costly Victory—the Wrong Way to Play. One way to lose is to play the IRS without bothering to learn the rules of the game, preparing, or devising a game plan. You’ll lose if you ignore IRS contacts or respond incorrectly, miss deadlines, or lie to IRS employees. Charlie is a prime example.
Charlie had been having IRS problems for five years when he called a tax professional, Sheila. He had lost an IRS audit, an appeal, and then in tax court. When the tax bills came, he threw them away. Charlie believed he was right, and he was sticking to his principles. An IRS collector repeatedly warned Charlie that his business assets were going to be sold at auction to pay the tax bill. Sheila asked when the sale was to take place. “Tomorrow,” Charlie replied. She agreed to try to help Charlie but made no promises—the game was just about over and he was behind by several touchdowns. Sheila called the IRS and got a postponement of the auction for 30 days to give Charlie a chance to get a home equity loan to pay the taxes. He tried, but the bank didn’t approve the loan. The IRS refused another postponement and sold the business assets for $92,000. The sad part is that if Charlie had sought tax advice at the beginning of the game, he would have been able to settle with the IRS for $7,000. By stubbornly refusing to meet the problem, he lost his business. And he cost himself $92,000 in taxes, penalties, interest, and tax professional fees. Charlie needed to know the rules and needed a plan before playing the IRS game.