The Internal Revenue Service Restructuring and Reform Act of 1998 (the "1998 act") was signed into law July 22, 1998, and is expected to create the most dramatic changes at the IRS in recent history. The 1998 Act changes more than 200 sections of the Internal Revenue Code. Taxpayer rights, IRS administration and tax procedure are focal points of the act and were part of the "hoopla" associated with the recent appointment of IRS Commissioner Charles O. Rossotti. There are also new provisions and "technical corrections" to the Taxpayer Relief Act of 1997 (the "1997 act"). I have attempted to highlight and summarize a few of the significant provisions in this new legislation.

Changes and Technical Corrections

Capital Gains Holding Period Reduced

The 1997 act reduced the maximum rate from 28% to 20% for most capital gains but extended the required "holding period" to more than 18 months. The 1998 act reduces this holding period and allows property held more than 12 months to qualify for the lowest capital gains rate, which is generally 20%, as noted, but can vary depending on income tax brackets and the type of property sold. This favorable change is retroactive to January 1, 1998.

Sale of Principal Residence Clarification

The 1997 act adopted an exclusion from taxable income of up to $250,000 ($500,000 for joint filers) of gain on the sale of a principal residence. This new provision included a requirement that the taxpayer own and use the property as a principal residence for at least two of the five years preceding the sale. Taxpayers who fail to meet the full two-year requirement, under certain circumstances, are still eligible for a reduced exclusion based on the portion of the two-year requirement that is met. The 1998 act clarifies that the fractional exclusion available is a portion of the $250,000 ($500,000 for joint filers) exclusion amount, rather than a portion of the actual gain on the sale.

IRS Reform

The 1998 act specifically directs the IRS to revise its mission statement to provide greater emphasis on serving the public and meeting the needs of taxpayers, and the IRS commissioner is required to restructure the IRS into operating units that will serve particular groups of taxpayers with similar needs, rather than the current geographic structure of the agency. The 1998 act also establishes an "Internal Revenue Service Oversight Board" made up of "private-life" and government members who will have responsibility for overseeing the IRS in its administration, management, conduct, direction and supervision of the execution and application of the Internal Revenue Code. The IRS commissioner is given broader authority and more flexibility in handling personnel matters, including the ability to bring in experts to improve the IRS. Beyond these "administrative" matters, the 1998 act also made several specific changes that may be considered "IRS reform."

Burden of Proof

Taxpayers were historically required to prove, by a preponderance of the evidence, that an IRS determination was in error. The 1998 act shifts this "burden of proof" to the IRS in most circumstances for individuals and small businesses (corporations, trusts or partnerships with a net worth of $7,000,000 or less). In order to shift the burden of proof to the IRS, taxpayers must introduce "credible evidence" and also demonstrate proper substantiation, record-keeping and cooperation with "reasonable requests" for information by the IRS.

The 1998 act also shifts the burden of proof to the IRS with respect to proposed adjustments based solely on statistical information of unrelated taxpayers. Further, the IRS now must produce evidence showing that it is appopriate to apply a particular penalty to a taxpayer. Once the IRS meets this "burden of production," taxpayers are still required to establish defenses such as reasonable cause to avoid penalties.

The burden of proof rules apply to proceedings arising in connection with examinations that are commenced after the date of enactment.

Innocent Spouse Relief

The 1998 act adds two new provisions regarding the availability of relief from liability for joint tax return items attributable to a spouse or former spouse. The first provision makes "innocent spouse relief" easier to obtain by eliminating the technical requirements under prior law for certain underpayment thresholds and for characterization of the items in question as "grossly erroneous." This provision of the act also allows a spouse relief from liability on an apportioned basis, so that a portion of the liability in question can be relieved if the spouse did not know of or have any reason to know of certain joint return items (but knew of others).

The other new provision is an election to limit liability for unpaid taxes on a joint return to a spouses allocable liability, with the allocation calculated as if the spouses had filed separate returns. This election can be made within two years after collection activities begin against the electing spouse, which is intended to provide that spouse with actual notice of the IRS collection efforts. The election is available if, at the time it is made, the parties are no longer married, are legally separated, or have been living apart for at least 12 months. Relief can be denied in the case of certain property transfers between the parties or the spouses actual knowledge of an erroneous item.

These new provisions apply to tax liabilities arising after the date of enactment, as well as existing liabilities that remain unpaid on the date of enactment. The two-year election period does not begin to run until the first IRS collection activity following the date of enactment.

Interest and Penalties

The 1998 act provides that, effective January 1, 1999, individuals and other non-corporate taxpayers will receive interest on tax overpayments at the same rate the IRS charges on tax underpayments. Prior law allowed the IRS to charge one percentage more on underpayments than it paid on overpayments.

A separate provision eliminates interest rate differentials on simultaneously outstanding overpayments and underpayments (allowing offsetting) for corporations and for individuals that may benefit prior to the effective date for the new interest equalization rules. This new rule applies to interest for periods beginning after the date of enactment and may be applied to previous periods in certain circumstances.

The 1998 act also suspends the accrual of penalties and interest after 18 months (one year for tax years beginning after December 31, 2003) if the IRS has not sent the taxpayer a notice of deficiency within 18 months (one year after 2003) following the later of the original due date of the return or the date the taxpayer timely filed the return. This provision only applies to individuals, and does not apply to the failure to pay penalty or with respect to fraud or criminal penalties. Interest and penalties resume 21 days after the IRS sends a notice and demand for payment to the taxpayer. This provision is effective for taxable years ending after the date of enactment.

Examination Activities

Privileged Communications

The 1998 act extends the attorney-client privilege to certain communications between a client and an authorized tax practitioner, which includes parties authorized to practice before the IRS such as certified public accountants, enrolled agents and enrolled actuaries. This privilege of confidentiality can only be asserted in non-criminal tax proceedings before the IRS and non-criminal tax proceedings in the federal courts brought by or against the United States. The privilege does not apply to communications that would not be protected by the attorney-client privilege. For example, information disclosed to an attorney for purposes of preparing a tax rturn is not privileged. Similarly, the privilege is waived under the same rules that apply to the attorney-client privilege. Because of these limitations, taxpayers should remain very cautious with respect to disclosures to tax practitioners. These new rules apply to communications made on or after the date of enactment.

Third Party Contacts

The 1998 act has several provisions relating to IRS contacts with third-parties (other than the taxpayer) in the context of an examination. Taxpayers now have the right to quash a third-party summons in certain circumstances. The IRS is required to give taxpayers prior notice of contact with third parties and must also give taxpayers periodic records of persons contacted by the IRS during the course of an examination.

Seizures

The 1998 act also addresses certain collection activities traditionally engaged in by the IRS. In particular, IRS seizures of real property used as a residence (by the taxpayer or another person) and businesses are limited. Generally, these IRS actions are to be treated as a "last resort" in the efforts to collect taxes.

These are just a few of the "IRS reform" measures in the 1998 act. It remains to be seen how the IRS will apply these provisions and whether we will now be faced with a "kinder and gentler" IRS. IRS representatives have confirmed that they have been made aware of the change in culture that is expected under the new law.