The effect of the IRS Restructuring and Reform Act of 1998 on federal income tax controversies.

On July 22, 1998, President Clinton signed the IRS Restructuring and Reform Act of 1998 (the Act).(1)(*) The Act represents the culmination of years of focus and debate on taxpayer rights, privilege issues, and overall improvements to the administration of federal tax law. The Act contains several administrative and procedural provisions that affect, in some cases significantly, the manner in which taxpayer controversies with the Internal Revenue Service will be handled in the future. This article summarizes these key provisions as they affect tax controversies at the audit, the IRS Office of Appeals, and judicial levels.

Conduct of IRS Audits

The Confidentiality Privilege

Under common law, confidential communications between a client and its attorney, acting as an attorney, for the purpose of securing legal advice are protected from disclosure to the IRS under the attorney-client privilege.(2) Prior to the Act, the privilege was limited to dealings between the taxpayer and its attorney (or individuals retained by the attorney to assist the attorney in rendering legal advice)(3), but not to dealings between the taxpayer and its other tax advisers.(4)

The Act extends under limited conditions the common law attorney-client privilege to communications with respect to tax advice rendered to the taxpayer by its "federally authorized tax practitioner" made on or after July 22, 1998.(5) A "federally authorized tax practitioner" is an individual authorized under federal law to practice before the IRS (i.e., attorneys, certified public accountants, enrolled agents, and enrolled actuaries).

The new confidentiality privilege is subject to various limitations. For instance, the privilege does not apply to criminal administrative and judicial tax proceedings.(6) It also is inapplicable to communications between a federally authorized tax practitioner and a corporate director, shareholder, officer, employee, agent, or representative in connection with the promotion of the corporation's direct or indirect participation in any tax shelter.(7) A "tax shelter" for these purposes is defined by reference to section 6662(d)(2)(C)(iii) and includes any partnership, other entity, investment plan or arrangement, or any other plan or arrangement having as a significant purpose the avoidance or evasion of federal income tax.(8) Congress deemed these communications to fall outside of the "routine relationship" between a taxpayer and its tax adviser and thus undeserving of privilege protection.(9) In addition, the privilege does not operate to limit the ability of other regulatory bodies, such as the Securities and Exchange Commission, from obtaining information and thus the privilege cannot be asserted in administrative or judicial dealings with those regulatory bodies.(10)

Moreover, the privilege applies only with regard to "tax advice," which is defined in the Act broadly as advice given by the federally authorized tax practitioner with respect to matters within the scope of that individual's authority to practice before the IRS..(11)

The confidentiality privilege is further limited by the common law principles governing the attorney-client privilege. The overarching principle is that the new privilege applies only to the extent that a communication would be privileged had it occurred between a taxpayer and its attorney.(12) For instance, the Conference Report provides that information used in preparing a tax return -- a document destined for disclosure to the IRS -- is not protected.(13) The privilege also does not protect general business Advice(14) or other communications intended for disclosure to third parties, including annual reports and similar public disclosures.(15) The common law conditions under which the attorney-client privilege is waived, such as disclosure to a third-party, apply with equal force to the confidentiality privilege.(16)

The application of the statutory and common law restrictions on privileged communications is fraught with ambiguity and ripe for controversy absent guidance from Congress or the IRS. For example, if the taxpayer's certified public accountant raises a sensitive tax issue during the course of preparing the taxpayer's annual report or tax return, do the ensuing communications relating to that issue with that accountant, or even with other members of the same accounting firm, relate to "tax advice" or to the preparation of the annual report or tax return that is intended to be disclosed to third parties? Similarly, if a communication relates to both tax and non-tax advice, is it protected under the confidentiality privilege in its entirety, in part, or not at all?

Unfortunately, dual-purpose communications or communications that depart from their original focus can undermine the protection of the privilege. Thus, until guidance is issued, taxpayers should exercise caution in their dealings with tax advisers and clearly distinguish (and identify) sensitive tax-related communications for which tax advice (and, hence, confidentiality) is sought from other communications that are either wholly or in part tax-related or which potentially are subject to third-party disclosure. In the same vein, taxpayers must carefully analyze the role and capacity of the adviser to whom the communications are directed to ensure that privilege is preserved.

In the event that this distinction is not maintained, taxpayers dealing with attorney and non-attorney tax advisers may under certain conditions be able to rely on the protection of the work product doctrine, a qualified privilege that protects from disclosure certain materials prepared by or in some cases for an attorney in anticipation of litigation.(17) The taxpayer still faces the challenge, however, in applying the work product doctrine to determine whether the information at issue was prepared "in anticipation of litigation."

The new confidentiality privilege applies to federal tax matters. It does not trump the applicability (or inapplicability) of state common law privileges as applied to information involved in state tax controversies. In addition, the federal privilege does not guarantee that items protected under the federal confidentiality statute retain their cloak of privilege in private litigation with parties other than the IRS. For these reasons, taxpayers should exercise caution in state tax or private controversies and may wish to have their attorneys retain non-attorney tax advisers (rather than retaining the non-attorneys directly).

Taxpayer Assistance Orders

If a taxpayer is suffering or is about to suffer a significant hardship as a result of how the IRS is conducting an examination of the taxpayer or the manner in which the IRS is administering the Code, the taxpayer since 1988 has had the right to bring this hardship to the attention of the office of the National Taxpayer Advocate.(18) The Taxpayer Advocate's office has authority to issue a Taxpayer Assistance Order (TAO) to require the IRS, for instance, to release levied property or cease or refrain from taking certain actions against the taxpayer.(19)

The Act attempts to clarify the TAO procedure by spelling out the circumstances under which a TAO should be issued. Specifically, it provides that a "significant hardship" exists if the taxpayer faces one of the following four conditions: (1) an immediate threat of adverse action; (2) a greater than 30-day delay in resolving account problems; (3) significant costs; or (4) irreparable injury or a long-term adverse effect.(20) The four specified conditions are intended to provide guidance to the IRS for issuing a TAO and are not intended to represent an exclusive list of factors giving rise to a "significant hardship." This provision is effective July 22, 1998.

Civil Damages for Unauthorized Collection

Under prior law, a taxpayer could sue the United States in a federal district court for up to $1 million in civil damages arising from the reckless or intentional disregard of the Code or regulations by IRS employees or officers in connection with the collection of federal tax.(21) The Act broadens the taxpayer's right to sue for such misconduct occurring after July 22, 1998. Specifically, it retains the $1 million damage cap for reckless or intentional disregard of the tax law, but now allows a taxpayer to recover up to $100,000 in damages arising from simple negligent disregard of the tax law by an IRS employee or officer in connection with the collection of federal tax.(22)

The Act further extends the right to sue to third parties who are adversely affected by improper IRS collection activity occurring after July 22, 1998.(23) The Act also reinstates the limitation that no civil damages may be awarded unless the taxpayer or the third-party litigant exhausts administrative remedies available within the IRS.(24)

Third-Party Contact: Pre-Contact Notification to Taxpayer

The IRS has broad investigative authority under sections 7602 and 7609 to contact third parties, including third-party recordkeepers, in connection with the examination of a taxpayer. Under prior law, the IRS was required to notify the taxpayer of this contact after the contact was made (i.e., within three days of serving a summons on the third party).(25)

The Act reverses this procedure by requiring the IRS to provide the taxpayer with reasonable notice in advance that the IRS may make contact with third parties in connection with an examination of the taxpayer.(26) The IRS also must periodically provide the taxpayer with a record of persons contacted.(27) No pre-contact notice is required, however, for contacts (1) authorized by the taxpayer; (2) for which notice would jeopardize collection efforts or would involve reprisal against any person; or (3) relating to a pending criminal investigation.(28) These provisions apply to contacts made after January 18, 1999.

As a practical matter, this pre-contact notification requirement should help prevent taxpayers in an audit or in litigation from being blindsided by third-party disclosures of facts or information not under the taxpayer's control or, in some cases, possibly not even known by the taxpayer. Along these lines, the notice requirement affords the taxpayer the opportunity to produce on its own the information sought from a third party and thus to avoid disclosing to the third party the fact of the audit or the nature of the IRS's inquiries. It should also assist the taxpayer in analyzing the potential contact to determine whether it can assert any claims of privilege to prohibit the third party from disclosing privileged information. The ability to conduct a privilege screen in advance of IRS contact not only gives the taxpayer a tactical advantage and stronger control over information flow, but also serves the critical function of preventing inadvertent waivers of privileged information.

Motion to Quash Third-Party Summonses

Under prior law, the IRS could formally request third-party information by issuing a summons to certain "third-party recordkeepers" as defined in section 7609 (e.g., accountants, attorneys, banks, brokers, or agents).(29) If the IRS issued a summons to the third-party recordkeeper, the IRS was required to give notice of that summons to the taxpayer within three days.(30) The taxpayer then had 23 days after the notice period to file a motion in a federal district court to quash the summons.(31)

The Act significantly broadens the taxpayer's rights by allowing the taxpayer to move to quash all third-party summonses served after July 22, 1998, not just those issued to "third-party recordkeepers."(32) As under prior law concerning third-party recordkeepers, once a summons has been issued to a third party, the IRS must notify the taxpayer of the summons within three days. The taxpayer then has up to 23 days to begin a proceeding in a federal district court to quash the summons.(33)

The Act does not require notice of the issuance of a third-party summons, however, with respect to summonses issued (1) to the taxpayer or any of its officers or employees; (2) to determine whether or not records of the business transaction or affairs of the taxpayer have been made or kept; or (3) by an IRS criminal investigator.(34)

Although these amendments expand the taxpayer's rights to control the flow of information to the IRS, Congress was careful to point out that nothing in amended section 7609 should be construed to limit the IRS's ability to gather information, formally or informally, through the general investigative procedures authorized in sections 7601 and 7602.(35)

Software Production and Related Trade Secrets Protection

Under prior law, subject only to general judicial limitations on the proper issuance of a summons,(36) the Code contained no specific statutory restrictions on the IRS's ability to demand production of a taxpayer's computer records, programs, source code, or similar materials in the possession of either the taxpayer or another party. As a result, sensitive trade secrets contained in or relating to these materials were at significant risk of unauthorized or inappropriate disclosure. The Act adds provisions to both control the IRS's access to and use of these materials and to protect from disclosure any sensitive trade secrets inherent in the software.

1. Limitation on Summonses for Software

With respect to production of software and related materials, the Act limits the IRS's ability to issue a summons to the taxpayer or to a third party to produce or analyze any tax-related computer software source code.(37) The limitation applies to summonses issued after July 22, 1998. The limitation is intended to prevent the "indiscriminate examination" of computer source code by the IRS.(38) "Software" for these purposes includes computer software source code and computer executable code.(39) "Computer source code" includes programmer code in a programming language that is understandable only by trained persons and that is not capable of being used directly to instruct a computer, including any related programmers' notes, designs, memoranda, and other documentation and customer communications.(40) "Computer software executable code" is any code readable by a computer when loaded into its memory and that is used directly to execute instructions, including any related user manuals.(41) The "owner" of software for these purposes includes the developer of the software.(42)

The limitation on software summonses is essentially swallowed by exceptions. The limitation does not apply if (1) the IRS determines that it cannot otherwise reasonably verify the accuracy of any return item from the taxpayer's books, records, or other data, or computer software executable code; (2) the IRS identifies with reasonable specificity the portion, item, or component of the source code needed to verify the return item; and (3) the need for the source code outweighs the risk of unauthorized disclosure of trade secrets.(43) The IRS is deemed to satisfy the statutory requirements for items (1) and (2) above if (a) it in good faith determines that it is not feasible to determine the accuracy of a return item without access to the software or data sought; (b) it formally requests production of the software or data from the taxpayer and production of the executable code from the owner of the software source code; and (c) the code and data are not provided within 180 days of the request.(44)

The limitation also does not apply to a summons issued (1) in connection with an inquiry into any offense connected with the administration or enforcement of the tax laws;(45) (2) for any tax-related computer software source code acquired or developed by the taxpayer or a related person primarily for internal use, rather than for commercial distribution; (3) for communications between the owner of the tax-related computer software source code and the taxpayer or related persons; or (4) for any tax-related computer software source code that is required to be provided under any other provision of the Code.(46)

Oddly, these comprehensive exceptions appear to vest authority for determining whether to overrule the limitation directly in the hands of the IRS, the party most interested in obtaining the information. In addition, the fairly subjective standards the IRS must follow to apply the exception are ripe for controversy. Some consolation may be drawn, however, from the ongoing requirements that the summons satisfy the good faith, proper purpose, and other judicial standards for summons enforcement.(47) Moreover, the taxpayer has the right under section 7604 to contest a summons issued under this provision and to request a hearing by the court to determine whether the IRS has satisfied these standards.(48) Resort to the court, and the related costs of doing so may ring hollow to a contesting taxpayer as a realistic limit on the IRS's authority.

2. Protection Against Disclosure of Trade Secrets

In addition to judicial safeguards relating to the protection of trade secrets and confidential information, such as protective orders, the Act contains several statutory safeguards to protect against the disclosure and improper use of trade secrets and other confidential information incident to the IRS's examination of computer software or source code acquired after July 22, 1998.(49)

The first safeguards limit the IRS's use of computer information by instituting a series of controls over the dissemination of the information. For instance, the IRS can use a taxpayer's computer software or code only in connection with proceedings relating to that taxpayer (i.e., an audit, Appeals, or a judicial proceeding).(50) The IRS also must provide to the taxpayer and the software owner a written list identifying all persons who will analyze or otherwise have access to the software.(51) Individuals who are not officers or employees of the United States who will examine or analyze software are required to enter into a confidentiality agreement with the IRS agreeing not to disclose the software to anyone outside of the IRS and not to participate for two years in the development of software that is intended for a similar purpose.(52)

Physical safeguards include a requirement that the software be maintained in a secure area, and in the case of computer source code, a prohibition on removal from the owner's place of business absent the owner's consent or a court order.(53) The IRS also cannot decompile or disassemble the software and may copy it only as necessary to perform required analyses.(54) All copies must be numbered and the IRS must certify that no other copies have been or will be made.(55) Computer software or source code (including copies) must also be returned to the taxpayer at the conclusion of any proceedings or permanently deleted if stored elsewhere.(56)

An additional layer of protection from disclosure is afforded by the Act's per se statutory classification of software and source code as "return information" for purposes of section 6103.(57) Section 6103 contains specific safeguards against disclosure of tax return information by the IRS.

Statute of Limitations

The statute of limitations on the assessment of additional tax is generally three years, which the IRS and the taxpayer can agree to extend by written agreement.(58) The Act maintains that procedure and time frame, but now requires the IRS to notify the taxpayer formally of its right to refuse to extend the statute of limitations period and, more important, to limit that extension to particular issues or to a particular time period for requests made after December 31, 1999.(59) This notice must be given each time the statute is extended. The taxpayer's ability to limit the extension to particular issues removes a powerful weapon from the IRS's examination arsenal by allowing the taxpayer to restrict the scope of the IRS's ongoing examination activities to those relating to identified unresolved issues.

IRS Appeals Proceedings

Early Referral of Issues

The internal IRS Appeals forum is intended to serve as an independent taxpayer forum for appealing assessments. Taxpayers generally may seek to take their case to Appeals after failing to reach agreement with the IRS examination team or before or after filing a Tax Court petition. Generally, large corporate taxpayers (i.e., those with assets over $250 million) are subject to the IRS's Coordinated Examination Program (CEP), under which the taxpayer has the right to seek early referral to Appeals of certain issues under audit while the audit continues. The Act charges the IRS with the task of implementing procedures whereby any taxpayer, and not just CEP taxpayers, may seek early referral of unresolved audit or collection issues to Appeals.(60)

Alternative Dispute Resolution

Under existing IRS procedures, Alternative Dispute Resolution, such as mediation or arbitration, is available at the conclusion of Appeals proceedings or unsuccessful attempts to execute a closing agreement only if the amount in dispute exceeds $10 million.(61) The Act requires the IRS to establish procedures by which a taxpayer or the IRS may request non-binding mediation for any issues remaining unresolved after Appeals proceedings or if attempts to execute a closing agreement or compromise have failed.(62) The Act also requires the IRS to establish a pilot program under which a taxpayer and the IRS may jointly request binding arbitration for disputes of all sizes for issues unresolved after Appeals proceedings or if attempts to execute a closing agreement or compromise have failed.(63)

Judicial Proceedings

Shifting the Burden of Proof to the IRS

Under prior law, except for a handful of policy-driven statutory exceptions, the taxpayer bears the burden of proof with respect to establishing the correctness of its tax liability.(64) This burden is a heavy one given that the IRS enjoys a judicial presumption of correctness with respect to its determination of tax liability in a statutory notice of deficiency.(65)

The Act shifts the burden of proof to the IRS in judicial proceedings involving certain taxpayers if the taxpayer presents credible evidence with respect to any factual issue relevant to ascertaining the taxpayer's income, estate, gift, or generation-skipping tax liability.(66) A taxpayer presents "credible evidence" if the quality of the evidence is such that, after critical analysis, the court would find the evidence a sufficient basis for its decision with respect to the issue if no contrary evidence were submitted (regardless of the presumption of correctness).(67) The credibility of the evidence is critical to the shift in the burden of proof.(68)

In addition to presenting credible evidence, the burden of proof will shift only if the taxpayer satisfies three conditions. First, the taxpayer must comply with any substantiation and record maintenance requirements with respect to the item.(69)

Second, the taxpayer must cooperate with reasonable IRS requests for witnesses, information, documents, meetings, and interviews.(70) The Conference Report explains that cooperation with the IRS for purposes of the statute means that the taxpayer has provided, within a reasonable time period, access to and inspection of witnesses, information, and documents within the control of the taxpayer.(71) It also includes providing reasonable assitance to the IRS in obtaining access to and inspecting witnesses, information, and documents that are not within the taxpayer's control, including foreign-based witnesses and information.(72) The taxpayer must also establish the applicability of any privileges with respect to that information, and must have exhausted its administrative remedies within the IRS, including any appeal rights provided by the IRS.(73) It is not necessary, however, that the taxpayer agree to an extension of the statute of limitations before the standard is satisfied.(74)

Finally, if the taxpayer is a partnership, corporation, or trust, the taxpayer must meet the net worth limitations applicable to awards of attorneys fees (i.e., net worth on a historical cost basis of less than $7 million).(75) These stringent net worth requirements imposed by the statute will preclude large entities from enjoying the benefits of the burden shifting statute. The Tax Court, however, has held that the net worth standard of section 7430 should be applied on a historical cost basis.(76) Thus, entities with a low historical cost basis in assets may be well-served to take a closer look at that computation before assuming that the new provision will not apply.

The burden shifting provisions are effective for court proceedings arising in connection with IRS examinations beginning after July 22, 1998. If there is no IRS examination, the provisions apply to court proceedings arising in connection with taxable periods or events beginning or occurring after July 22, 1998.

The burden shifting statute, while on its face seemingly generous to taxpayers, is not without significant costs, both financially and in terms of effort and time. For instance, satisfying the "cooperation" requirement could prove costly to taxpayers, particularly if the IRS overcompensates for the burden shift by engaging in more extensive audit techniques, including increased use of summouses, and burdensome pre-trial discovery. Moreover, the issue whether a taxpayer "cooperated" with the IRS will most likely prove a fertile ground for factual disputes to be resolved at the cost of additional litigation fees and court time.

More significant perhaps is the requirement that a taxpayer exhaust all administrative remedies. This provision will essentially force taxpayers to incur the additional costs and delay of pursuing Appeals resolution, regardless of how productive or reasonable that avenue may be. In some cases, such costs and delays can be avoided by bypassing Appeals after the audit (or altogether) and proceeding to trial, often an effective and judicious litigating tool. Thus, in light of this requirement, taxpayers and their advisers must carefully weigh the costs and benefits associated with shifting the burden of proof to the IRS in planning and evaluating their litigation strategy.

Small Tax Case Cap Increase

The Code provides special procedures for "small tax cases" that, under prior law, involved disputed deficiencies of $10,000 or less.(77) The Act increases the cap for small tax cases commenced after July 22, 1998 from $10,000 to $50,000.(78)

Decisions in small tax cases have no precedential value with regard to other cases and are not reviewable on appeal by either the taxpayer or the IRS.(79) Thus, the significant increase in the cap potentially sweeps in cases that otherwise would have precedential value for other taxpayers but that, under the small tax case procedure, will become meaningless for that purpose. The Conference Report provides that Congress anticipates that the Tax Court will carefully consider (1) IRS objections to small case treatment, such as those based on the potential precedential value of the case; and (2) the financial effect on the taxpayer, including fees and costs, of not using the small case procedure.(80)

Refund or Credit of Overpayments Before Final Determination

The IRS cannot take action to collect a deficiency during the 90-day period in which the taxpayer may petition the Tax Court with respect to that deficiency or, if a petition is filed, until the Tax Court's decision becomes final.(81) Under prior law, although action with respect to deficiencies was clearly enjoined, no statutory authority existed for a court to order the IRS to refund amounts relating to the deficiency that were collected by the IRS during the prohibited timeframes. Effective July 22, 1998, the Act provides that authority for a proper court (including the Tax Court) to order a refund of any amount relating to the deficiency at issue collected by the IRS during periods when it was prohibited from collecting the deficiency.(82)

Moreover, under prior law the Code provided no authority for a court to order a credit or refund of contested income tax for contested taxable years except under a final court decision.(83) Thus, if the court determined that an overpayment existed and the taxpayer was due a refund, there was no statutory authority for the court to order a refund of amounts that were not contested on appeal. Effective July 22, 1998, the Act supplies the statutory authority for the Tax Court to refund or credit any overpayment to the extent the overpayment is not contested on appeal.(84)

Notification of Deadline for Filing Petition

The Tax Court has jurisdiction over a tax case only if the taxpayer files a petition with the Tax Court within 90 days after a statutory notice of deficiency is mailed by the IRS.(85) The Act now requires the IRS to state on each notice of deficiency mailed after December 31, 1998, the date which the IRS determines to be the last day on which the taxpayer can file a Tax Court petition. Petitions filed by that designated date are considered to be timely filed for purposes of establishing Tax Court jurisdiction.(86) This requirement eliminates the risk that a taxpayer will be barred from proceeding in Tax Court as a result of misapplying the 90-day filing requirement.

Court-Ordered Awards

Taxpayers meeting certain net worth requirements (i.e., net worth of $2 million or less for individuals and $7 million or less for corporations or partnerships) who substantially prevail in an action against the United States in connection with the determination, collection, or refund or tax, interest, or penalty may recover reasonable administrative and litigation costs.(87) The Act amends the basis for and computation of that award for costs incurred after January 19, 1999.

Substantively, the Act liberalizes awards in cases where the government maintains an unreasonable position in two ways. First, in determining whether the government's position on an issue is "substantially justified," the court will consider whether the government lost in the courts of appeal for other circuits on substantially similar issues.(88)

Second, the Act builds in an additional incentive for the government to settle cases by treating a taxpayer as a "prevailing party" if the taxpayer makes a qualified offer that is rejected by the government and subsequently the judgment obtained by the government is equal to or less than the initial offer.(89) The taxpayer must make a qualified offer during the "qualified offer period," which begins on the mailing date of the first letter of proposed deficiency that allows the taxpayer an opportunity for administrative review in Appeals and ends 30 days before the date the case is first set for trial.(90) The offer must be in writing and must specify the amount of the offered liability.(91)

The qualified offer provision is a very meaningful amendment that should give the IRS considerable pause in litigating positions that could be deemed unreasonable or unsupported against taxpayers who are amenable to settlement and demonstrate that willingness with bona fide settlement offers. Because of this, taxpayers potentially eligible to recover fees should consider making qualified offers to maximize their chances of recovering fees.

Procedurally, the Act makes two changes to how awards are computed. First, under prior law, reasonable administrative fees were those incurred before the earlier of the date of the notice of deficiency or the date of the notice of an Appeals decision. The Act now fixes that cutoff date at the earliest of (1) the date of the notice of deficiency; (2) the date of the notice of an Appeals decision; or (3) the date the first letter of proposed deficiency is sent allowing the taxpayer an opportunity for Appeals review.(92) Second, the Act raises hourly caps on fee awards from $110 to $125 per hour (indexed for inflation), subject to adjustment for factors such as difficulty of the case or availability of expertise, and clarifies that an award of attorneys fees may be made to certain persons who represent taxpayers on a pro bono basis or for a nominal fee.(93)

Miscellaneous Provisions: Interest, Penalties and Refunds

1. interest Netting(94)

Concerns about the accumulation of interest on tax deficiencies prompted several key procedural and substantive amendments in the Act relating to the running of interest charges on deficiencies. Under prior law, taxpayers bore a higher rate of interest on underpayments than the IRS bore on overpayments. Specifically, underpayments bore interest at the short-term federal interest rate plus three percentage points.(95) The add-on increased to five percentage points for "hot interest" that applied to underpayments of large corporations. In contrast, overpayments bore interest at the short-term federal interest rate plus two percentage points.(96) For corporate overpayments in excess of $10,000, the add-on decreased the overpayment rate to one-half of a percentage point over the short-term federal interest rate.(97) As a result, in periods in which the taxpayer had overlapping underpayments and overpayments, even to the point of a zero net balance, the taxpayer could pay interest equal to the difference between the underpayment and overpayment rates, at rates as high as 4.5 percent.

The IRS under prior law attempted to cure this defect by netting underpayments and overpayments arising in the same tax period and applying a single interest rate, the amount of which depended on whether an underpayment or overpayment resulted from the netting.(98) If either the underpayment or overpayment had been satisfied, however, the IRS generally would not offset the two amounts, but rather assessed or credited interest on the full amounts of the underpayment or overpayment at the applicable rate. Hence, taxpayers who delayed the payment of underpayments kept those underpayments available for offset by any subsequently occurring overpayments and taxpayers who promptly paid tax liabilities were in effect penalized.(99)

After concluding that taxpayers should only be charged interest on the net amount they actually owe the IRS for all open taxable years, Congress in the Act adopted a system of global interest netting. Under this regime, taxpayers are charged a zero rate of interest on equivalent amounts of underpayment and overpayment on mutual indebtedness between the IRS and the taxpayer that exist for any period.(100) The Conference Report notes that the zero interest rate applies regardless of differentials in the applicable statutory interest rate such as "hot interest" on underpayments by large corporations or reduced rates on corporate overpayments.(101) Moreover, netting is available for (and between) any type of tax imposed under the Code.(102) It applies to partnerships as well as to other taxpayers.

In applying the netting principles, the Act directs the IRS to take into account interest paid on previously determined deficiencies or refunds, regardless of whether the underpayments or overpayments are currently "outstanding."(103) The Act further directs the IRS, where interest is both payable from and allowable to a taxpayer, to make all reasonable efforts to offset the liabilities rather than processing them using the zero net interest rate.(104)

Interest netting applies prospectively from July 22, 1998. It also applies for periods beginning before the date of enactment if (1) the taxpayer identifies and establishes the periods of overlapping underpayments and overpayments to which the zero net interest rate applies; and (2) the taxpayer requests the IRS to apply the zero net interest rate to those periods before December 31, 1999.(105) As a result of the potential savings resulting from the interest rate differentials in prior years, taxpayers should review all open tax years to determine whether underpayments and overpayments overlapped for any period of time and should act to apply the zero interest rate prior to December 31, 1999.

2. Refund Offset for State Income Tax Liabilities

The Act expands the IRS's refund offset program to now include past-due, legally enforceable state income tax debt that has been reduced to judgment or final administrative decision.(106) The revised priority for refund offsets is, as follows: (1) any federal tax liability; (2) past-due child support; (3) past-due, legally enforceable debt owed to a federal agency; (4) past- due, legally enforceable state income tax debt; and (5) future liability for federal tax.(107) Before applying the refund, the taxpayer must be notified by certified mail that the state proposes to collect the past-due state income tax liability by offset and the state must allow the taxpayer at least 60 days to prove that the debt is not past due or not legally enforceable.(108) The offset applies to refunds payable under section 6402 after December 31, 1999.

3. Reasons for Refund Disallowance

If the IRS disallows a taxpayer's claim for refund payable after December 31, 1999, the Act requires the IRS to provide the taxpayer with an explanation for the disallowance.(109) The notice requirement applies to complete and partial disallowances occurring after January 18, 1999.(110)

Conclusion

The procedural provisions of the IRS Restructuring and Reform Act for the most part represent a genuine attempt to enhance taxpayers' rights vis-a-vis the IRS. Although some provisions are ambiguous and should be addressed by regulations or congressional clarification, several provisions provide tactical and cost-recouping advantages that must be considered and, where appropriate, acted upon by taxpayers in a timely manner. As such, a careful review of present and potential tax controversies may generate significant benefits to taxpayers.

Notes

(1) Pub. L. No. 105-206, 112 Stat. 685.

(2) In Re Fischel, 557 F.2d 209, 211-12 (9th Cir. 1977); United States v. United Shoe Mach. Corp., 89 F. Supp. 357, 358-59 (D. Mass. 1950).

(3) See United States v. Adlman, 68 F.3d 1495 (2d Cir. 1995); United States v. Kovel, 296 F.2d 918 (2d Cir. 1961).

(4) See, e.g., Arthur Young & Co. v. United States, 465 U.S. 805 (1984) (denying privilege for accountant-client relationship with respect to tax accrual workpapers).

(5) I.R.C. [sections] 7525.

(6) I.R.C. [sections] 7525(a)(2).

(7) I.R.C. [subsections] 7525(a)(1), (3).

(8) I.R.C. [sections] 7525(b).

(9) H.R. Rep. No. 105-599, 105th Cong., 2d Sess. 89 (1998) (hereinafter "Conference Report").

(10) Id. at 88.

(11) I.R.C. [sections] 7525(a)(3)(B).

(12) I.R.C. [sections] 7525(a)(1); Conference Report at 88.

(13) Conference Report at 89.

(14) See Olender v. United States, 210 F.2d 795, 806 (9th Cir. 1954).

(15) See, e.g., United States v. Johnson, 465 F.2d 793, 795 (5th Cir. 1972).

(16) Conference Report at 89.

(17) Hickman v. Taylor, 329 U.S. 495 (1980). The work product doctrine has been extended to certain agents of an attorney. See, e.g., United States v. Nobles, 422 U.S. 225 (1975).

(18) I.R.C. [sections] 7811.

(19) Id.

(20) I.R.C. [sections] 7811(a)(2).

(21) I.R.C. [sections] 7426(h)(1).

(22) Id.

(23) Id.

(24) I.R.C. [sections] 7426(h)(2).

(25) I.R.C. [sections] 7609(a)(1).

(26) I.R.C. [sections] 7602(c)(1).

(27) I.R.C. [sections] 7602(c)(2).

(28) I.R.C. [sections] 7602(c)(3).

(20) I.R.C. [sections] 7609.

(30) I.R.C. [sections] 7609(a).

(31) Id.

(32) I.R.C. [sections] 7609(a)(1).

(33) Id.

(34) I.R.C. [sections] 7609(c)(2).

(35) I.R.C. [sections] 7609(j).

(36) See Powell v. United States, 379 U.S. 48 (1964) (standards for prima facie case for summons enforcement).

(37) I.R.C. [sections] 7612. The limitation does not apply to software or source code required to be provided in connection with the registration of tax shelters under section 6111. as Conference Report at 93.

(38) I.R.C. [sections] 7612(d)(1).

(40) I.R.C. [sections] 7612(d)(3).

(41) Id.

(42) I.R.C. [sections] 7612(d)(4).

(43) I.R.C. [sections] 7612(b)(1).

(44) I.R.C. [sections] 7612(c)(3).

(45) It is not clear from the statute whether this exception applies only to criminal offenses.

(46) I.R.C. [sections] 7612(b)(2).

(47) Conference Report at 94. See Powell v. United States, 379 U.S. 48 (1964).

(48) I.R.C. [sections] 7612(c)(4).

(49) For software acquired on or before July 22, 1998, the safeguards apply beginning October 20, 1998.

(50) I.R.C. [sections] 7612(c)(2)(A).

(51) I.R.C. [sections] 7612(c)(2)(B).

(52) I.R.C. [sections] 7612(c)(2)(G).

(53) I.R.C. [sections] 7612(c)(2)(C).

(54) I.R.C. [sections] 7612(c)(2)(D).

(55) I.R.C. [sections] 7612(c)(2)(F).

(56) I.R.C. [sections] 7612(c)(2)(E).

(57) I.R.C. [sections] 7612(c)(2)(H).

(58) I.R.C. [sections] 6501(c).

(59) I.R.C. [sections] 6501(c)(4).

(60) I.R.C. [sections] 7123.

(61) Conference Report at 113.

(62) I.R.C. [sections] 7123(b)(1).

(63) I.R.C. [sections] 7123(b)(2).

(64) Tax. Ct. Rule 142.

(65) See Danville Plywood Corp. v. United States, 899 F.2d 3, 9 (Fed. Cir. 1990).

(66) I.R.C. [sections] 7491(a)(1).

(67) Conference Report at 57.

(68) Id.

(69) I.R.C. [sections] 7491(a)(2)(A). The Conference Report identifies the following provisions as examples of these requirements: sections 6001, 6038, 6038A, 170(a)(1), 170(f)(8), 274(d), and 905(b). Conference Report at 56-58.

(70) I.R.C. [sections] 7491(a)(2)(B).

(71) Conference Report at 57.

(72) Id.

(73) Id.

(74) Id.

(75) I.R.C. [sections] 7491(a)(2)(C). See also I.R.C. [sections] 7430(c)(4)(A); 28 U.S.C. [sections] 2412(d).

(76) See Swanson v. Commissioner, 106 T.C. 76, 94 (1996).

(77) I.R.C. [sections] 7463(a).

(78) I.R.C. [sections] 7463.

(79) I.R.C. [sections] 7463(b).

(80) Conference Report at 61-62.

(81) I.R.C. [sections] 6213.

(82) I.R.C. [subsections] 6213(a), 6512(a)(5).

(83) I.R.C. [sections] 6512(b)(1).

(84) I.R.C. [subsections] 6512(a)(6) and (b)(1).

(85) I.R.C. [sections] 6213(a).

(86) I.R.C. [sections] 6213(a).

(87) I.R.C. [sections] 7430.

(88) I.R.C. [sections] 7430(c)(4)(B)(iii).

(89) I.R.C. [sections] 7430(c)(4)(E).

(90) I.R.C. [sections] 7430(g)(2).

(91) I.R.C. [sections] 7430(g)(1).

(92) I.R.C. [sections] 7430(c)(2).

(93) I.R.C. [sections] 7430(c)(3)(B).

(94) The Act's interest netting provisions were the subject of a separate article in the July- August 1998 issue of The Tax Executive. See Kathy L. Everidge, Taxpayer Actions required to Take Advantage of LongAwaited Interest Netting Legislation, 50 Tax Executive 261 (July-August 1998).

(95) I.R.C. [sections] 6621(a)(2).

(96) I.R.C. [sections] 6621(c).

(97) I.R.C. [sections] 6621(a)(1).

(98) Rev. Proc. 94-60, 1994-2 C.B. 774.

(99) Conference Report at 75.

(100) I.R.C. [sections] 6621(d).

(101) Conference Report at 75.

(102) I.R.C. [sections] 6621(d).

(103) Conference Report at 75-76.

(104) Conference Report at 76.

(105) Conference Report at 75.

(106) I.R.C. [sections] 6402(e).

(107) I.R.C. [sections] 6404(d)(2).

(108) I.R.C. [sections] 6402(e)(4).

(109) I.R.C. [sections] 6402(k).

(110) Conference Report at 120

APPENDIX D -- EDI TRANSACTION SETS

       Description

810    Generic Invoice

820    Remittance Advice
       (Payment Order)

824    Application Advice

850    Purchase Orders

856    Ship Notice/Manifest

861    Receiving Advice

862    Supplier Delivery Schedule
       (SDS)

997    Functional Acknowledgment

       Explanation

810    Standard electronic invoice sent by supplier to customer.

820    Instructions to the bank/payment (information) notification.

824    Computer-generated response to another ANSI X12
       transaction set. Example: Bank validates information
       sent on 820 was correct.

850    Standard electronic purchaser order sent to supplier.

856    Supplier acknowledges the order placed by customer.

861    Used for freight forwarders. Send 850 to vendor.

862    Similar to 861.

997    (Non-computer) Non-application response to all transaction
       sets. Generated by EDI translators checking for ANSI X12
       standards.

TAMARA L. FRANTZEN is an associate in the Kansas City office of Sonnenschein Nath & Rosenthal where she specializes in tax controversies and international tax matters. JANE WELLS MAY is a partner in the Chicago office of Sonnenschein Nath & Rosenthal where she specializes in tax controversies.