PART 3 REPRESENTATION, PRACTICE, AND PROCEDURES. Taxpayer's ability to pay the tax (e.g., installment agreements, offer in compromise)

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1 PART 3 REPRESENTATION, PRACTICE, AND PROCEDURES Section 2: Representation before the IRS Part 3 Taxpayer s Financial Situation Taxpayer's ability to pay the tax (e.g., installment agreements, offer in compromise) IRS encourages taxpayers to use installment payment plans for delinquent taxes. Approval of an application for an installment plan is guaranteed if the amount of tax due is no more than $10,000. The offer in compromise is a means by which to negotiate the principal amount of the tax deficiency where the taxpayer's financial position makes it unlikely that the full amount of tax, penalty, and interest will be collected. a. Such offers may include reductions in tax or penalty amounts, or installment payment plans (perhaps for the reduced amounts). b. The IRS can waive the user fee for an offer in compromise, and allows a delay in the payment schedule, if the taxpayer s income level is modest. Offers in compromise are appropriate in the following situations. a. There is doubt as to the taxpayer s liability. b. Collectibility of the full tax is questionable. c. Disputed tax amount would cause an economic hardship for the taxpayer. Closing agreements are quite common and serve a useful purpose of getting the water under the bridge. They are almost a must with the winding up of sizable estates and the liquidation of large corporations. They are binding on both the IRS and the taxpayer.

2 General financial health (e.g., filed for bankruptcy, lawsuits, garnishments, Liquidation under Chapter 7 is a common form of bankruptcy. It is available to individuals who cannot make regular, monthly, payments toward their debts. Businesses choosing to terminate their enterprises may also file Chapter 7. Chapter 7 provides relief to debtors regardless of the amount of debts owed or whether a debtor is solvent or insolvent. A Chapter 7 Trustee is appointed to convert the debtor s assets into cash for distribution among creditors. To take full advantage of the bankruptcy laws and get a fresh start, it is important that taxpayers do not continue to incur additional debt. If all or part of the reason taxpayers are filing bankruptcy is overdue federal tax debts, they may need to increase their withholding and/or estimated tax payments. Find basic information about Chapter 7 bankruptcy below. For more detailed information see the U.S. Courts Bankruptcy Basics web page. Federal Tax Refunds During Bankruptcy Taxpayers can receive tax refunds while in bankruptcy. However, refunds may be subject to delay, to turnover requests by the Chapter 7 Trustee, or used to pay down tax debts. Discharge At the conclusion the Chapter 7 bankruptcy taxpayers will receive a discharge of debt. A discharge releases the debtor from personal liability for certain dischargeable debts. Some taxes may be dischargeable. Whether a federal tax debt may be discharged depends on the unique facts and circumstances of each case. Taxpayers should consult with a bankruptcy attorney to determine which tax debts may be discharged.

3 Lawsuit and Settlements and Award Proceeds The following determinations should be made when reviewing lawsuit verdicts and settlements received after August 20, Determine if any taxable lawsuit, award or settlement proceeds are unreported. Determine if proper amounts were allocated between compensatory and punitive damages. This is especially important for out of court settlements. Because many cases are settled to avoid the imposition of punitive damages, it is anticipated that some taxpayers may erroneously allocate amounts between excludable and punitive damages in these cases. This allocation may also have an impact on the deductibility of attorneys fees and court costs since IRC 265 expressly denies any deduction for expenses related to tax-exempt income. Determine if any of the lawsuit, award or settlement proceeds constituted punitive damages. All punitive damages are taxable whether received in relation to a physical or non-physical injury or sickness. (Caution: See IRC 104(c) exception when applicable State law provides only punitive damages may be awarded in wrongful death actions, i.e., Alabama.) Determine if any of the settlement proceeds are designated as interest, and if so, such interest is reported as income. Verify that amounts excluded from income were received in a case of physical injury or physical sickness. Damages for emotional distress on account of physical injuries or sickness are excludable by IRC 104(a)(2). However, costs incurred to treat emotional distress, even those due to physical injury, are taxable if they were previously deducted as a medical expense in a prior year. Verify the amount of out of pocket expense excluded for emotional distress in non-physical injury cases (e.g., discrimination, fraud, etc.). Damages for emotional distress in these cases are only excluded to the extent of paid medical expenses. Verify that the taxpayer reported taxable amounts at gross rather than reporting them net of legal and other fees paid. Determine if allowable legal fees were deducted properly. They should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C or a capital transaction.

4 Verify that expenses were paid on or after October 24, 2004 in cases involving IRC 62(a)(20) (relating to costs involving discrimination suits). For cases involving IRC 62(a)(21) (relating to the deductibility of attorney fees paid in connection to a whistleblower s award), verify the information provided as part of the claim had been provided on or after December 20, In both instances, verify total deductions have been limited to the amount includible in the taxpayer s gross income on account of the underlying discrimination suit or whistleblower award. These sections allow above the line deduction of legal costs. Verify that for a non-corporate taxpayer, legal fees deducted as a Schedule A miscellaneous itemized deduction are not allowed for purposes of computing the alternative minimum tax (AMT). Verify that for purposes of the AMT Credit, legal fees that are disallowed for purposes of calculating the AMT do not contribute to the amount of the credit. They are "exclusion" items. Taxability of Lawsuit Payments General rule relative to taxability of amounts received from lawsuit settlements is IRC 61 that states that all income is taxable from whatever source derived, unless exempted by another section of the Code. Terminology/Definitions

5 Types of Claims Tort: A civil wrong, not involving breach of contract, for which a remedy may be obtained; A wrongful act committed by one person against another person or his/her property; The breach of a legal duty imposed by law, other than by contract; May cause or constitute, but is not necessarily, a personal injury. A tort award may be received from litigation or settlement of a claim for physical injury or illness, mental pain and suffering, interference with economic relations, and/or property damage. Example 1 X punches Y, thus committing the tort of battery. Example 2 X sets foot on Y s property, thus committing the tort of trespass, but causing no personal injury. Contractual: Claims based on rights given by contract. A remedy provided specifically by the contractual agreement or as interpreted by a court. Whether damages based on a contractual claim are taxable usually depends on the underlying claim. Example 3 X forces Y to leave his employment before the time specified in an employment contract, thereby breaching the contractual agreement. Example 4 X refuses to pay Y the amount specified in a homebuilding contract, thereby breaching the contractual agreement.

6 Types of Damages/Awards Compensatory Damages intended to compensate the taxpayer for a loss, i.e., payment to compensate the injured party for the injury sustained, and nothing more. This loss may be purely economic, for example, arising out of a contract, or personal, for example, sustained by virtue of a physical injury. Generally speaking, most people view the term "compensatory" to mean "nontaxable." However, the term compensatory merely means that the payment compensated the taxpayer for a loss. Thus, determinations of the taxability of lawsuit awards cannot always be made by simply referring to the terminology used, that is, compensatory or punitive; contractual or tort. For example, not all torts constitute personal injuries. Some torts may involve invasion of property rights, conversion, interference with economic interests, tortious interference with contractual relations, purely personal interests, or defamation. Further, not all compensation payments for personal injuries are received on account of any personal physical injury or illness. Moreover, damages arising from contractual claims can be taxable, such as those paid for lost wages and benefits, profits, and other forms of business receipts, or non-taxable. For example, X receives an insurance policy to replace one previously purchased that had lapsed due to an insurance agent s misappropriation of premiums paid. The facts and circumstances of each lawsuit settlement must be considered to determine the purpose for which the money was received. Then, it can be determined whether these amounts are excludable. A key question is In lieu of what were the damages awarded? Finally, if prior deductions under IRC 213 or any other applicable Code section were taken (that is, medical deductions; interest expense, attorney fees, etc.) then pursuant to the Tax Benefit Rule, amounts received for reimbursement of these expenses would be taxable to the extent includible under IRC 111.

7 Punitive Generally, punitive damages are not awarded for simple breach of contract or negligent tort. They are added to any compensatory damages where the defendant acted recklessly, with malice or deceit, or in any other manner that would justify penalizing the wrongdoer or making an example to others. Punitive damages are often awarded when the defendant acted Knowingly Willingly Deliberately Recklessly Fraudulently Generally, punitive damages are taxable, but there are exceptions (See Wrongful Death discussed below.) Resolution of Claims Determining the correct allocations among taxable payments and non-taxable payments is usually the most difficult part of an examination. Claims are generally resolved in one of two ways: Jury/Court Verdicts If damages have been clearly allocated to an identifiable claim in an adversarial proceeding by judge or jury, the Service will usually not challenge their character because of the impartial and objective nature of the determinations. However, care should be taken where the Court s decision is simply a ratification of a settlement entered into by the parties. See Robinson v. Commissioner, 102 T.C. 116, 122 (1994), aff d in part and remanded, 70 F.3d 34 (5th Cir. 1995) and Kightlinger v. Commissioner, T.C. Memo In Robinson, the Court incorporated the parties allocation of damages in its judgment by reference to their settlement agreement. However, the Service successfully argued that the allocation was not a bona fide allocation that was reached at arms length. Robinson, 102 T.C.at 133. Although both of these cases are pre 1996 Amendment cases, they show how in cases where there was not an impartial and objective determination of the allocation of the award to its components, a reconsideration of the allocation is warranted.

8 Settlements Out of Court Many lawsuits are settled prior to a jury verdict. When damages are received pursuant to a settlement agreement, the nature of the claim that was the actual basis for settlement controls whether such damages are excludable under IRC 104(a)(2). These settlements should be closely reviewed, and the underlying facts and circumstances should be carefully determined. The allocation among the various claims of the settlement can be challenged where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement. See these pre 1996 Amendment cases to illustrate such reallocations; Bagley v. Commissioner, 105 T.C. 396 (1995), aff d, 121 F.3d 393 (8th Cir. 1997); Robinson v. Commissioner, 102 T.C 116, 122 (1994), aff d in part and remanded, 70 F.3d 34 (5th Cir. 1995);.Phoenix Coal Company, Inc. v. Commissioner, 231 F.2d 420 (2d Cir. 1956). The Court in LeFleur v. Commissioner, T.C. Memo , a pre 1996 Amendment case, addressed the reallocation issue in a case involving claims for breach of contract, emotional distress (pain and suffering), and punitive damages. In an out-of-court settlement, the parties expressly agreed to allocate $800,000 of the $1 million sum to personal injuries, $200,000 to contract, and none to punitive damages. The taxpayers included the $200,000 of settlement proceeds allocated to the contract claim in their gross income on Schedule C, and excluded the $800,000 allocated to the personal injury claim under IRC 104(a)(2). The Service disregarded the terms of the written settlement agreement and reallocated the previously excluded $800,000 to income. The Tax Court upheld the IRS s reallocation and referring to the settlement agreement stated, "the allocation did not accurately reflect the realities of the petitioner s underlying claims." LeFleur at 9. In determining the $800,000 was not excludable under IRC 104(a)(2), the Court stated: In light of the facts and circumstances, we conclude that petitioner suffered no injury to his health that could be attributed to the actions of the defendants, and we are not persuaded that such injury was the basis of any payment to him. LeFleur at 10. For additional information on issues dealing with the allocation or reallocation of settlements, see discussions of "Physical Injury or Sickness" and "Non-Physical Injury or Sickness" below.

9 Tax Treatment of Awards and Settlements Awards and settlements can be divided into two distinct groups. One group includes claims arising from a physical injury and the other group includes those arising from a non-physical injury. The claims from each of the two groups will usually fall into three categories: 1. Actual damages resulting from the physical or non-physical injury; 2. Emotional distress damages arising from the actual physical or non-physical injury; and 3. Punitive damages Garnishments If a levy on wages, bank account or other property is causing a hardship, the taxpayer should: Contact the IRS at the telephone number on the levy or correspondence immediately and explain your financial situation. Service is available from 8 a.m. to 8 p.m. local time, Monday through Friday. If it is determined the levy is creating an immediate economic hardship, the levy may be released. A levy release does not mean taxpayers are exempt from paying the balance. The IRS will work with taxpayers to establish payment plans or take other steps to help pay off the balance. Employers generally have at least one full pay period after receiving a Form 668-W, Notice of Levy on Wages, Salary and Other Income before they are required to send any funds from their employee s wages..

10 Discharge of the tax liability in bankruptcy The Bankruptcy Code provides rules for debtors to consolidate and resolve their debts to various creditors, including the Service, in various ways. Section 301 of the Bankruptcy Code allows debtors to commence a bankruptcy case by filing a voluntary petition with the bankruptcy court. Once a petition is filed, creditors have an opportunity to file proofs of claim. 11 U.S.C A proof of claim asserts the right of a creditor to payment and can include rights that are fixed, contingent, liquidated, or unliquidated. See 11 U.S.C. 101(5). A properly filed proof of claim is prima facie evidence of the validity and amount of the claim. Fed. R. Bankr. P. 3001(f). The proof of claim is deemed allowed, unless a party in interest objects. 11 U.S.C. 502(a). If a party in interest objects, the bankruptcy court, after notice and a hearing, determines the validity and amount of the claim as of the date of the petition and allows the claim in the proper amount. 11 U.S.C. 502(b). Generally, the bankruptcy court may determine the amount or legality of any tax, any fine or penalty relating to a tax, or any addition to tax, whether or not previously assessed and whether or not paid. 11 U.S.C. 505(a)(1). This includes the determination of the eligibility of a debtor for relief from joint and several liability under section 6015 in appropriate cases. See In re French, 242 B.R. 369 (Bankr. N.D. Ohio 1999). The determination of the bankruptcy court on the merits of a claim is a final judgment and, unless appealed, is binding on the parties to a contested matter. See Freytag v. Commissioner, 110 T.C. 35 (1998). The determination also precludes subsequent litigation by a debtor over the merits of the liability under principles of res judicata. See id. at 40. The Supreme Court in Commissioner v. Sunnen explained the rule of res judicata: [W]hen a court of competent jurisdiction has entered a final judgment on the merits of a cause of action, the parties to the suit and their privies are thereafter bound not only as to every matter which was offered and received to sustain or defeat the claim or demand, but as to any other admissible matter which might have been offered for that purpose. 333 U.S. 591, 597 (1948) (quoting Cromwell v. County of Sac, 94 U.S. 351, 352 (1876)). Although filing a bankruptcy petition commences a case, a bankruptcy case is simply an aggregation of controversies. See In re Martin Bros. Toolmakers, Inc., 796 F.2d 1435, 1437 (11th Cir. 1986). In order to bring a controversy before the bankruptcy court, a party generally moves for relief in a contested matter under

11 Federal Rule of Bankruptcy Procedure 9014 or initiates an adversary proceeding under Rule The merits of a tax liability are generally raised in one of two ways. Either the debtor or the Service can seek a determination of a tax liability under section 505 of the Bankruptcy Code, or a party in interest can object to a proof of claim listing tax liabilities under section 502(a). See In re Taylor, 132 F.3d 256, 262 (5th Cir. 1998). Unless a party in interest moves for relief or initiates a proceeding, the merits of a tax liability are not before the bankruptcy court, and the bankruptcy court does not inquire into the merits of the tax liability or enter a final judgment fixing the tax liability. IRS Collection Financial Standards Collection Financial Standards are used to help determine a taxpayer's ability to pay a delinquent tax liability. Allowable living expenses include those expenses that meet the necessary expense test. The necessary expense test is defined as expenses that are necessary to provide for a taxpayer s (and his or her family's) health and welfare and/or production of income. National Standards for food, clothing and other items apply nationwide. Taxpayers are allowed the total National Standards amount for their family size, without questioning the amount actually spent. National Standards have also been established for minimum allowances for out-ofpocket health care expenses. Taxpayers and their dependents are allowed the standard amount on a per person basis, without questioning the amount actually spent. Maximum allowances for housing and utilities and transportation, known as the Local Standards, vary by location. In most cases, the taxpayer is allowed the amount actually spent, or the local standard, whichever is less. Generally, the total number of persons allowed for necessary living expenses should be the same as those allowed as exemptions on the taxpayer s most recent year income tax return. If the IRS determines that the facts and circumstances of a taxpayer s situation indicate that using the standards is inadequate to provide for basic living expenses, we may allow for actual expenses. However, taxpayers must provide documentation that supports a determination that using national and local expense standards leaves them an inadequate means of providing for basic living expenses.

12 Third-party research (e.g., property assessment for municipal taxes, asset values, state and local tax information)