A year ago the JofA gave readers a look at the blueprint for the new IRS (see “IRS Begins Its Metamorphosis,” JofA , Mar.99, page 23). It has taken some time, but finally the service is putting into place the structure that will characterize the IRS of the 21st century.

Commissioner Charles O. Rossotti outlined the agency’s reorganization at The New IRS Stands Up, a conference on IRS modernization presented by the service and cosponsored by the AICPA, the ABA Section of Taxation, the American Tax Policy Institute, the National Association of Enrolled Agents and the Tax Executives Institute.

“Although modernizing the IRS is not Mission Impossible, neither is it Fantasy Island, ” said Commissioner Rossotti of the ups and downs of the colossal undertaking. “The purpose of the reorganization is to improve the entire way the IRS works.”

Michael E. Mares, the immediate past chairman of the AICPA tax executive committee, said, “This reorganization is like trying to change a jet engine on a plane as it is flying over the ocean.” The IRS has managed to keep the plane in the air while making enormous changes. The modernized organizational structure combined with new technology will give the IRS the ability to deliver faster and better customer service in the future, Mares said.

The IRS’s new structure is designed to efficiently meet the distinct needs of specific groups of taxpayers. The service has moved away from its traditional geographical orientation and adopted the customer focus and quality models used in industry today. Four operating divisions are replacing the regional-office structure. The new organization will improve customer service to taxpayers, reduce inconsistencies in practices and policies and increase management accountability within the IRS.

Though the IRS will continue to refine its new structure over the next several years, it is already well into the implementation of this modern configuration.

Last December, the Tax Exempt and Government Entities Division (TE/GE) became the first of the four divisions to begin operating. (See “IRS Establishes New Business Unit,” JofA , Feb.00, page 20.) This division will provide service to employee plans (of which there are more than a million, both private and public, representing $4.1 trillion in assets), exempt organizations (more than 1.5 million organizations with $1.3 trillion in assets) and government entities (86,000 federal, state and local entities and 559 federally recognized Indian tribes).

Division Commissioner Evelyn Petschek leads this unit. She had served as IRS assistant commissioner of employee plans and exempt organizations from 1996 until she assumed this position.

The Large and Mid-Size Business Division (LMSB), which is directed by Larry R. Langdon, will begin operation this month. A veteran of industry, Langdon was vice-president for tax, licensing and customs at Hewlett-Packard Co. before joining the IRS to run the large business unit.

LMSB serves corporations, S corporations and partnerships with more than $5 million in assets. It has five industry units: financial services and health care (headquartered in Manhattan); retailers, food and pharmaceuticals (Chicago); natural resources (Houston); communications, technology, and media (the San Francisco Bay area); and manufacturing, construction and transportation (central New Jersey).

The TE/GE and LMSB operating divisions are both headquartered in Washington, D.C. The remaining operating divisions, Small Business and Self-Employed (SB/SE) and Wage and Investment (W&I), which will have their national headquarters in New Carrollton, Maryland, and Atlanta, respectively, are scheduled to begin operation in the fourth quarter of this year.

Joseph Kehoe, who worked as a consultant with Pricewaterhouse-Coopers for 26 years, will be commissioner of the SB/SE division. The 40 million taxpayers in this group pay $915 billion in taxes. Approximately 39,000 IRS employees will staff the division. It will serve 7 million small businesses (companies and partnerships with assets of $5 million or less) and 33 million self-employed taxpayers. It will also serve estate and gift tax filers, fiduciary return filers and individuals who file international tax returns.

The fourth and largest operating division is the Wage and Investment Division. W&I will serve the 90 million tax filers who pay about $380 billion annually in taxes. The division will be divided into three main operating units—communications, assistance, research and education, customer account services and compliance. It will emphasize taxpayer education.

John M. Dalrymple will oversee the 21,000 W&I employees. Prior to his appointment, he served as chief operations officer of the IRS. He joined the service in 1975 as a revenue officer.

Rossotti said that the success of the agency’s new reorganization hinged on whether the IRS would be able to use its limited resources productively and provide its employees with the necessary tools and training to do a quality job.

“The new organization is not the real change that will occur at the IRS. It merely enables the IRS to change,” Rossotti said. “It is the new leadership teams and the thousands of employees who will make the difference. Over time, they—not the structure—will produce the real change in service, compliance and productivity in the IRS.”

The IRS’s new focus on the needs of specific taxpayer groups and better service is a result of the landmark IRS Restructuring and Reform Act of 1998.

On August 3, 1994, Irma Drye died without a will, leaving her son and sole heir, Rohn, an estate worth $236,000. Rohn was insolvent and owed the IRS approximately $325,000. The IRS had valid tax liens against all of his property. So, Rohn disclaimed all interest in his mother’s estate, letting it pass to his daughter, Theresa.

Theresa subsequently established a trust naming her parents and herself as beneficiaries. She gave a third-party trustee the discretionary power to dispense funds to the family for health care and financial support.

The IRS served a notice of levy on the trust assets to satisfy Rohn’s federal tax debt. The trust countered with a suit for wrongful levy.

The district court, however, sided with the IRS and ruled the tax liens were valid and Rohn’s disclaimer was fraudulent. On appeal, the Eighth Circuit Court of Appeals affirmed the decision. It held that a federal tax lien attaches to property inherited by a taxpayer, even if that taxpayer later disclaims any interest in the property under state law. Since this result conflicted with other court decisions, the U.S. Supreme Court agreed to review the appellate court ruling.

According to IRC section 6321, if a taxpayer doesn’t pay his or her federal taxes, the IRS can attach a tax lien to any property a taxpayer owns or subsequently acquires. In its decision, the Supreme Court observed that the language in this section is broad and meant to encompass any interest in property that a taxpayer might have.

The Court also examined IRC section 6334(a), which contains an exclusive list of property exempt from levy. The list does not include inheritances disclaimed under state law.

Speaking for the Court, Justice Ruth Bader Ginsburg agreed with the Eighth Circuit and held Rohn’s right to inherit constituted a valuable and transferable property right. The Court upheld the earlier ruling that the tax lien against the trust was valid.

Observation: Often CPAs are the only ones who know of a client’s tax predicament. You should advise any client in a similar situation to consider disclosing the situation to his or her parents. Under circumstances of that kind, the parents could amend their wills to avoid having their estate go to the government to pay off a child’s debt.

• Rohn F. Drye Jr., v. United States, Sup. Ct. 1999.

—Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.

A professional medical corporation specializing in oncology and hematology maintained a two-week supply of chemotherapy drugs on its premises. Nurses administered the drugs, but a physician was always on site to respond to emergencies. The drugs could not be self-administered and patients could select neither the type or the quantity of drugs for treatments. Under state law, only a doctor could prescribe these drugs and only a licensed pharmacist could sell them.

The IRS challenged the corporation’s use of the cash basis of accounting. The service forced it to inventory the drugs and to include the related accounts receivable in income.

The corporation argued it was not selling the drugs but providing medical services for which the cash basis of accounting was allowed. The taxpayer believed the administration of the drugs was an integral part of the service provided.

The Tax Court sided with the taxpayer and held that the drugs were not “merchandise” under regulations section 1.471-1, and, therefore, the taxpayer properly used the cash method of accounting to deduct the drugs currently as supplies. ( Osteopathic Medical Oncology and Hematology, PC v. Commissioner, 113 TC no. 26, 11-22-99.)

Service Gives Heads Up on Tax Shelters

The IRS announced in Notice 99-59 (1999-52 IRB) that it was going after another “tax product” designed to generate tax losses. The service described a bond and options sales strategy involving a partnership and a foreign corporation, which generated a loss but lacked economic substance. According to the IRS, taxpayers using these shelters claimed artificial losses for capital outlays that they had in fact recovered.

The IRS warned that such losses would not be allowed for tax purposes. The service intends to impose penalties not only on taxpayers that participate in such schemes but also on individuals who promote or report them on tax returns.

No Depreciation for Demos

A large furniture maker displayed in several of its showrooms units it manufactured. The company claimed it generally did not sell the displays to the public unless they were damaged or discontinued. The company also claimed its furniture sometimes remained on the showroom floor for up to 10 years. Consequently, the furniture maker had been depreciating the displayed furniture, using a five-year life for the products.

An IRS examiner disagreed with the company, stating the furniture pieces were displayed on the showroom floor for a much shorter period and were in excellent condition when sold. Moreover, in field service advice 199949031, the IRS determined that displayed furniture was inventory and could not be depreciated.

The IRS concluded that the manufacturer sold the furniture to the public in the ordinary course of business. It said, however, that if the furniture maker could prove any of the furniture had been on display for 10 years, it would consider allowing the company to take a depreciation deduction for those units.

—Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.

In 1998, Congress added section 7525 to the Internal Revenue Code, creating an accountant/client privilege. Like the privilege that already exists between attorneys and their clients, it extends to tax advice but not tax return preparation. A recent decision by the Seventh Circuit Court of Appeals examined the scope of this privilege.

Taxpayers Randolph and Karin Lenz, and their corporation, KCS Industries, were under IRS investigation. They hired Richard Fredrick, an attorney and accountant, to represent them. The IRS issued summonses to Fredrick asking him to turn over hundreds of documents. Fredrick refused to do so. The district court ruled that some of the documents were not protected by privilege. He appealed the decision.

Result. For the IRS. This case presented a number of different privilege-related issues. The first question the Seventh Circuit addressed was whether numerical information was subject to privilege. The court held that, although rare, it was possible for such information to be privileged. It used as examples an attorney’s estimate of damages or the amount a client stole. Based on these examples, it appears few, if any, of an accountant’s numerical workpapers will be eligible for privilege.

The second issue the court considered concerned dual-purpose documents—those an attorney or accountant creates for use in preparing a client’s tax return, as well as for use in litigation or providing tax advice. The Seventh Circuit concluded that such dual-purpose documents are not privileged.

The Seventh Circuit also considered documents an attorney or accountant creates in connection with an IRS audit. The court said these documents could be privileged in certain situations. If the documents are used to determine the client’s tax liability or the accuracy of the filed return, they are not privileged. If the documents discuss statutory interpretations or case law, they are privileged. As indicated above, if the attorney or accountant uses them for both purposes, they are subject to IRS summons.

Although the case itself involved issues related to attorney/client privilege, the Seventh Circuit also addressed the scope of the new accountant/client privilege. The court said the latter privilege covers only communications between the client and his or her accountant, not the accountant’s work product. If other courts accept the Seventh Circuit’s conclusions, section 7525 will provide a very limited benefit to taxpayers and accountants.

• U.S. v. Richard Fredrick, 99-1 USTC 50, 465, 83, AFTR 2d 1870, CA-7.

—Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.