National Taxpayer Advocate Nina Olson said in her annual report to Congress that taxpayers affected by the recession should be treated more compassionately by the IRS.

"When the IRS contemplates taking enforced collection action against a taxpayer, both the Tax Code and IRS procedures require that IRS personnel consider whether the collection action will impose an economic hardship on the taxpayer," said the report. "When the economy struggles and more taxpayers become unable to pay their tax liabilities, the importance of considering the impact of collection actions on taxpayers and their families becomes critical."

The IRS announced several measures on Tuesday to aid struggling taxpayers, including greater authority to suspend collection actions in certain hardship cases (see IRS Pledges to Help Financially Distressed Taxpayers). "Current IRS guidance provides little direction to help IRS employees identify taxpayers who are experiencing economic hardship and prevent undue economic burden," Olson wrote.

She recommended that the IRS make greater use of collection alternatives when economic hardship is present. Those include offers in compromise and partial-payment installment agreements. Olson (pictured) also said the IRS should ease the burden of rules that subject people to taxes on canceled debts.

She also said the IRS should implement a "screen" to protect low-income Social Security recipients from continuous, automated tax levies. Olson noted that under the Federal Payment Levy Program, the IRS is authorized to withhold 15 percent of any federal payment made to a delinquent taxpayer. Using this authority, the IRS levied against 1.8 million payments to Social Security recipients in 2008. Olson's office estimates that more than 25 percent of these taxpayers had incomes below the poverty level and more than one-third would likely be classified by the IRS as unable to pay if their cases were subject to human review. However, the automated levy system does not use built-in screens to identify and shield these taxpayers.

Olson also called for tax simplification measures, especially in the alternative minimum tax and in tax breaks for education and retirement savings. She also reiterated a longstanding recommendation that Congress regulate unenrolled tax preparers to protect taxpayers from preparer errors and exploitation.

Her report also proposed reforming the penalty provisions in the Tax Code, especially for tax shelters. She noted that Section 6707A imposes a penalty of $100,000 per individual per year and $200,000 per entity per year for failure to make special disclosures of a "listed transaction." The penalty creates what Olson calls "unconscionable" results and may have the effect of bankrupting middle-class families who had no intention of entering into a tax shelter.

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