Reform of the federal civil tax penalty system is long overdue.
November 12, 2009
There are many areas of the tax law that are studied regularly with suggestions made for improvement. Yet, many of these reports and recommendations are continuously overlooked (see Remembering Forgotten Tax Issues, January 2009). This article reviews the purpose of penalties and describes key issues that indicate reform is needed. Selected recommendations from the studies are noted along with what it might take to actually improve this area of the federal tax law.
The list of studies on federal tax penalties includes the following reports, several of which are referenced in this article.
Mandated by the IRS Restructuring Act of 1998 (PL 105-206, July 1998):
National Taxpayer Advocate (NTA):
Governmental Accountability Office (GAO):
Treasury Inspector General for Tax Administration (TIGTA):
The primary purpose of tax penalties is to encourage voluntary compliance with the tax laws (or to discourage noncompliance). In its 1999 report, the JCT categorized civil penalties by type as follows (JCT, pages 18 - 27):
Tax penalties date back to the time of the Civil War. The start of modern day civil penalties was a five percent negligence penalty enacted in 1918. Over the years, the number of penalties increased with significant growth in the past two decades. The IRC of 1954 included 13 civil penalties. The number grew to about 75 by 1986 and to over 130 by 2008. (See Treasury (PDF), p. 19; and NTA (PDF), p. 4.) Reasons for this growth include additional information reporting rules, efforts to combat abusive tax shelters and lack of an overall penalty strategy that might better enable new penalties to conform to the existing structure.
Data from the IRS Statistics of Income (SOI) Division indicate the following quantity and dollar amount of civil penalty assessments for fiscal year 2008.
The most frequently assessed civil penalty was for failure to pay, representing 56 percent of the number of assessed return penalties. During fiscal year 2008, about three million civil penalties were abated totaling approximately $12 billion.
Described below is a sampling of the problems warranting reform of the civil-tax penalty-system.
Confusion of purpose: Some concern has been raised in recent years that the key purpose of penalties — encouraging voluntary compliance, is being thwarted. The 2008 NTA report suggests that in the 21st century, the philosophy for penalties shifted from voluntary compliance to "economic deterrence." The NTA describes the new policy as "ensuring that penalties are always developed and applied, especially if "a significant purpose" of the transaction was the avoidance or evasion of federal tax" (NTA (PDF), p. 11). The AICPA has noted a "worrisome trend" that some penalties may be designed to raise revenue (AICPA Report (PDF), p. 4). The American Bar Association (ABA) has observed that some penalties, such as §6707 and §6707A on reportable transactions, are designed "merely to punish rather than to encourage compliance" (ABA Report (PDF), p. 10).
Equity and fairness: Several inequities exist in the current penalty regime. Some penalties are not in proportion to each taxpayer's degree of non-compliance activity. For example, the §6651 failure to file penalty is five percent per month with a maximum penalty of 25 percent. As pointed out by the NTA, a taxpayer who files five months late has the same penalty as someone who files one year late or never (NTA (PDF), p. 25). The strict liability penalty of §6707A can be imposed for a minor oversight, where there is substantial compliance and in an amount beyond the tax owed (ABA Report (PDF), pages 8 &12; AICPA Report (PDF), pages 8 & 10).
Some penalties provide relief to larger taxpayers but not smaller ones. For example, §6721 generally imposes a penalty of $50 per incorrect information return limited to $250,000. Thus, a large taxpayer with over 5,000 incorrect returns is provided relief. The limit is not equitable in that it doesn't correlate to the percentage of incorrect returns filed. Also, as noted by Treasury (PDF) in 1984: "Maximum penalty amounts do not encourage compliance with the tax laws, nor do they promote uniformity of treatment among equals."
Inequities can also occur in inconsistent enforcement. As noted by TIGTA, taxpayers are not consistently charged interest on the failure to pay penalty because sometimes the "IRS is accruing rather than assessing this penalty."
Complexity: Some penalties can be complex due to use of subjective terms, complexity of calculations and if they can apply along with other penalties (stacking).
Logic and structure: Some penalties are out of proportion to the offense, as noted earlier for the §6707A penalties. Penalties of a fixed dollar amount become less effective over time because they are not adjusted annually for inflation.
Enforcement: High levels of penalty abatements and litigation might indicate problems with the penalty system. The NTA (PDF) reports that for 2008, three of the top ten most litigated tax issues involved penalties, such as the accuracy-related penalty (p. 13). Some penalties also have high abatement rates. For example, 13 percent of the failure to file penalties (§6651(a)(1)) representing 41 percent of the amount assessed in fiscal years 2003 to 2005 were abated as of March 2008 (p. 14). The NTA notes that "some penalties the IRS frequently abates may need to be modified to promote more efficient administration and avoid burdening taxpayers and the IRS with unnecessary assessments. Frequent abatements could also be evidence that the IRS has difficulty determining when a taxpayer has violated a rule, or is taking shortcuts when making assessments" (p. 15).
A tax system with 130 civil penalties, various inequities and complexities and without a cohesive underlying approach or policy, does not bode well for a strong system of voluntary compliance. Reform is needed. Reform efforts should find ways to reduce the number of penalties by using similar penalties for similar types of problems.
The principles of equity, economy in collection, simplicity and transparency must be considered in the reform effort. The set of reports listed earlier are comprehensive and thoughtful with numerous recommendations for improving the system. Reform should be accomplished in a single legislative act rather than piecemeal to be sure that the entire structure is logical and supports voluntary compliance.
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Annette Nellen, CPA, Esq., is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the ABA and AICPA. She serves on the AICPA's Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.