JCT Staff Report on Selected Tax Procedure and Administration Issues" (4/26/13)

The Staff of the Joint Committee on Taxation has published "Present Law And Background Information Related To Selected Tax Procedure And Administration Issues" dated April 14, 2013, available here.

The three principal topics are (as presented):

I.  Background and Federal Tax Provisions and Practices Implicated in Identity Theft Fraud
II.  Authority to Regulate the Conduct of Paid Tax Return Preparers.
III. Civil Tax Penalties as a Factor in Voluntary Compliance.

I focus here on the last item -- Civil Tax Penalties as a Factor in Voluntary Compliance.  The subtopics are:

A. Civil Assessment Process
B. Civil Tax Penalties
Overview of penalties
Legislative and other history
Selected Issues Raised by Practitioner Groups and Others

The first first of these subtopics -- A. Civil Assessment Process -- is short and probably already known to readers of this blog.  Hence, I do not dwell upon that portion of the Report.  The first two divisions of the second subtopic - B. Civil Tax Penalties -- is probably also known to readers, hence I focus only on the last (Selected Issues) and quote it in its entirety (footnotes omitted), although it too is cryptic.

Whether penalties encourage voluntary compliance 

One criticism of the current regime is that many of the penalties which have been enacted, particularly over the past decade, seem to be designed for the purpose of raising revenue or punishing taxpayers rather than encouraging voluntary compliance. To support this assertion, practitioner groups and others have pointed to the strict liability penalty created under section 6662(b)(6) which imposes a penalty on transactions which lack economic substance and the strict liability penalty provided under section 6707A for failure to disclose reportable transactions. They argue that the lack of a reasonable cause defense under these provisions eliminates the opportunity, and the incentives, to remediate and to become compliant. Under section 6707A, for example, the penalty may be imposed even if the failure to disclose the transaction is not willful but instead inadvertent (perhaps because the taxpayer could not identify whether a transaction was a reportable transaction).

On the other hand, the fact that revenue increases due to penalties is not dispositive of this point and Congressional intent in enacting penalty legislation has generally been to improve compliance. Thus, if a penalty is effective it will raise revenue though the penalty is never in fact assessed. 

Whether standards in some penalties are sufficiently clear 

Practitioners point out that penalties relating to potentially abusive transactions has made this area inconsistent and confusing with respect to disclosure and reasonableness of questionable positions. For example, if a substantial understatement penalty imposed on an individual is attributable to a transaction with a significant purpose of tax avoidance that is not a reportable transaction and that has economic substance, that individual can raise a defense to the penalty by relying in good faith on the opinion of a professional tax advisor, without disclosure and without establishing that the position had a "more likely than not" level of confidence. 

On the other hand, for listed transactions (and transactions substantially similar to listed transactions) and other reportable transactions having a significant purpose of tax avoidance, disclosure, substantial authority and a reasonable belief that the treatment was more likely than not the proper treatment and the presence of economic substance are prerequisites to a reasonable cause and good faith defense, and special rules apply to determine whether the tax advisor or tax opinion is "disqualified." For the same reportable transaction, if a taxpayer is able to demonstrate a lack of a significant purpose of tax avoidance or evasion, and that the transaction is not a listed transaction or substantially similar to a listed transaction, no penalty will apply if the taxpayer discloses the relevant facts relating to the questionable position and can demonstrate a reasonable basis for the tax treatment. 

Perception that automatic assessment of penalties lacks procedural fairness 

The IRS automatically assesses penalties through the application of its automated matching system under section 6038(b)(1) for failures to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and under section 6651(a)(1), for failures to file. 

Practitioners and others have noted that when penalties are imposed automatically, there is no mechanism in place to first determine whether the taxpayer's error was the result of particular conduct of a type that merits a penalty. Though such penalties may later be abated, one group has argued that in many cases, taxpayers pay penalties even if they are unwarranted because of the difficulty and expense involved in challenging an assessed penalty. 

Whether penalties are disproportionate 

Some penalties are not in proportion to each taxpayer's degree of non-compliance. For example, the failure to file penalty under section 6651 of the Code is five percent per month with a maximum penalty of 25 percent. Thus, although a taxpayer who files five months late is penalized more severely than a person whose delinquency is cured after 30 days, he is penalized the same as a person who files one year late or a person that never files. Another example that has been noted as presenting the possibility of being disproportionate is the penalty for failure to maintain lists of advised clients with respect to reportable transactions under section 6708. That penalty is $10,000 per day with no cap if the IRS determines that efforts to timely produce documents are not sufficient, without regard to the number of persons omitted.

This is by no means a detailed presentation of the quirks and problems in the penalty regime.  Indeed, it seems very, very basic.  But then, I suppose, the Report is directed to Congressmen rather than practitioners or even taxpayers.