A bipartisan group of members of the House and Senate have written to IRS Commissioner Doug Shulman asking him to temporarily suspend the penalties on small businesses found using some questionable tax shelters.

The legislators plan to introduce a bill in Congress to end what they consider to be “disproportionate” penalties imposed on small businesses after the IRS began outlawing some types of tax shelters. The letter from prominent members of the Senate Finance Committee and the House Ways and Means Committee follows on the heels of complaints from National Taxpayer Advocate Nina Olson, the Small Business Council of America and business owners themselves about harsh penalties imposed on small businesses that unknowingly engaged in what the IRS considers a “listed transaction.” However, the penalties originated with congressional legislation.

Section 6707A of the Tax Code imposes a penalty of $100,000 per individual and $200,000 per entity for each failure to make special disclosures with respect to a transaction that the Treasury Department characterizes as a “listed transaction” or “substantially similar” to a listed transaction. Section 6707A was enacted in the American Jobs Creation Act of 2004 as part of a package of provisions intended to help the IRS detect, deter and shut down tax shelters.

The letter, signed by Senate Finance Committee Chairman Max Baucus, D-Mont., ranking member Chuck Grassley, R-Iowa, House Ways and Means Oversight Subcommittee Chairman John Lewis, D-Ga., and ranking member Charles Boustany, R-La., pointed out that such disproportionate consequences were unexpected at the time the penalty was enacted, however. They acknowledged that the penalties have helped the IRS end many abusive deals, but they contended that many of the shelters being examined by the IRS involve significantly smaller dollar amounts, and the current penalty levels may be excessive in some circumstances.

“Congress needs to do its part to ensure the Tax Code treats these businesses fairly,” said Baucus. “We’re asking the IRS to temporarily suspend the collection of certain penalties while we work on legislation to bring the assessed tax penalties in line with the received tax benefits. This is an issue of fairness, and making sure businesses are not forced to pay undue penalties, particularly in a struggling economy.”

He added that the legislation should be completed as soon as possible, and the IRS should comply with the lawmakers’ request. The lawmakers said that small businesses should not be so heavily penalized when larger companies were the original targets of the tax shelter crackdown.

“When I advanced the legislation to shut down tax shelters, I did not intend to bankrupt small businesses that had no ill intent,” said Grassley. “I was focused on the big corporations that were actively seeking to hide their participation in tax shelters. The penalty should be commensurate with the transgression.”

The National Taxpayer Advocate’s 2008 report to Congress criticized the heavy penalties on small business in Section 6707A, noting that the statute allows for penalties of up to $300,000 per year to be imposed on taxpayers with no underpayment of tax and no knowledge that they entered into transactions that the IRS has “listed.”

“It is rare that a tax provision is found to violate the United States Constitution, but we believe the imposition of such a large penalty on a taxpayer who entered into a transaction that produced little or even no tax savings, and without regard to the taxpayer’s knowledge or intent, raises significant constitutional concerns, including possible violation of the Eighth Amendment’s prohibition against excessive government fines and due process protections,” said the National Taxpayer’s Advocate report. “In practice, the requirement that this penalty be imposed without regard to culpability may have the effect of bankrupting middle-class families who had no intention of entering into a tax shelter – an outcome that has dismayed even hardened IRS enforcement personnel.”

The Small Business Council of America has called on Congress to place an immediate moratorium on the assessment and collection of the Section 6707A penalty until the statute can be thoroughly reviewed. It cited cases such as that of Robert Mathew, the owner of a small Indiana asphalt-paving company, who purchased a type of life insurance policy known as a “springing cash value” plan in 2002 as an alternative to a straightforward pension plan for his employees. Two years later, the IRS added this type of plan to its list of abusive tax shelters, and said Mathew should have disclosed his purchase to the IRS.

Mathew contended that the financial advisor who sold him the insurance plan at no point told him he needed to make such a disclosure. The IRS demanded taxes and interest totaling $60,000 and set penalties of $600,000 on him, but has so far granted him several extensions.

"I trusted people, my advisor, to take care of this,” he was quoted as saying by the SBCA. “Then the IRS came and said, 'Here's $600,000 you're going to have to pay.' If I had to pay these fees, I would actually have to go bankrupt.”

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