Institute and others urge lawmakers to reform civil penalties
The time is past due for civil tax penalty reform, the American Institute of CPAs recently told lawmakers and administration officials.
"In the 20 years since Congress enacted the Improved Penalty and Compliance Tax Act, there have been numerous legislative and administrative changes in the civil tax penalty regime that have negatively influenced the effectiveness of civil tax penalties as a means of encouraging voluntary compliance," Alan Einhorn, the chair of the AICPA's Tax Executive Committee, explained to Treasury and IRS officials, as well as members of congressional tax-writing committees.
In an accompanying report, the AICPA cited a number of concerns about the current state of civil tax penalties, including: the trend away from voluntary compliance; the lack of clear standards in some penalties; the fact that some penalties are disproportionate in amount and severity; the fact that some penalties are overbroad, deter remedial and other good conduct, and punish innocent conduct; and inconsistencies between penalty standards and the role of tax professionals.
"Our report took a historical view," said Rochelle Hodes, chair of the task force that completed the study and a managing director with PricewaterhouseCoopers. "The IMPACT study in 1989 concluded that the primary purpose of penalties should be to encourage voluntary compliance and should not be to raise revenue."
Both the National Taxpayer Advocate and the American Bar Association Tax Section have also joined in calling for a review of the existing penalty framework.
NOT ABOUT COMPLIANCE
However, the report noted, there has been a trend of new penalties being proposed and existing penalties being enhanced for purposes other than voluntary compliance, such as raising revenue.
"For instance, the high revenue score of the proposed strict liability penalty associated with codification of economic substance, which has varied between a 30 percent and 40 percent penalty, has made this provision an attractive revenue-raiser to offset the cost of other tax changes," the report stated.
The task force cited a recent Government Accountability Office report that said that the IRS was not asserting the $50 information reporting penalty because the cost of asserting it "was not worth it."
"Although the intent of this example was to demonstrate that some penalties are not severe enough to deter noncompliance, the real message seems to be that the IRS views penalties as a revenue source, that a cost-benefit analysis is performed around whether or not to assert penalties, and that only penalties that have high dollar amounts attached to them are worth enforcing," the task force suggested.
A number of penalties fail to articulate clear standards, according to Hodes. "Who can define tax shelters? Taxpayers can't, and the government has yet to define them," she said. "If you want someone to do something, you should be clear as to what they should do. Otherwise, it will frustrate taxpayers who want to abide by the rules and create uncertainty that unscrupulous people can exploit. No one wins but the bad guys."
The determination of whether a transaction is a tax shelter or has a significant purpose of tax avoidance is crucial, yet neither "tax shelter" nor "a significant purpose" has been clearly defined, according to the task force.
Hodes pointed to a shifting of responsibility for ensuring taxpayer compliance from the IRS to the tax practitioner.
"Although the preparer is not armed with first-hand information about the taxpayer's activities, the preparer is 'accountable' for the taxpayer's transactions and decisions," the report said.
TOO TOUGH?
A number of penalties are disproportionate to the degree of misconduct and the amount of harm resulting from the misconduct, the report said. The stacking of penalties may contribute to a lack of proportionality.
"A penalty that is viewed as excessive undermines voluntary compliance and may be less likely to be imposed," the report said.
The penalties for failure to properly file reports of foreign bank or financial accounts illustrate the trend toward using penalties merely to punish, rather than to encourage compliance, according to the ABA Tax Section. (See box at right.)
"Because each failure can result in application of a penalty equal to 50 percent of the balance in the account, a taxpayer who fails to properly file an FBAR at least twice with respect to a particular account can be penalized the entire value of the account, even if the taxpayer properly reported the income from the account on his annual income tax return," the Tax Section stated.
The automated assessment of penalties has led to an "assess first, talk later" process where taxpayers are pulled into the system, said Hodes. "It creates burdens for the taxpayer and the service, and it may lead taxpayers to pay penalties that they believe are unwarranted because it's easier to do that than fight it within the system."
The report recommended that consideration be given to a streamlined process for administrative challenges to penalties below a certain amount, similar to small-case procedures in Tax Court.
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