Imagine a street with a twenty-five-mile-per-hour speed limit, but everyone knows the police don't patrol the street. Would you go twenty-five miles per hour? In a voluntary tax system, the Internal Revenue Service enforces the Internal Revenue Code (IRC, or the Code) with the threat of the civil tax penalty. Yes, the IRS has to catch you--but when it does, you could get hit with a huge penalty in addition to tax and statutory interest.
Civil tax penalties come in all shapes and sizes. Some are automatic (such as penalties for failure to pay on time), and some are discretionary (such as negligence penalties). Some can be abated by having a good excuse and being able to demonstrate it. But all are meant to enforce compliance. In recent years, the IRS has used the penalties in its arsenal with increasing frequency, asserting them in situations in which they have never applied before in, for example, garden-variety transactions.
So how can you protect yourself against the assessment of a civil tax penalty? In this article we discuss some common penalties that the IRS has asserted against taxpayers and some tips to prepare and defend against them. Large corporate taxpayers are generally well versed in the mechanics of an IRS examination and the potential for disagreements over return positions. Tax adjustments, while not desirable, are a fact of life and the cost of engaging in routine tax planning. But penalties imposed by the IRS are another case entirely.
In a recent report, the Treasury Inspector General for Tax Administration (TIGTA) stated that the IRS is failing to patrol the streets and enforce the speed limit. Indeed, the IRS does not levy civil tax penalties in the vast majority of its cases. (1) For example, for the tax years 2015 to 2017, TIGTA found that, in the IRS' Large Business and International (LB&I) Division examinations that resulted in additional tax assessments of $10,000 or more, the IRS collected $14 billion for 4,600 returns reviewed. In all of those examinations, the IRS asserted a penalty only six percent of the time. TIGTA determined that "[i]f the IRS does not properly consider and propose the accuracy-related penalty, taxpayers may be treated inconsistently and unfairly, undermining tax system integrity and diminishing voluntary compliance."
The IRS, however, disagrees with TIGTA's conclusions, and takes the position that each examination depends upon its own facts and circumstances. At the recent New York University Tax Forum in June 2019, IRS Commissioner Charles Rettig commented on the TIGTA report. He noted that penalties should be determined on a case-by-case basis and that the IRS will assert penalties when appropriate. Clearly, the IRS believes it is appropriately policing taxpayers, using civil penalties when needed to enforce tax laws. One thing TIGTA did not consider is that, during examinations, the IRS Exam team may use the penalty as a bargaining chip to get the taxpayer to agree to pay additional tax. IRS Exam teams, unlike IRS Appeals officers, are not supposed to settle cases by negotiating a percentage of the additional tax determined. Instead, they are supposed to "examine" the tax return and to propose additional tax (and penalties) based on what they discover during the audit. Giving up a civil tax penalty in exchange for an agreed-to proposed adjustment is one of the only bargaining chips IRS Exam teams have to resolve matters.
IRS Foot Faults-Procedural Requirements for IRS Penalty Assertions
In the late 1990s, Congress was concerned that the IRS was inappropriately asserting penalties as a bargaining chip. Unknown to many taxpayers and practitioners, Congress enacted IRC Section 6751. (2) Subject to certain exceptions, this new statute provided that "[n]o penalty under [the Code] shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate." (3)
It took almost twenty years before courts began interpreting this provision, ultimately leading to the current view that the IRS bears the burden of demonstrating that the initial determination to assert a penalty against a taxpayer must be approved in writing by a supervisor, and that such approval must occur before the first formal communication to the taxpayer of the initial determination. (4) No particular form is required for such approval, and any form of approval will generally suffice so long as it is in writing. And there can be multiple initial determinations--for example, the IRS might determine one penalty during examination and a different penalty after IRS Appeals, all of which may be procedurally permissible so long as supervisory approval is obtained for each penalty.
Recently, the supervisory approval requirement has been the subject of significant litigation. Because of the IRS' failure to adhere to IRC Section 6751 requirements in many older cases, some taxpayers have been able to take advantage of the IRS' foot fault to avoid penalties. However, going forward the IRS almost certainly will follow Section 6751 requirements as interpreted by the courts to ensure that necessary approval is obtained before a penalty is formally communicated to a taxpayer. In the unfortunate situation where penalties are asserted and a case goes to litigation, taxpayers should ensure that the IRS has met its obligations under IRC Section 6751.
The "Norm"-Common Civil Tax Penalties and Defenses
The most common civil tax penalty asserted against taxpayers is the so-called "accuracy-related" penalty in IRC Section 6662. This provision imposes a penalty equal to twenty percent (and in some cases forty percent) of any underpayment of tax on various grounds, including:
* negligence or disregard of rules or regulations;
* substantial understatement of income tax;
* certain misstatements related to valuation, basis, pension liabilities, and undisclosed foreign financial assets; and
* disallowance of claimed tax benefits by reason that a transaction lacks economic substance within the meaning of IRC Section 7701(o).
Of these grounds, negligence/disregard of rules or regulations and substantial understatement of income tax are the most common. "Negligence" includes any failure to make a reasonable attempt to comply with the Code, and "disregard" includes any careless, reckless, or intentional disregard. "Rules or regulations" encompasses the provisions of the Code, temporary or final regulations, and revenue rulings or notices. For corporations (other than S corporations and personal holding corporations), a substantial...