Rethinking Imposition of a Legal Duty to Correct Material Tax Return Errors

• Publication year: 2021

76 Nebraska L. Rev. 223. Rethinking Imposition of a Legal Duty to Correct Material Tax Return Errors

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Judson L. Temple*

Rethinking Imposition of a Legal Duty to Correct Material Tax Return Errors

TABLE OF CONTENTS

I. Introduction 225
A. Propriety of a Duty to Correct Material Tax Return Errors 225
B. Penalty Structure and Statutes of Limitations 226
C. Article Organization 227
II. Merits of an Amended Return Obligation 228
A. Current Lack of a Duty to Correct Tax Return Errors 228
B. Justifications for Requiring Taxpayer Correction
of Material Errors 231
C. Constitutional Barriers to an Amended Return Obligation 234
III. Definition of a Proposed Amended Return Obligation . . 235
A. Definition of "Error" 236
1. Return Positions Less Likely than Not to Prevail 236
2. Retroactive Changes in the Law 238
B. "Materiality" Defined 239
1. Basic Definition 239
2. "Materiality" of Multiple Errors 240
3. "Materiality" of Errors with No Impact
on Tax Liability 240
C. Taxpayer's "Knowledge" of an Error and a
Duty to Investigate 241
IV. Amended Return Obligation and the Penalty Structure 243

A. Current Penalty Structure 243

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B. Penalties: A Normative Approach 245

1. Parity Structure Defined 245
2. Existing Penalties Contrasted with a Parity Structure 247
C. Penalty Recommendations: Obligatory Amended Returns Filed 248

1. Abrogation of Penalty Exposure for Nonfraudulent
Errors Voluntarily Corrected 248
2. Nonabrogation of Penalty Exposure for Fraudulent Errors 249
a. Immunization from Fraud Penalties Undermining the
Duty to File a Correct Return 250
b. Lesser Appeal of Relief for Taxpayers Committing Fraud 250
c. Fraud Penalty Relief Unlikely to Enhance Tax Compliance 251
d. Difficulty of Formulating a Workable Rule that
Waives Criminal Fraud Penalties 251
3. Countervailing Considerations 253
a. Fairness of Compelling Taxpayers to Provide Evidence
of Fraudulent Conduct 254
b. Inhibiting Effect on Taxpayers Who Fear Innocent
Errors Will Be Treated as Fraudulent 256
D. Penalty Recommendations: Breaches of a Duty to Amend 257
1. A Parity Structure Favored 258
2. No Double Penalty 261
3. Reasonable Opportunity to Comply with a Duty to Amend 261
V. Amended Return Obligation and Statutes of Limitations 263
A. Current Statutes of Limitations 263
B. Limitations Periods: A Normative Approach 265
C. Limitations Period Recommendations 265
1. Nonfraudulent Original Returns 266
2. Fraudulent Original Returns 268
VI. Conclusions 270

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I. INTRODUCTION

A. Propriety of a Duty to Correct Material Tax Return Errors

A lingering oddity of the procedural rules governing federal taxation is the failure of those rules to unambiguously require a taxpayer who discovers she has materially understated her federal tax liability on her federal tax return to file an amended return correcting the errors, assuming the errors are discovered before expiration of the limitations period for the taxable year to which the return relates.(fn1) The propriety of a duty to file an amended return might seem to follow from a federal tax system that imposes upon the taxpayer, not the government, the burden of making a correct determination of tax liability.(fn2)

Only two reasons seem to excuse the taxpayer's failure to correct an error on an amended return if the taxpayer discovers the error within the period of limitations. First, the error might be de minimis (not material) so that its correction is not worth the taxpayer's time, trouble, or expense. Second, the taxpayer's discovery of the error might be so recent that the taxpayer has not yet had a reasonable amount of time to discharge her obligation to correct the error.

If this analysis is correct, any duty to amend must be properly circumscribed. The duty should be limited to "material" errors, with ma

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teriality defined to enable a taxpayer to determine whether or not an error is material. Errors, the net effect of which entitle the taxpayer to a refund of taxes paid, normally should not give rise to a legal obligation to amend. The taxpayer's self-interest in not overpaying her federal taxes should sufficiently assure that the taxpayer will file an amended return whenever the refund involved justifies the taxpayer's time, trouble, and expense of filing a corrected return.

Further, noncompliance with a duty to amend should not be penal-izable until the expiration of a reasonable amount of time to comply with the duty, an amount of time that must be statutorily defined. No duty to amend can follow if discovery of the error occurs after expiration of the limitations period for the taxable year to which the error relates. A duty to amend is predicated upon the existence of an unpaid tax. Once the statute of limitations expires, the unpaid tax is no longer a debt owed to the government. The taxpayer's duty to report additional tax must expire concomitantly with the government's ability to assess and collect it.

This Article examines the law's failure to require taxpayers to correct material understatements of their tax liabilities and the consequences of this failure, and recommends enactment of a legal duty to amend. This Article suggests a definition of the legal duty to amend that assures that the duty is properly circumscribed.

A duty to amend might (or might not) be accompanied by a correlative duty to investigate. If imposed, the duty to investigate would be applicable when the taxpayer reasonably suspects that a material reporting error may have been committed and would be undertaken to determine whether in fact an amended return is required. This Article supports extending the duty to amend to incorporate a correlative duty to investigate in appropriate circumstances and identifies circumstances that would give rise to the duty to investigate. It is recognized, however, that a viable tax compliance system might include a duty to correct known material understatements of tax liability without requiring the taxpayer to investigate possible, but unconfirmed reporting errors.(fn3)

B. Penalty Structure and Statutes of Limitations

The enactment of a legal duty to amend raises a number of questions concerning the relationship between the duty to amend and applicable penalties or statutes of limitations. What effect should the taxpayer's corrected amended return have on penalties otherwise applicable to the erroneous original return? What penalties should be applicable if the taxpayer fails to comply with a duty to file an amended return? What effect, if any, should filing an amended return

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have on the statute of limitations for the taxable year at issue? What effect, if any, should failure to file an amended return have on the statute of limitations for the taxable year at issue?

There is a complete spectrum of possible answers to these questions. The approach favored in this Article proceeds from the observation that enactment of a legal duty to amend would subject the taxpayer to a continuous, ongoing duty to correctly report tax liability. The duty would begin with the due date of the original return and would end with the expiration of the period of limitations for the assessment of tax for the taxable year.

This Article argues that, if a legal duty to amend is enacted, a taxpayer culpably committing or perpetuating a reporting error generally should face the same exposure to penalty whether the culpable behavior occurs at the time of filing of the original return or at some later date within the limitations period. Similarly, a taxpayer voluntarily correcting a reporting error generally (but not always) should enjoy the same mitigated (or eliminated) exposure to penalty whether the error is caught and corrected before the original return is filed or at some later date within the limitations period.

Under current law, the limitations period within which the Internal Revenue Service may assess additional tax generally depends on the magnitude and culpability of the taxpayer's reporting errors. This Article argues that if a legal duty to amend is enacted, a taxpayer culpably committing or perpetuating a reporting error generally should face the same duration of exposure to an IRS audit whether the culpable behavior occurs at the time of filing of the original return or at some later date within the limitations period. Similarly, a taxpayer correcting a reporting error generally (but not always) should enjoy the same reduced duration of exposure to an IRS audit whether the error is caught and corrected before the original return is filed or at some later date within the limitations period.

It is important to realize that although adoption of a legal duty to correct tax return errors raises questions about the penalty structure and applicable statutes of limitations that will best accommodate the duty, any debate about these questions is not a debate about the propriety of adoption of a legal duty to amend. Instead, penalty issues and limitations period issues are subsidiary issues to be resolved once it is determined that adoption of a legal duty to amend is appropriate. This is so even though tax compliance clearly is impacted not only by adoption of a duty to amend, but also by the choices of appropriate penalties and accompanying limitations periods.

C. Article Organization

Part II of this Article examines the law's failure to require correction of material tax return errors, the consequences of this failure, and

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the merits of an amended return obligation. The conclusion endorses the promulgation of a rule requiring taxpayers to correct material reporting errors by amending erroneous tax returns. Part III examines the definitional problems engendered by such a rule and suggests a resolution of these problems. Part IV recommends a penalty structure applicable to both original return errors...