IRS Defends Its Policy Of Not Penalizing Small Errors

This post was originally published on Forbes Jul 22, 2015

In something of a man bites dog story, the IRS is being criticized for being too easygoing in handing out penalties  and is pushing back to defend its right to be forgiving of small errors.  The argument is laid out in one of the latest Inspector General Reposts.  Here is the story.

Automated Underreporter Program

One of the frustrating things about being a tax practitioner trying to help people be in pretty good compliance (Perfect compliance is an impossible dream for any but those with very simple lives) is the knowledge that your clients could probably get away with a lot more than you let them get away with.  It is a violation of the AICPA standards of tax practice to give advice based on the audit lottery.  The more I learn about how broken the system is, the more tempting it becomes to violate that rule.

One thing that I thought was a for sure you are going to get caught is failing to report income that is documented by a 1099 or something like that. A recently released report by the Treasury Inspector General For Tax Administration (TIGTA) on the Automated Underreporter Program (AUP) tells me that it is not quite as sure a thing as I thought.  Nonetheless TIGTA was overall pleased with how the program is working.  Their main recommendation was for the IRS to be more assertive in issuing penalties.  The IRS gave some pushback on the penalty recommendations.

The report noted that AUP assessments have gone up substantially in dollar terms $4.24 billion in Fiscal Year 2006 to $7.84 billion in Fiscal year 2013,  despite personnel constraints.  TIGTA attributes the success to better discernment in which discrepancies to actively investigate.  This was the background part of the report that really surprised me.  AUR routinely identifies over 20 million returns with apparent discrepancies between the amounts on the return and the amounts reported by third parties.

Limited Resources

There are only enough resources to investigate about 20% of the returns with discrepancies.  They are manually reviewed to see if the discrepancy can be resolved without contacting the taxpayer.  If not a CP2000 Notice  is sent out.  The CP2000 Notice reminds me of Ricky's classic (possibly misattributed) line on I Love Lucy - "Lucy, you got some splainin to do".  Frequently the taxpayer will turn to a preparer to do the "splainin". Knock on wood, it's been a while since I had to deal with one of those suckers.  Sometimes it turns out that the return was correct as filed and it is some sort of mixup about names or something.

The fact that the IRS does not have the resources to investigate all 20 million discrepancies, since this is essentially shooting fish in the barrel is a little disturbing. In my experience this is one of the least upsetting intrusions the IRS can make into people's lives and these notices have a salutary effect on compliance.

At any rate, the TIGTA report notes that the increased revenue from AUP is the result of doing a better job in picking the discrepancies worth investigating.  There is also another change.

Historically, the AUR Program would match information returns to individual tax returns twice a year to select its inventory. The first match identifies discrepancies among individual tax returns filed on time (by April 15). The second match identifies discrepancies among individual tax returns filed after April 15 but on or before December 31. This generally includes taxpayers who received extensions to file or who filed their individual tax returns late. Starting in FY 2011, the AUR Program began testing a third match to identify additional discrepancies for tax returns filed significantly past the due date. Specifically, this third match identifies tax returns filed between January and March of the calendar year subsequent to that in which the tax return was due.

I don't know how many people realized that late filed returns were effectively exempt from automated document matching. So a canny taxpayer could make up for the late file, late pay penalty by leaving out a few 1099s.  Who knew?  Not anymore though.

Penalties

If you omit income from your return, there are a host of bad things that can happen to you going all the way up to being deprived of your liberty.  AUP only deals with the more modest punishments - the negligence penalty and the substantial understatement penalty - both 20%.  Those two penalties don't stack.  You can only get hit with one of them.  Substantial understatement kicks in when whatever you got wrong caused you to understate your tax by 10% or more.  Negligence does not have any threshold.

Substantial Understatement

You can get out of either penalty by showing that you have reasonable cause.  TIGTA criticized the AUP examiners for being too easygoing about accepting excuses on the substantial understatement penalty.  I don't know if "The dog ate my 1099s" would work, but it might be worth a try.  TIGTA wants some rigor in the process.

According to the IRS, AUR Program examiners should be allowed to determine whether to waive a penalty based on their experience and judgment of the facts and circumstances of each case and apart from the specific criteria in the IRM. While we agree that the examiner should evaluate all the facts and circumstances in each case when determining whether the taxpayer’s justification met one of the reasonable causes noted in the IRM, the development of additional guidance (e.g., lead sheet or desk guide) would help better ensure that existing IRM requirements are followed as well as ensure that penalties are waived appropriately and consistently.

Apparently the AUR examiners had added a couple of excuses to the list of what would fly that did not have any official sanction.

The AUR Program analysts also stated that they considered the following when reviewing our exception cases: 1) whether the income omission was a new source of income, 2) whether the taxpayer was compliant in the previous three tax years, and 3) how quickly the taxpayer responded to the CP 2000 Notice. These additional factors were not listed in the IRM, or any other AUR Program guidance or training materials, as factors to consider when determining reasonable cause that would warrant penalty relief.

 Negligence

The big argument between TIGTA and IRS is on the negligence penalty. TIGTA being a bunch of hard-assed internal auditors figures that if somebody omits income they were negligent - end of story. (Remember the negligence penalty is for the misstatements that misstate the tax by less than 10%). The programmatic approach of AUP is to let people off with a warning the first time.  Thus the for the lower understatements a negligence penalty is only proposed for "repeaters" i.e. somebody who has previously been dinged in the last four years.  TIGTA does not think there is any support for this easy going approach.

The IRS’s basis for this treatment of the negligence penalty comes from a long-standing AUR Program policy. Although this policy has been in existence for several decades, no rational basis has been provided for the policy, and there is no legal authority that prohibits the AUR Program from imposing the negligence penalty against taxpayers on their first offence. Furthermore, this policy allows a significant amount of noncompliance to go unaddressed. Specifically, we estimate that on an annual basis there are approximately 1.9 million taxpayers who have understatements of tax liabilities beneath the substantial understatement threshold that are not assessed an accuracy-related penalty for negligence. If the AUR Program addressed negligence as it occurred rather than waiting until a taxpayer becomes a “repeater,” approximately $657 million in accuracy-related penalties for negligence could have been assessed for Tax Year 2010 alone.

IRS Pushback

The IRS response has a certain elegance to it.

 IRS management stated that they did not agree with our outcome measures.  The use of penalties to raise revenue, as suggested by the outcome measures, is inconsistent with the position of many stakeholders.

I read that to mean that the purpose of penalties is to encourage compliance, not to gain more revenue.

Given the ferocious reputation of the IRS in some circles, I find it refreshing to see it standing up for policies that allow it to cut a generally compliant taxpayer a break on small isolated errors.