. *. 

. 

United St&es General Accounting Office I35YB7 

Testimony 

d i 

or Release 

n Delivery 

xpected at 

:jO a.m. EST 

hursday 

arch 31, 1988 

'Comprehensive Review of Civil Penalties 

Needed 

Statement of 

Johnny C. Finch, Deputy Director 

General Government Division 

Before the 

Subcommittee on'oversight 

Committee on Ways and Means 

House of Representatives 

I Ill 

13548'7 

/ 99H7 

=n7,3 

AO/T-GGD-88-24 
. 

CIVIL PENALTIES 

SUMMARY OF STATEMENT 

JOHNNY C. FiNCH 

DEPUTY DIRECTOR 

GENERAL ACCOUNTING OFFICE 

Congress has enacted nearly 150 civil. pen,alties in the Internal 

Revenue Code (Code) to encourage compliance with the tax laws. 

In many instances , penalties were enacted or modified on an ad 

hoc basis without full consideration being given to the overall 

civil penalty structure. Given this and the sweeping impact of 

the lfiax Reform Act of 1986, this Subcommittee, other 

Congressional committees, and the Commissioner have expressed 

concerns over the civil penalty provisions of our tax laws. We 

share these concerns and support the notion that a comprehensive 

review of those provisions is in order. 

The IRS Commissioner has initiated a comprehensive study of.civil 

penalties. We think the study timetable is ambitious. The 

methodology of the study is evolving, but at present it does not 

appear to encompass the empirical analysis we believe n~ecessary 

to fully address the issues. Our work will help fill part of the 

gap by providing the empirical evidence necessary to ev'aluate the 

effectiveness of IRS' administration of a limited numbeir of 

specific penalties. 

We were asked to determine if by using computers, IRS assesses a 

significant number of inaccurate penalties which are ultimately 

abated or erroneously paid by the taxpayer. We found that IRS 

does not have readily available data to identify the number of 

computer-generated penalty assessments or the percentage of those 

assessments abated or erroneously paid. Theoretically; computergenerated penalties should be assessed in a more consistent 

fashion than manually-generated penalties. This is because 

penalties assessed by the computer involve conditions which are 

specific, well defined, and do not require the exercise of 

subjective judgment. 

We have not yet done sufficient work to be in a position to 

comment conclusively on IRS' overall effectiveness in i 

administering civil penalties. However, our work rela ed 

;: 

to 

several specific penalties and recent reports by the I S Internal 

Audit staff identify potential problems that should beiconsidered 

in any comprehensive review. These problems include 

where IRS did not assess certain 

warranted, abated penalties when 

made computational errors, ssessment 

policies among IRS offices. 
Mr. Chairman and Members of the Subcommittee: 

We are pleased to be here today to assist the Subcommittee in its 

review of the civil penalty provisions in the Internal Revenue 

Code (Code). My statement today covers four points: 

-- first, we endorse the need for a comprehensive 

review of civil penalties and discuss some of the 

objectives for such a review, 

-- second, we comment on the evolving methodology of 

the IRS Commissioner's Study of Civil Penalties, 

-- third, we describe the circumstances in which 

computers generate penalties, and 

-- fourth, we summarize what we know about problems in IRS' 

administration of civil penalties. 

COMPREHENSIVE REVIEW OF CIVIL PENALTIES NEEDED 

The success of our tax system depends on voluntary taxpayer 

compliance. To encouraqe compliance and to punish noncompliance, 

Congress has enacted numerous civil penalties. In the past 70 

years, nearly 150 civil penalties have been placed in the Code. 

In many instances, penalties were enacted or modified oh an ad 

hoc basis without full consideration being given to the overall 

structure of civil penalties. 

1 
With greater use of penalties, more questions have been raised as 

to the role civil penalties should play in our tax system. In 

fiscal year 1987, IRS assessed almost 27 million penalties, 

totaling over $14 billion. This was more than a 100 percent 

increase over the total dollar amount of penalties assedsed in 

1986. IRS' administration of civil penalties frequently results 

in criticism. The criticisms have focused primarily on IRS' (1) 

failure to fully utilize all penalty provisions, (2) assessment 

of many penalties which are subsequently abated, and (3) 

inconsistent assessment of penalties by different IRS offices and 

functions. 

/ Our tax system and our society are different than they were in 

the past. We now face a tax gap of over $80 billion, large 

federal budget deficits, and what IRS describes as growing 

animosity between the taxpayer and the tax administrator. Given 

this, the ad hoc approach with which many of the present 

penalties were enacted, and the sweeping impact of the Tax Reform 

Act of 1986, this Subcommittee, other congressional committees, 

and the Commissioner have expressed concerns over the current 

structure of the civil penalty provisions of our tax laws. We 

share these concerns and support the notion that a comprehensive 

review of those provisions is in order. 

2 
Objectives of Planned Studies 

If civil penalties are to be a major enforcement tool in our tax 

, 

! system, we need to assure ourselves that they are well thoughtout, credible, understood by the nation's taxpayers and tax 

practitioners, can be administered consistently and effectively 

/ by IRS, and do in fact achieve their purposes. Whether the 

present system of penalties accomplishes these goals is not 

/ known. 

/ * 

I The first step in examining civil penalties should be to identify 

and understand the problems with the existing system. To this 

end, the Commissioner has launched a study of the civil sanctions 

available to IRS. The study proposes to review the value of 

these sanctions to the tax system, identify problems arising from 

their administration, and make recommendations for improvement. 

Similarly, at the request of this Subcommittee and the Senate 

Finance Committee's Subcommittee on Private Retirement Plans and 

Oversight of IRS, we are beginning work which will focuS on IRS b 

efforts to fairly and consistently administer civil penalties. 

We will analyze the quality of the information used by IRS in 

assessing and abating certain penalties, determine if IRS is 

assessing and abating the penalties in a fair and consistent 

fashion, and if appropriate, comment on how the adminigtration of 

the penalties could be improved. 

3 
Chairman Pryor has requested that we examine civil penalties for 

substantial understatement of tax lia,bilities [section 66611, 

civil negligence and fraud [section 6653 (a) and (b)], and 

understatement by a return preparer (section 6694 (a) and (b)]. 

We are presently discussing with Subcommittee staff the penalties 

and scope of work that will be involved in responding to your 

request. 

Our work and that of the Commissioner's study group will provide 

much of the information needed to consider the adequacy of the 

civil penalty structure and will establish a better foundation 

for congressional deliberation and debate. 

COMMISSIONER'S STUDY OF CIVIL 

PENALTIES STILL EVOLVING 

At the request of this Subcommittee and the Senate Subcommittee 

on Private Retirement Plans and Oversight of IRS, we have begun 

to review the methodology being used in IRS' study. Our analysis 

to date has been limited to the study prospectus. Our 

preliminary observations are that the methodology (1) is still 

evolving, (2) currently draws heavily on expert opinion and 

advice from IRS management and outside organizations, and (3) 

will attempt to aggregate existing IRS statistics in a ifashion 

that will enhance their usefulness in analyzing civil *nalties. 

4 
While expert opinions and advice are valuable in identifying 

problems and developinq recommendations for improvement, 

I I the IRS study does not presently provide for any scientific 

/ 

I sampling of taxpayer returns and accounts to validate the 

experts' concerns and opinions, or to empirically determine how 

well IRS is administering the various penalties. Without this 

, information it will be difficult to quantify the nature and 

extent of the problems or to identify and correct their cause. 

The IRS study calls for the assembly of existing data on each 

penalty and for the identification of gaps in this information. 

It is our experience that IRS has not historically aggregated the 

penalty data it collects in such a fashion to make it useful in 

reviewing all of the various issues and concerns associated with 

the imposition of civil penalties against taxpayers. For 

example, IRS does not routinely aggregate penalties by Code 

section. 

Further, it is unclear whether IRS statistics capture all of the 

penalties assessed and abated. For example, the most dramatic 

increase from fiscal year 1986 to 1987 in penalty assessments was 

in the non-return category. The non-return category includes 

penalties assessed in situations where the noncompliance is not 

associated with the filing of a return by the taxpayer, such as 

tax shelter promoter penalties and preparer penalties. 

5 

,:c,*; , “’ ,, .’ 
Assessments in this category rose from $268 million in 1986 to 

about $6.0 billion in 1987. In terms of the number of penalties 

assessed, the non-return category increased from about 106,000 in 

1986 to about 478,000 in 1987. IRS attributes most of this 

increase to penalties which had previously not been captured in 

IRS statistics. 

The quality of IRS' statistical data also needs to be considered. 

An October 1987 IRS Internal Audit report concluded that penalty 

management information reports may contain misleading and 

inflated figures on assessments, abatements, and abatement rates. 

Internal Audit found that in 1986 about $340 million in Failure 

To Deposit employment tax penalties had been erroneously assessed 

and subsequently abated. Since IRS detected and abated over 90 

percent of these erroneous penalties before notifying taxpayers, 

including such figures in IRS statistics produced misleading 

results. 

The Commissioner's study prospectus calls for the identification 

of data needed to complete the study by April 1988. The points 

we have made should be included in this needs assessment. 

COMPUTERS USED TO GENERATE 

NONSUBJECTIVE PENALTIES 

You asked us to determine the extent to which IRS uses 'computers 

to assess penalties and, if by using computers, IRS asdesses a 

6 
significant number of inaccurate penalties which are ultimately 

abated or erroneously paid by taxpayers. We found that IRS does 

not have data readily available to identify the number of penalty 

I 

, 

, assessments which are computer generated. Neither is information 

, I / available on abatements or erroneous payments. 

IRS began using computers for tax administration purposes in the 

early 1960s. Since that time, IRS has included penalty 

assessments in its use of computers. Presently, the majority of 

penalties assessed by the 10 IRS service centers are computer 

generated. These penalties typically result when the taxpayer 

fails to take a required action by a specific date, such as 

failure to file a return on time. 

While returns and related documents are being processedy the 

computer will identify situations in which the required: 

conditions for a specific penalty are present. For example, when 

a service center receives a tax return with an outstanding tax 

liability after the due date, the computer will automatically 

assess the failure to file penalty, unless the taxpayer's account 

indicates that an extension was previously granted. The computer 

would also assess a failure to pay penalty if there is any 

outstanding tax liability. 

After a penalty is assessed, the computer prepares a noitice that 

is mailed to the taxpayer stating a reason for the penqlty. If 

7 
the taxpayer disagrees with the assessment, the taxpayer can 

present evidence requesting an abatement. 

Theoretically, computer generated penalties should be more 

consistently assessed than manually-generated penalties. 

Penalties assessed by the computer involve conditions which are 

specific, well-defined, and do not require the exercise of 

subjective judgement. The computer uses the information provided 

or lack thereof to determine that a penalty is or is not 

appropriate. 

In contrast, penalties are assessed manually when the complexity 

of the issue requires the use of subjective judgement. These 

penalties include negligence, fraud, or promoting abusive tax 

shelters. The accuracy of manually generated penalties can be 

affected by many factors, including IRS employee judgement, 

training, clarity of guidance, and district policy. 

Conversely, computer-generated penalty inaccuracies generally 

stem from instances where the data provided the computer is 

inaccurate or incomplete, or where there is an error in the 

computer program. In such instances, computer-generateti 

penalties haye the potential to affect many more taxpaybrs than 

those that are manually generated. For example, in Febiruary 1988 

I 

the IRS, using inaccurate information provided by the Sbcial 

Security Administration, generated thousands of erroneous penalty 

8. 
notices assessing penalties against employers for failing to file 

W-2 information on magnetic media. While one service center 

discovered the inaccuracy before notifying the employers, other 

service centers did not and mailed out inaccurate notices. 

IRS reviews a selected sample of both computer-generated and 

manually generated penalty notices before they are sent to 

taxpayers. The review is performed to ensure that the notices 

/ are technically as well as mathematically correct. 

PROBLEMS IDENTIFIED IN IRS 

ADMINISTRATION OF PENALTIES 

We have not done sufficient work at this time to be in a position 

to comment on IRS' effectiveness or on the difficulties it 

encounters in administering an increasingly complex system of 

civil penalties. However, we believe our work related to several 

specific penalties and recent reports by the IRS Internal Audit 

staff identify some types of problems which should be considered 

in a comprehensive review of the civil penalty structure. These 

problems include instances where penalties were not assessed when 

warranted, where penalties were not computed accurately~, and 

where IRS District Office policies varied on the assessment of 

certain penalties. 

9 
Penalties not assessed when warranted 

Three IRS Internal Audit and two GAO studies have shown that IRS 

did not assess penalties in all cases where they were warranted. 

For example, a 1987 IRS Internal Audit report concluded ~that in 

1986 IRS overlooked millions of dollars in penalties that should 

have been assessed against employers who claimed fictitious tax 

deposits on their employment tax returns. Internal Audit's 

sample of 426 taxpayer accounts contained 217 accounts with 

fictitious tax deposits. Of the accounts with fictitious 

deposits none were assessed the penalty. Internal Audit staff 

projected that, on a nationwide basis, IRS did not assess $437 

million in such penalties in 1986. 

As a second example, our study of IRS' administration of the 

penalty for promoting abusive tax shelters at three selected 

district offices shows that IRS should have but did not assess 

all applicable penalties in 39 percent of the 28 total cases the 

three offices closed between September 1982 and July 1986. 

Penalties were not assessed because district officials did not 

know that multiple acts of organizing, promoting, and selling 

abusive tax shelters by the same person are each subject to 

penalty. National Office guidance did not illustrate hbw to 

treat multiple acts. 

10 
Penalties Not Computed Accurately 

Computation and other types of errors have also been documented 

by GAO and IRS internal auditors. IRS' Internal Audit reported 

in 1987 that computation errors were found in 27 percent of 75 

selected examination cases. These cases covered examinations of / 

1983 and 1984 individual income tax returns in 5 districts and 

I one service center. The calculation errors ranged from an 

I overassessment of $1,386 to an underassessment of $259. 

In our tax shelter promoter study, we found that IRS made several 

computation and oversight errors when assessing abusive tax 

shelter promoter penalties. IRS made 20 such errors re$ulting in 

about $4.0 million in penalty underassessments in 31 percent of 

the 29 total cases at 3 selected district offices. 

Inconsistent District Office enforcement policies 

Inconsistent enforcement of penalties by IRS District Offices has 

also been identified as a problem. For example, in a 1983 GAO 

report on return preparer penalties, we found that each IRS 

district determined its own level of activity for assessing the 

penalty against preparers who endorsed or negotiated tajtpayers' 

refund checks. One district office, which took a more vigorous 

approach to identifying such situations and assessing the penalty 

11 
accounted for 75 percent of these penalties assessed nationwide 

during 1981. 

As a second example, in our study of IRS' administration in three 

districts of the tax shelter registration late or non-filing 

penalty, we found that one district decided not to administer the 

penalty because of a belief that it was too new. The other 

districts were assessing late filing penalties but were using a 

late filing grace period greater than that established by the 

National Office. 

Abatement of civil penalties 

Taxpayers assessed a penalty have the right to request that IRS 

abate the assessment. However, the taxpayer must provide IRS 

with information which demonstrates reasonable cause for the 

noncompliance, evidence that the noncompliance did not occur, or 

other acceptable reasons for abatement. Upon receipt, tax 

examiners are to determine the merits of the evidence. 

IRS has developed guidelines for its employees to use in abating 

penalties. The guidelines require that each request for 

abatement be judged on all the facts in hand. If the tax 

examiner denies the request for abatement, a notice is Ito be sent 

to the taxpayer explaining the reason for the denial and 

informing the taxpayer of the right to appeal the decision. If 

12 
the information provided by the taxpayer satisfies the examiner, 

the penalty is to be abated and a notice is to be sent advising 

the taxpayer of such action. These abatement procedures apply to 

1 both computer-generated and manually generated penalties. 

, 

I 

I In 1984, we reported that while most IRS penalty abatements were 

, appropriate, IRS inappropriately abated penalties in 8 percent of 

j the abatements made in fiscal year 1981 by six selected districts 

, and three selected service centers. On a projected basis for 

I those 9 offices, we estimated that IRS granted 32,600 

inappropriate abatements out of 407,700 total abatements made. 

This amounted to $21.7 million in inappropriate abatements. 

I Abatements for reasonable cause (48,800 of the total abatements) 

were most in need of improvement. Twenty-six percent of the 

reasonable cause abatements (12,700 out of 48,800) were 

inappropriate. 

We attributed the causes of inappropriate abatements to (1) 

incomplete IRS guidance defining reasonable cause, (2) minimal 

penalty abatement training, and (3) inadequacies in IRS review 

and quality assurance processes. IRS took action on our 1984 

recommendations. However, much has changed since then and we do 

not know what IRS' current performance may be in abating 

penalties. 

13 
SUMMARY 

In summary, we support the need for a comprehensive review of the 

civil penalty structure. We also believe that now is a good time 

to begin that review. As the tax system has become more complex 

so have the accompanying penalties. This has occurred with 

limited attention being paid to the overall structure of the 

civil penalty provisions, their effectiveness, or to the role 

they should play. The passage of the Tax Reform Act of 1986, 

with its extensive changes to the tax laws, provides a timely 

opportunity for this review. 

Several issues need to be addressed. These include the purpose, 

need for, and effectiveness of each penalty provision, and the 

equity and efficiency of IRS' civil penalty administration. Past 

work by GAO, IRS, and others provides a starting point. But all 

the information necessary to respond to these issues is not 

presently available. 

The Commissioner's civil penalties study is an important step in 

developing the information needed. Undertaking a review of 

almost 150 penalty provisions and their interrelationshjips is a 

massive task which will require time and the commitment8 of 

resources. The schedule established by the study group calls for 

the presentation of conclusions and recommendations to ithe 

Commissioner in July 1988. In our review, the study is, an 

14 
ambitious undertaking for the targeted timeframes. 

The methodology of the study is evolving, but at present it does 

not appear to encompass the empirical analysis we believe 

necessary to fully address the issues. Our work will help fill 

part of the gap by providing the empirical evidence necessary to 

evaluate the effectiveness of IRS' administration of a limited 

number of specific penalties. 

1 The IRS study includes a milestone for identifying additional 

( data needed. We will continue to monitor the evolution of the 

study and keep IRS advised of our thoughts as that milestone 

nears. The Subcommittee may also wish to follow up with IRS in 

this regard. 

. 

Mr. Chairman, that concludes my statement. I would be,happy to 

respond to any questions the Subcommittee may have. 

15