IRS Penalty Report: A Call for Objective Standards

By Dennis J. Ventry Jr. Dennis J. Ventry Jr. is an assistant professor of law at American University Washington College of Law. Comments are welcome at dventry@wcl.american. edu. Copyright 2006 Dennis J. Ventry Jr. All rights reserved. I. Introduction While practitioners bickered over the relative merits of the substantial understatement penalty, 1 the IRS under- took a comprehensive study of the civil penalty system. In November 1987 then-IRS Commissioner Lawrence Gibbs established the Executive Task Force on Civil Penalties, comprised of IRS employees from offices throughout the country. 2 The task force worked closely with the American Bar Association Section of Taxation, the American Institute of Certified Public Accountants Tax Division, the Tax Executives Institute, the National Society of Public Accountants, and the National Associa- tion of Enrolled Agents, in addition to other professional, academic, and business groups. 3 According to the task force, a thorough examination and reconsideration of the penalty system was desper- ately needed to make sense of more than a decade of penalty legislation. Congress had added penalties for various reasons, including: to create a downside risk to overaggressive tax reporting positions; to offset declining IRS audit coverage; to alter taxpayer behavior and en- courage tax compliance; to raise revenues; to educate taxpayers about their tax obligations; to punish noncom- pliant behavior and maintain fairness from the perspec- tive of compliant taxpayers; and to ensure that noncom- pliant taxpayers ultimately paid for IRS enforcement See Dennis J. Ventry Jr., ‘‘Vices and Virtues of an Objective Reporting Standard,’’ Tax Notes, Sept. 18, 2006, p. 1085, Doc 2006-18619, 2006 TNT 181-35. Executive Task Force, Commissioner’s Penalty Study, IRS, ‘‘Report on Civil Tax Penalties’’ (Feb. 21, 1989), at 1. Lawrence Gibbs, Commissioner of Internal Revenue, testi- mony before U.S. Congress, House Committee on Ways and Means, Subcommittee on Oversight, Hearings on ‘‘Review of the Civil Penalty Provisions Contained in the Internal Revenue Code’’ (Mar. 31, 1988, and July 28, 1988), at 9. TAX NOTES, September 25, 2006 programs. 4 ‘‘The very multiplicity of possible rationales,’’ the task force said, ‘‘shows the piecemeal way in which penalties have evolved over the years.’’ 5 The ad hoc and frenzied development of the penalty system had con- fused taxpayers, practitioners, and administrators. The task force issued three reports. They were remark- able documents, analyzing the civil penalty system from philosophical, economic, political, and administrative vantage points. The purpose of the studies, Gibbs said, was threefold: to identify principles around which ‘‘to build a sound framework for the administration of penalties’’; to identify penalties requiring ‘‘modification, consolidation or repeal’’; and to identify IRS practices that could be changed or improved ‘‘to facilitate or make more equitable our administration of the penalty provi- sions.’’ 6 While the task force adopted a systemic, holistic approach to its analysis and examination, it spent an inordinate amount of time on what task force member Daniel Wiles called ‘‘the most controversial civil penalty,’’ section 6661. 7 II. A ‘Philosophy’ of Penalties The first report, released in June 1988, outlined a general philosophy on civil tax penalties. The method provided the basis for the analytical approach used by the task force in its two subsequent reports. It was of vital importance to distinguish between the consequence of violating a tax rule (that is, the penalty) and the rule itself. Substantive tax rules described, for instance, the computation of income and allowable de- ductions as well as how to file a tax return. Tax penalties were imposed as a consequence of violating those sub- stantive rules. ‘‘This is a seminal distinction,’’ the task force said, ‘‘since it negates the proposition that a penalty has an end in itself.’’ 8 Penalties were levied only regard- ing abuses of substantive tax rules, and thus ‘‘should be enacted and evaluated based on their relationship’’ to those rules. 9 Civil penalties served two primary purposes. First, they established norms of taxpayer conduct. Second, they preserved and enhanced voluntary compliance with the tax laws. Penalties should keep compliant taxpayers in line and induce noncompliant taxpayers to alter their behavior. ‘‘Each penalty has two goals — a goal of Executive Task Force, Commissioner’s Penalty Study, IRS, ‘‘A Philosophy of Civil Tax Penalties,’’ Discussion Draft (June 8, 1988), at 1. Id. at 2. Gibbs, supra note 3, at 9. Michael Moriarty and George Guttman, ‘‘IRS Official Dis- cusses New Penalty Study,’’ Tax Notes, June 20, 1988, p. 1371. Executive Task Force, supra note 4, at 5. Id. (C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. IRS Penalty Study: A Call for Objective Standards