Tax Politics and the New Substantial Understatement Penalty

By Dennis J. Ventry Jr. Dennis J. Ventry Jr. is an assistant professor of law at American University Washington College of Law. Copyright 2006 Dennis J. Ventry Jr. All rights reserved. I. Introduction Concurrent with the IRS investigation of civil penal- ties in 1988 and 1989, Congress conducted its own inquiry into the penalty regime. Both the House and Senate held hearings on penalty reform in 1988 against the backdrop of tax reform. The review of the penalty system, noted Rep. J.J. Pickle, chair of the House Ways and Means Subcommittee on Oversight, which con- ducted a series of hearings on the structure and admin- istration of the penalty system, ‘‘is the natural outgrowth and necessary follow-up to the Tax Reform Act of 1986, as well as the accumulating complexities that have devel- oped through the years.’’ 1 The congressional effort re- vealed widespread discontent with the penalty system among taxpayers and tax practitioners, legislators and administrators. Much of the ire was directed at the substantial understatement penalty. II. Penalty Hearings: A Chorus of Complaints The code’s collection of more than 150 civil penalties reflected a ‘‘morass of inconsistency and irrationality that often discourages, rather than encourages, compliance,’’ announced Sen. David Pryor, chair of the Finance Sub- committee on Private Retirement Plans and Oversight of the Internal Revenue Service, which conducted the Sen- ate’s penalty hearings. 2 Pickle expressed similar senti- Review of the Civil Penalty Provisions Contained in the Internal Revenue Code: Hearings Before the H. Comm. on Ways and Means, Subcomm. on Oversight (hereinafter 1988 Hearings), 100th Cong. 6 (1988) (testimony of Rep. J.J. Pickle). See also id. at 16 (testimony of Dennis Ross, noting that ‘‘Congress has just completed a fundamental reform of the substantive tax rules, and a compre- hensive assessment of the role of the tax penalties is a natural second step.’’). Joe Thorndike, ‘‘Regional Differences in Penalty Application Highlighted,’’ Tax Notes, Oct. 3, 1988, p. 10. TAX NOTES, October 2, 2006 ments from the other chamber. The ‘‘hodgepodge’’ of civil and criminal tax enforcement provisions were added by Congress in ‘‘piecemeal fashion,’’ he said, resulting in penalties that were ‘‘too complex to administer, too complex to understand, too numerous, and too harsh.’’ 3 Taxpayers and tax practitioners were ‘‘feeling frazzled’’ with a penalty system that ‘‘may well deter, rather than enhance, voluntary compliance.’’ 4 Beginning in the early 1980s, Congress had added a ‘‘heavy battery of penalties’’ to curb runaway noncom- pliant behavior. 5 The audit rate had been falling, the use of tax shelters was exploding, and as a result, legislators ‘‘began to add penalty after penalty’’ 6 and encouraged the IRS to use those penalties to punish or deter noncom- pliance. 7 But the penalty regime had grown out of control and lacked coordination. Individual penalties were enacted ‘‘without any view to an overall scheme.’’ 8 Penalties overlapped, resulting, for instance, in the imposition of the substantial understatement penalty on top of negli- gence or fraud penalties for the same tax deficiency. 9 Penalties were applied unevenly, creating regional differ- ences. 10 Also, the system could not distinguish between negligent or intentional noncompliance and good-faith 1988 Hearings, supra note 1, at 6 (Pickle). Others echoed the theme of undue complexity. See, e.g., id. at 81 (Charles W. Hall, chair of the American Bar Association Section of Taxation, calling the penalty system ‘‘too complex’’); id. at 189 (Fred Goldberg: ‘‘too complex’’); id. at 224 (Ken Gideon: ‘‘too com- plex’’). Id. Id. at 177 (Mortimer Caplin). Id. at 151 (Roscoe Egger). Id. at 8 (Lawrence Gibbs). Id. at 161 (Jerome Kurtz). See also id. at 81 (Hall: ‘‘not coordinated’’); id. at 151 (Egger: ‘‘done in less than coordinated fashion’’); id. at 224 (Gideon: ‘‘not integrated’’); ABA Tax Section, Committee on Civil and Criminal Tax Penalties, ‘‘Penalties Study Report,’’ (July 28, 1988), at 7, reprinted in 1988 Hearings, supra note 1, at 362 (the ‘‘cumulation’’ of penalties ‘‘have been added to the Code or existing penalties have been modified without any integrated or coherent plan’’). See, e.g., 1988 Hearings, supra note 1, at 81 (Hall); id. at 189 (Goldberg); id. at 356 (Michael Saltzman); ‘‘Penalties Study Report,’’ supra note 8, at 24. Thorndike, supra note 2, at 11 (quoting Pryor). See also id. (quoting Jennie S. Stathis, General Accounting Office associate director of tax policy and administration, as saying that ‘‘there really is some variation’’ between districts); Karin M. Skadden, ‘‘Substantial Understatement Penalty Centers Debate on Practi- tioner’s Role in the Tax System,’’ Tax Notes, Oct. 17, 1988, p. 253 (describing additional regional differences). (C) Tax Analysts 2006. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Tax Politics and a New Substantial Understatement Penalty