Report Asks: Does IRS Administration of Tax Penalties Further or Hinder Voluntary Compliance?


Encouraging voluntary compliance is the end game for the penalties under the tax code, but the IRS’s penalty actions may be detracting from that goal, an agency advisory panel said.

The report released Nov. 16 by the Internal Revenue Service Advisory Council called on the agency to conduct a system-wide review of its penalty actions to see if they support voluntary compliance.

Much of the section of the report dealing with this issue centered on inconsistencies in the agency’s handling of taxpayers’ requests for penalty relief.

Such relief is available for “reasonable cause” under Section 6664(c) of the tax code, including for violations of Section 6662(b)(2) for substantial underpayment of income tax.

Though not mentioned in the report, this relief is also available for penalties imposed on pension plans under Section 6662(b)(4) for substantially overstating their pension liabilities.

Today there are more than 170 penalty provisions in the tax code compared to just 14 in 1955, the report said.

Voluntary Compliance First and Foremost

The report said that its recommendations on strengthening or enhancing the fairness and consistent treatment of taxpayers are premised on encouraging voluntary compliance.

“First and foremost, policy decisions need to be consistent with the universally agreed-upon purpose of penalties: encouraging voluntary compliance,” it said. “To ensure this, the effect of penalty actions on voluntary compliance needs to be clearly understood.”

The panel recommended “the streamlining and modest liberalization of penalty abatement decisions,” which it said would “create greater efficiencies for the IRS, reduce the burden on substantially compliant taxpayers, and increase voluntary compliance.”

Reasonable Cause

Taxpayers may request relief under Section 6664(c) from Section 6662 penalties by showing “reasonable cause” for any portion of an underpayment as to which the taxpayer acted in good faith.

“The disposition of requests for reasonable cause relief, however, varies widely,” owing to differences in the particular taxpayer’s situation and the training and experience of IRS employees, the report said.

“In addition, the automatic, computer-generated assertion of penalties in numerous cases has the effect of undermining the congressional directive that the IRS should make correct penalty assertion decisions in the first instance rather than mechanically asserting penalties and only later correcting cases meriting penalty relief,” it said.

This was a reference to the agency’s Automated Underreporter Program, or AUR, which flags discrepancies between the amount of income reported by taxpayers on their tax returns and what income they report on their information returns.

No Human Review

In general, the tax code requires that before assessing a penalty IRS employees have written approval from a supervisor. However, an exception allows the IRS to calculate a penalty automatically “through electronic means.”

“The IRS interprets this exception as allowing the use of its AUR system to propose the substantial understatement and negligence components of the accuracy-related penalty without human review,” the report said.

“Only if a taxpayer responds to an AUR-generated proposed assessment will the IRS involve its employees to determine whether the penalty is appropriate,” it said. “If the taxpayer does not respond timely to the initial notice, the computers automatically convert the proposed penalty to an assessment.”

Administrative Waivers

Expanding the agency’s administrative waivers program could alleviate some of the strain on the AUR units, freeing them up to focus on more penalty relief requests, the report said.

IRS Policy Statement 20-1, issued in 2009, allows for administrative remedies “where doing so will promote sound and efficient tax administration.”

The IRS Office of Servicewide Penalties, which analyzes and evaluates the repercussions of penalty policy and administration, should “evaluate the feasibility of developing one or more rules of administrative convenience to abate section 6662(b)(2) penalties in particular circumstances, for example, where the taxpayer has a history of prior good behavior and has not previously been penalized,” the report said.

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