Reportable transaction penalties--too high, or reasonably fierce?

 A big part of the tax shelter problem, it has been surmised, comes from taxpayers (and tax advisers) who take (or advise) super-aggressive positions, gambling on the "audit lottery" that either they won't be audited at all or that, on audit, the position won't really be noticed or, if it is noticed and they lose, they will at most have to pay the tax liability and interest, but no significant financial penalty.  This was clearly an issue in a number of tax shelters handled by KPMG, as the Senate Finance investigative subcommittee revealed in each report, where practitioners were caught in emails scoffing at the puny registration rules for tax shelters, since the penalty for failing to report was so low that it was well worth the gamble to avoid reporting and enhance the chance of winning the audit lottery sweepstakes.

Because of the audit lottery and the scofflaw attitude in some law and accounting firms towards tax compliance (or, in many others, a well-honed tax minimization norm that supports and even demands super-aggressive tax positions), one of the enforcement tools that has been developed over the last ten years is the requirement that taxpayers (and advisers) flag certain aggressive positions.  The 2004 Jobs Act, which included a huge smorgasbord of corporate tax breaks, included a few revenue raisers and loophole closers.  One such was the codification of the new reportable transaction regime already developed through regulations, along with new penalties.  These rules are set out in the "reportable transaction" regulations in 1.6011-4 and related sections.  These rules relate to a variety of transactions, including "listed" transactions that the IRS has identified in published notices as likely to be a tax shelter. The new penalties for not reporting reportable transactions are much steeper than the piddling prior penalties for not registering a tax shelter, and the new penalties for not reporting a "listed" transaction are higher than the penalties for not reporting other types of transactions.  (After all, it is highly likely that the person not reporting is hoping to win the audit lottery and get away with the (likely) artificial loss and improperly low tax payment. ) For "normal" transactions, the penalty under section 6707A for not reporting is $10,000 for people and $50,000 for entities.  For listed transactions, the penalty is $100,000 for people and $200,000 otherwise.

Now, most tax academics know that those penalties are still low.  You need penalties equal to about 1800% times the tax liability to have an impact in terms of discouraging likely shelter transactions, since audits are so rare and recovery of the full amount of tax on audit is even rarer (especially if you discount for the government's cost of litigation).  So if only about 1 in 20 returns with inappropriate positions are audited and caught and ultimately forced to pay the real tax due, you'd need a penalty of about 20 times the tax due that one time to have a hope of deterring.  When the new 6707A penalties were enacted, it was encouraging that they finally had some numbers on them high enough to get  attention ($100,000, $200,000) though still , of course, not high enough to ensure  uniform compliance.  It would probably have been better if the penatly were written in terms of 10-20 times the tax liability at stake or gross income earned from promoting a deal, but Congress has still had trouble grappling with penalties that are just 100% of the gross income earned, for tax shelter promoters, for example, so it wasn't likely to do that.  

I find it discouraging, then, that there is apparently now a "bipartisan, bicameral commitment" to modify section 6707A to reduce the penalties to make them "more in a line with the tax benefits resulting from the transaction."  See Letter from IRS Commissioner Doug Shulman to Congressman John Lewis (Chair, House Ways and Means Subcommittee on Oversight), regarding a decision to suspend collection efforts in cases where taxpayers' tax benefits are below the penalty amounts, through  Sept. 30 while Congress works to change the penalty rule.

This reflects mostly a failure, again, of Congress (and even the IRS) to put enough muscle behind the tax laws to get them the respect they are due.  Yes, taxpayers will howl when they face penalties for engaging in listed transactions that exceed their purported tax savings.  Should we sympathize with the taxpayers or should we hope that the steep penalties will encourage taxpayers to file prudently rather than aggressively and, when they do undertake an aggressive transaction, to report it as they are supposed to rather than risking the fierce penalties?  I think the latter course is the more likely to result in improved compliance and less assertion of super-aggressive tax positions.

Comments

[DFMahey]

"Now, most tax academics know that those penalties are still low. You need penalties equal to about 1800% times the tax liability to have an impact in terms of discouraging likely shelter transactions,..."

How did you come up with this or is this just rhetoric?

[LindaMBeale]

I thought I explained the logic (which is probably in several of the introductory texts on tax). If there are very few audits (and there are--far fewer than 5% of returns are audited) and if aggressive or fraudulent positions aren't always caught at audits (which they are not), then you'd have to expect a penalty the one out of 20 times that you do get caught that is as much as you would have paid if you had been caught every single time for it to be much of a deterrent. Since otherwise, you will still win even if you get caught and pay the piper that 1 out of 20 times.

[DFMahey]

Linda,
I can appreciate your passion in highlighting tax abuses as much as any concerned taxpayer but I find your posts humorous at times at how you attempt to tighten your logic in making an argument using anecdotal evidence. Simply put your post is really grasping at air.

What you are arguing against is simply an attempt by the IRS to address an error in the broad and strict reach of the penalty provision. Keep in mind that the 6707A penalty provision has been criticized by many non-partisan groups including the Small Business Council of America, the American Bar Association Section of Taxation, and National Taxpayer Advocate, Nina Olson. The problem is due to the harshness of the law because it imposes strict liability, furthermore it must be imposed by IRS and cannot be rescinded under any circumstances and it cannot be appealed in court. The real problem is that it applies without regard to whether the taxpayer has knowledge that the transaction has been listed, whether the transaction is reported correctly on the taxpayer's return or whether the taxpayer derived little or no tax savings from the transaction.
Finally, the IRS Commissioner made it pretty clear that his letter to Congress relates only to certain taxpayers who were caught up in a penalty regime in a way that the legislation did not intend. He wasn’t arguing to eliminate the statute, in fact he stated that taxpayers employ abusive tax shelters in an attempt to avoid paying tax remains “sound and critically important” to IRS.

[LindaMBeale]

DF
I'm not sure that the fact that the Small Business Council, the ABA, and/or Nina Olson object to the strict liability penalty is a telling reason to eliminate it, even for those (as noted) to whom the suspension is directed, who garner tax benefits less than the penalties that apply. High strict liability penalties in an area where there has been significant and intentional noncompliance is not a bad idea per se. Yes, strict liability makes it hard on the taxpayer and requires that the taxpayer (and tax advisers) better inform themselves about the law. Yes, strict liability penalties at high levels will hit those who are doing less significant deals (or who don't even know that they are doing a listed transaction) particular hard. You may disagree with me in thinking that we need harsher penalties in order to reinstate more respect for the law in this area, but it is not "grasping at air" to argue that severe problems require such solutions.

Certainly every tax practitioner has seen the attitude prior to the advent of the reportable transaction rules, which was essentially an expectation that penalties would hardly ever apply (the "good faith" affirmative defense relied on as a "get out of jail free" card) and that what penalties were there were so small as to be not worth taking into account. Strict liability penalties are a strong answer to that problem.

My post made clear that the IRS's suspension (and plans for changing the statute) applied to those whose tax benefits were less than the applicable penalty. You apparently think that there will be too many "innocent" taxpayers caught by that, who will have, say, $90,000 of tax benefit from entering into a listed transaction and failing to report it, and that they shouldn't have to pay a $100,000 penalty. I will certainly agree that one of the things that makes strict liability penalties harsher is that they apply whether or not the person had "bad intent", I'm not convinced that the negatives are sufficient to merit changing the penalty for these cases where the tax benefit is less than the penalty. Sure, there is more concern when the taxpayer is intentionally engaging in a multimillion dollar tax benefit scam. But being softer on the smaller fry is still not necessarily a good idea. There is a pervasive norm of tax avoidance that I think has to be addressed, else more and more taxpayers will begin to treat compliance as a not-too-important goal.