Tax Administration
IRS Should Evaluate Penalties and Develop a Plan to Focus Its Efforts Gao ID: GAO-09-567 June 5, 2009Civil tax penalties are an important tool for encouraging compliance with tax laws. It is important that the Internal Revenue Service (IRS) administers penalties properly and determines the effectiveness of penalties in encouraging compliance. In response to a congressional request, GAO determined (1) whether IRS is evaluating penalties in a manner that supports sound penalty administration and voluntary compliance and, if not, how IRS may be able to do so, and (2) whether IRS's guidance for a new penalty for failure to disclose reportable transactions was issued in a timely manner and was useful to affected parties, and whether and how IRS has assessed the penalty. GAO reviewed IRS documents and guidance, and interviewed IRS officials and tax practitioners.
The Office of Servicewide Penalties (OSP) does not comprehensively evaluate the administration of civil tax penalties or their impact on voluntary compliance, but a plan could help it do so. OSP has responsibility for administering penalty programs and determining the action necessary to promote voluntary compliance. According to IRS policy, OSP should collect information to evaluate penalties and penalty administration and to determine the effectiveness of penalties in promoting voluntary compliance. This policy is consistent with positions expressed in 1989 by both an IRS Task Force report and by Congress when reforming penalties in 1989, and more recently by the National Taxpayer Advocate. OSP does not fulfill the responsibilities specified in IRS policy. Rather, OSP analysts focus on short-term issues, such as sudden spikes in assessments or abatements. OSP officials said that they have not done more to evaluate the administration of penalties and their effect on voluntary compliance because of resource constraints, methodological barriers, and limitations in available databases. A plan could help IRS focus its efforts and address the constraints to evaluating penalties. In developing a plan, IRS could identify the analyses it should do and the resources needed to do them. OSP could then determine what resources are available to assist it and what additional resources, if any, are needed. A plan also could lay out feasible research for evaluating the effect of penalties on voluntary compliance. For example, fairness is believed to undergird voluntary compliance. Thus, analyses that determine whether penalties are being consistently applied across IRS would provide pertinent information. Data limitations could be addressed in a plan, as well. The Enforcement Revenue Information System (ERIS) contains substantial data on IRS enforcement activities, but does not include all of the information recommended by the 1989 IRS Task Force report. For example, ERIS does not include readily usable information related to taxpayer income that could be used to determine equitable treatment of taxpayers. IRS issued guidance regarding its implementation of a penalty for failure to disclose reportable transactions-- transactions IRS identified as tax avoidance transactions--within 3 months of the provision's passage. IRS officials said that their criterion for issuing timely guidance is whether it was released in time to meet customers' needs. Tax practitioners from two leading practitioner organizations said the guidance was issued timely and included information they needed. However, the practitioners said more targeted outreach about the penalty was needed, specifically regarding reportable loss transactions caused bythe current economic climate in which many taxpayers may experience losses that could trigger the reportable transaction requirements. IRS officials recognize the need to further raise awareness of the penalty, but their planned efforts would reach only a small portion of tax return preparers and taxpayers. As of January 2009, IRS has assessed 98 penalties for $13.7 million.In addition, 1,188 returns had been assigned to field groups.
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Report to the Committee on Finance, U.S. Senate:
United States Government Accountability Office:
GAO:
June 2009:
Tax Administration:
IRS Should Evaluate Penalties and Develop a Plan to Focus Its Efforts:
GAO-09-567:
GAO Highlights:
Highlights of GAO-09-567, a report to the Committee on Finance, U.S.
Senate.
Why GAO Did This Study:
Civil tax penalties are an important tool for encouraging compliance
with tax laws. It is important that the Internal Revenue Service (IRS)
administers penalties properly and determines the effectiveness of
penalties in encouraging compliance.
In response to a congressional request, GAO determined (1) whether IRS
is evaluating penalties in a manner that supports sound penalty
administration and voluntary compliance and, if not, how IRS may be
able to do so, and (2) whether IRS‘s guidance for a new penalty for
failure to disclose reportable transactions was issued in a timely
manner and was useful to affected parties, and whether and how IRS has
assessed the penalty. GAO reviewed IRS documents and guidance, and
interviewed IRS officials and tax practitioners.
What GAO Found:
OSP does not comprehensively evaluate the administration of civil tax
penalties or their impact on voluntary compliance, but a plan could
help it do so. OSP has responsibility for administering penalty
programs and determining the action necessary to promote voluntary
compliance. According to IRS policy, OSP should collect information to
evaluate penalties and penalty administration and to determine the
effectiveness of penalties in promoting voluntary compliance. This
policy is consistent with positions expressed in 1989 by both an IRS
Task Force report and by Congress when reforming penalties in 1989, and
more recently by the National Taxpayer Advocate. OSP does not fulfill
the responsibilities specified in IRS policy. Rather, OSP analysts
focus on short-term issues, such as sudden spikes in assessments or
abatements. OSP officials said that they have not done more to evaluate
the administration of penalties and their effect on voluntary
compliance because of resource constraints, methodological barriers,
and limitations in available databases.
A plan could help IRS focus its efforts and address the constraints to
evaluating penalties. In developing a plan, IRS could identify the
analyses it should do and the resources needed to do them. OSP could
then determine what resources are available to assist it and what
additional resources, if any, are needed. A plan also could lay out
feasible research for evaluating the effect of penalties on voluntary
compliance. For example, fairness is believed to undergird voluntary
compliance. Thus, analyses that determine whether penalties are being
consistently applied across IRS would provide pertinent information.
Data limitations could be addressed in a plan, as well. The Enforcement
Revenue Information System (ERIS) contains substantial data on IRS
enforcement activities, but does not include all of the information
recommended by the 1989 IRS Task Force report. For example, ERIS does
not include readily usable information related to taxpayer income that
could be used to determine equitable treatment of taxpayers.
IRS issued guidance regarding its implementation of a penalty for
failure to disclose reportable transactions” transactions IRS
identified as tax avoidance transactions”within 3 months of the
provision‘s passage. IRS officials said that their criterion for
issuing timely guidance is whether it was released in time to meet
customers‘ needs. Tax practitioners from two leading practitioner
organizations said the guidance was issued timely and included
information they needed. However, the practitioners said more targeted
outreach about the penalty was needed, specifically regarding
reportable loss transactions caused by the current economic climate in
which many taxpayers may experience losses that could trigger the
reportable transaction requirements. IRS officials recognize the need
to further raise awareness of the penalty, but their planned efforts
would reach only a small portion of tax return preparers and taxpayers.
As of January 2009, IRS has assessed 98 penalties for $13.7 million. In
addition, 1,188 returns had been assigned to field groups.
What GAO Recommends:
The Commissioner of Internal Revenue should direct the Office of
Servicewide Penalties (OSP) to evaluate penalty administration and
penalties‘ effect on voluntary compliance and develop a plan to focus
its efforts. The Commissioner also should use IRS‘s standard outreach
methods to again alert taxpayers of the need to disclose reportable
loss transactions.
In commenting on a draft of this report, IRS concurred with GAO‘s
recommendations, and summarized the actions it plans to take.
To view the full product, including the scope and methodology, click on
[hyperlink, http://www.gao.gov/products/GAO-09-567]. For more
information, contact Michael Brostek (202) 512-9110 or
brostekm@gao.gov.
[End of section]
Contents:
Letter:
Background:
IRS Does Not Comprehensively Evaluate the Administration of Tax
Penalties or Their Impact on Voluntary Compliance, but a Plan Could
Help It Do So:
Reportable Transaction Guidance Was Timely Issued, but Could Be More
Useful to Affected Parties:
Conclusions:
Recommendations for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Comments from the Internal Revenue Service:
Appendix II: GAO Contact and Staff Acknowledgments:
Abbreviations:
ABA: American Bar Association:
AICPA: American Institute of Certified Public Accountants:
ERIS: Enforcement Revenue Information System:
FTA: Federation of Tax Administrators:
FTD: Failure to Deposit:
IRC: Internal Revenue Code:
IRS: Internal Revenue Service:
NAEA: National Association of Enrolled Agents:
OSP: Office of Servicewide Penalties:
OTSA: Office of Tax Shelter Analysis:
SB/SE: Small Business/Self Employed division:
TAS: Taxpayer Advocate Service:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
June 5, 2009:
The Honorable Max Baucus:
Chairman:
The Honorable Charles E. Grassley:
Ranking Member:
Committee on Finance:
United States Senate:
As a part of the Internal Revenue Service's (IRS) enforcement programs
and activities, civil tax penalties are an important tool for
encouraging taxpayer compliance with tax laws. It is important that IRS
administers penalties properly and determines the effectiveness of
penalties in encouraging compliance. The Internal Revenue Code (I.R.C.)
has more than 150 penalties. In fiscal year 2007, IRS assessed more
than 37.6 million civil penalties, totaling more than $29.5 billion,
while abating--that is, rescinding in whole or in part--more than 4.9
million civil penalties for more than $11.1 billion. Major reforms to
civil tax penalties were last made in 1989.
Your committee has expressed interest in the process IRS follows when
administering penalties and the effectiveness of the penalty regime,
and about the implementation of a penalty for failing to disclose
reportable transactions--transactions IRS has identified as tax
avoidance transactions or that are substantially similar thereto--and
whether it was being appropriately assessed. Therefore, we agreed to
determine (1) whether IRS is evaluating penalties in a manner that
supports sound penalty administration and voluntary compliance and, if
not, how IRS may be able to do so and (2) whether guidance for a new
penalty for the failure to disclose reportable transactions was issued
in a timely manner and was useful to affected parties, and whether and
how IRS has assessed the new penalty.
To determine whether IRS is evaluating penalties in a manner that
supports sound penalty administration and voluntary compliance, we
reviewed official documents and guidance, including the Internal
Revenue Manual. We interviewed officials from the IRS Office of
Servicewide Penalties (OSP) and the four IRS business divisions (Small
Business/Self Employed (SB/SE), Large & Mid-Size Business, Tax Exempt
and Government Entities, and Wage and Investment) to determine their
roles in penalty administration. In addition, we interviewed state
officials and reviewed academic studies regarding assessments of
penalty effectiveness and contacted the Federation of Tax
Administrators (FTA) for recommendations of states to contact.[Footnote
1] In all, we spoke with representatives of 25 states.[Footnote 2] To
determine whether IRS issued guidance for a new penalty for failure to
include reportable transactions information with returns[Footnote 3] in
a timely manner that was useful to affected parties and whether and how
IRS has assessed the new penalty, we reviewed IRS documentation and
guidance for implementing the penalty and implementation action plans.
We also interviewed officials from IRS's Office of Tax Shelter Analysis
(OTSA), Office of Chief Counsel, and the four business units about
their roles in implementing the penalty, as well as officials from the
Department of the Treasury's (Treasury) Office of Tax Policy. Finally,
because they collectively represent a significant portion of tax
preparers, we contacted the American Institute of Certified Public
Accountants (AICPA), the American Bar Association (ABA), and the
National Association of Enrolled Agents (NAEA) and asked to interview
members who were knowledgeable about the reportable transaction
penalty. We interviewed nine tax practitioners affiliated with the
AICPA and the ABA about the timeliness and usefulness of IRS outreach
efforts regarding the implementation of the reportable transaction
penalty, as well as their observations on IRS's use of the penalty. The
NAEA said that its membership had little experience with the reportable
transaction penalty, and did not provide names of any members for us to
contact. Because we interviewed a nonprobability sample of
practitioners, our discussion about the effectiveness of IRS's
implementation of the reportable transaction penalty cannot be used to
generalize to any other practitioners or group. Additionally, those we
spoke with presented their personal views, not those of the
professional associations through which they were contacted.
We conducted our work from October 2007 through May 2009 in accordance
with generally accepted government auditing standards. Those standards
require that we plan and perform the audit to obtain sufficient,
appropriate evidence to provide a reasonable basis for our findings and
conclusions based on our audit objectives. We believe that the evidence
obtained provides a reasonable basis for our findings and conclusions
based on our audit objectives.
Background:
The U.S. tax system depends on the principle of voluntary compliance,
that is, when taxpayers comply with the law without compulsion or
threat. Penalties are intended to encourage compliance by supporting
the tax reporting and remittance standards contained in the I.R.C.
According to IRS's penalty handbook, in order to advance the fairness
and effectiveness of the tax system, penalties should be severe enough
to deter noncompliance, encourage noncompliant taxpayers to comply, be
objectively proportioned to the offense, and be used to educate
taxpayers and encourage their future compliance.
Penalties are assessed either automatically by IRS's systems or as a
result of audits that reveal the compliance issues. For example, the
penalty for filing a tax return late is usually assessed automatically
when IRS's computer system detects a return filed after the filing
deadline. Penalties such as those assessed against taxpayers involved
with abusive tax shelters are assessed as a result of audits.
Supervisors must review and approve the results of an audit to assess a
penalty. Most penalties can be abated for reasonable cause if IRS
determines that the taxpayer exercised ordinary business care and
prudence in determining tax obligations but nevertheless was unable to
comply with those obligations. Examples of reasonable cause include,
but are not limited to, serious illness or an inability to obtain
records.
Following the release of an IRS Task Force report on civil tax
penalties in 1989[Footnote 4] Congress made its last major effort to
reform the tax penalty regime because of concerns that a piecemeal
approach to legislating civil tax penalties over the course of many
years resulted in a complex penalty system that was difficult for IRS
to administer and the taxpayer to comprehend. The legislation, the
Improved Penalty Administration and Compliance Tax Act,[Footnote 5] was
enacted in large part to simplify civil tax penalties. For example, the
act consolidated into one part of the I.R.C. all of the generally
applicable penalties relating to the accuracy of tax returns and
reorganized accuracy penalties to eliminate situations where one
infraction could receive more than one penalty. Overall, the act
reformed information reporting penalties; accuracy-related penalties;
preparer, promoter, and protester penalties; and penalties for failure
to file, pay, withhold, and make timely tax deposits.
OSP is assigned overall responsibility for IRS's penalty programs. As
such, OSP is charged with coordinating policy and procedures concerning
the administration of penalty programs, reviewing and analyzing penalty
information, researching taxpayer attitudes and opinions, and
determining appropriate action to promote voluntary compliance.
Current Treasury regulations[Footnote 6] state that every taxpayer that
has participated in a reportable transaction[Footnote 7] and that is
required to file a tax return must attach a disclosure statement to his
or her return for the taxable year and send a copy to OTSA.[Footnote 8]
In 2004, the American Jobs Creation Act[Footnote 9] created a new
penalty for failing to disclose reportable transactions with a tax
return.[Footnote 10] The purpose of the reportable transaction penalty
is to promote compliance with taxpayers' duty to disclose their
participation in transactions IRS has determined to have potential for
tax avoidance or evasion. For example, a taxpayer claiming a loss on
their tax return of at least $2 million in a single taxable year must
separately disclose the transaction to IRS. For most types of
reportable transactions, the penalty is $10,000 for an individual
taxpayer's return and $50,000 for other returns, such as business
returns and returns for benefit plans. For one type of reportable
transaction, a listed transaction, the amount of the penalty is
increased to $100,000 for individuals and $200,000 for other returns.
The Commissioner of Internal Revenue can abate the penalty for a
reportable transaction, other than a listed transaction,[Footnote 11]
if abating the penalty would promote compliance with the requirements
of the I.R.C. and effective tax administration. The decision to abate
must include a record describing the facts and reasons for the action
and the amount abated, and any decision to not abate the penalty is not
subject to judicial review.
IRS Does Not Comprehensively Evaluate the Administration of Tax
Penalties or Their Impact on Voluntary Compliance, but a Plan Could
Help It Do So:
Although IRS policies state that IRS should collect information to
evaluate the administration of penalties and their impact on voluntary
compliance, and IRS is collecting some relevant information, OSP is not
comprehensively evaluating penalty administration or penalties' impact
on voluntary compliance. According to IRS policies, OSP is to do the
following:
* Administer the penalty statutes in a manner that is fair and
impartial to both the government and the taxpayer, is consistent across
taxpayers, and ensures the accuracy of the penalty computation.
* Collect statistical and demographic information to evaluate penalties
and penalty administration and to determine the effectiveness of
penalties in promoting voluntary compliance.
* Design, administer, and evaluate penalty programs based on how those
programs can most efficiently encourage voluntary compliance.
* Continually evaluate the impact of the penalty program on compliance
and recommend changes when the I.R.C. or penalty administration does
not effectively promote voluntary compliance.
These policies are consistent with positions expressed in the 1989 IRS
Task Force report and by Congress when reforming penalties in 1989 and
with more recent views expressed by the National Taxpayer Advocate. All
stressed the need for IRS to evaluate the administration of penalties
and their impact on voluntary compliance. For example, the task force's
report and Congress in the conference report for the act that included
the penalty reform recommended that IRS analyze information concerning
the administration and impact of penalties for the purpose of
suggesting changes in compliance programs, educational programs,
penalty design, and penalty administration. The task force also
recommended that IRS analyze data to enable IRS, Treasury, and Congress
to evaluate how well penalties operate and what impact they have on
voluntary compliance. Similarly, in her 2008 annual report, the
National Taxpayer Advocate wrote that before serious penalty reform can
occur, better data about whether and how penalties promote voluntary
compliance is needed.[Footnote 12]
However, OSP generally does not fulfill the responsibilities specified
in IRS policy or as envisioned by the 1989 IRS Task Force report,
Congress, or the National Taxpayer Advocate. Rather, OSP analysts focus
most of their efforts on addressing short-term issues, such as sudden
spikes in assessments or abatements. These analyses are useful and
should continue, as they could identify emerging problems with how
penalties are being administered, but they do not constitute a
comprehensive assessment of penalty administration.
OSP officials said that they have not done more to evaluate the
administration of penalties and their effect on voluntary compliance
primarily because of resource constraints both within OSP and IRS's
various research units, methodological barriers that impede their
ability to research the effect of penalties on voluntary compliance,
and limitations in available databases.
A Plan Could Help Identify Needed Resources and Support Resource
Requests:
OSP does not have a plan for fulfilling its responsibilities. The
Government Performance and Results Act of 1993[Footnote 13] may be a
useful resource in developing such a plan as it provides several key
management principles needed to effectively guide, monitor, and assess
program implementation. These principles include (1) general and long-
term goals and objectives, (2) a description of actions to support
goals and objectives, (3) performance measures to evaluate specific
actions, (4) schedules and milestones for meeting deadlines, (5)
identification of resources needed, and (6) evaluation of the program
with processes to allow for adjustments and changes. This approach is
intended to ensure that agencies have thought through how the
activities and initiatives they are undertaking are likely to add up to
the meaningful result that their programs are intended to accomplish.
A plan would help to identify resource requirements and support
resource requests. In developing a plan, OSP would need to identify the
key penalty issues on which to focus its efforts, the types of analyses
that would best address those key issues, and the type and amount of
resources--whether within OSP or elsewhere in IRS--needed to execute
the plan. Thus, by focusing on what it is attempting to accomplish by
developing a plan, OSP would be better positioned to determine what
resources within IRS are available to assist it. Further, a well-
developed plan can provide policymakers within the executive branch and
Congress a better basis for determining the appropriate level of
resources for a program.
A Plan Could Lay Out Feasible Research for Evaluating the Effect of
Penalties on Voluntary Compliance:
Although OSP officials' concerns about methodological barriers to
determining the effect of penalties on voluntary compliance are valid,
relevant analyses likely could be performed. Developing a plan would
help OSP officials determine which analyses could be useful for this
purpose and possible strategies for furthering the state of knowledge
on the effect of penalties on compliance.
OSP officials pointed to several examples of the methodological
barriers to determining the effect of penalties on voluntary
compliance. For example, increases in penalty amounts might be
accompanied by other changes in enforcement activities, such as a
higher audit rate, and separating the effect of these factors on
voluntary compliance is difficult. In addition, a number of issues
other than IRS enforcement activities affect a taxpayer's behavior,
including income, tax rates, demographics and social factors, and the
influence of tax practitioners. Another complication is that a penalty
set at a certain amount may effectively encourage voluntary compliance
for one type of taxpayer, such as individuals, but not for another type
of taxpayer, such as businesses.
Our discussions with state officials and review of academic studies
raised similar concerns about the methodological barriers. None of the
25 states we contacted evaluate the impact of penalties on voluntary
compliance, and FTA was unaware of any states currently doing such
evaluations. State officials added that limited resources, political
disinterest, and technological barriers further constrain their penalty
analysis capacities. Some state officials said that they rely on IRS
information and research to establish state enforcement priorities and
similarly would look to IRS for penalty research. The academic studies
we reviewed concluded, consistent with OSP's view, that measuring the
impact of penalties on voluntary compliance is difficult because
numerous variables go into determining a taxpayer's decision to
voluntarily comply with tax laws. These variables include how risk
averse a person is and how likely he or she is to attempt to "get away"
with not complying.
Nevertheless, some analyses likely would be useful for better
understanding the effect of IRS penalties on taxpayers' voluntary
compliance. For example, it is widely believed that taxpayers are more
likely to comply voluntarily if they believe that the tax code is
implemented fairly and consistently across taxpayers. The 1989 IRS Task
Force noted that better knowledge of both penalty applications and the
perceptions of taxpayers that have been penalized were important in
ensuring that taxpayers feel they are being treated fairly. Thus,
analyses that determine whether penalties are being consistently
applied across IRS so that similarly situated taxpayers receive the
same penalties could provide pertinent information.
Penalties are also unlikely to have much effect on voluntary compliance
if they are not used. Treasury noted the importance of better
understanding the relationship between penalty administration and
voluntary compliance in its strategic plan for reducing the tax gap.
[Footnote 14] The plan states that Treasury wants penalties to be set
at more appropriate levels because some penalties may be too low to
change behavior but others may be so high that examiners are reluctant
to assess them.
The penalties for failure to provide appropriate information returns
are an example of penalties that do not appear to be properly
calibrated to influence compliance. The instructions for certain
information returns[Footnote 15] require that taxpayers submit the form
printed with special ink.[Footnote 16] Those that fail to do so are
subject to a $50 penalty. IRS officials said that this penalty and
other format-related penalties are not assessed because the cost of
developing and asserting the penalty was not worth it. Instead, IRS
officials correct the forms manually. IRS officials said that the
penalty would have to be raised substantially to make it worthwhile to
assess. The decision to not assess penalties for this error based only
on the revenue received from those penalized may have actually
undermined voluntary compliance. A version of a popular tax preparation
software package informs taxpayers that IRS has accepted forms that are
not printed with the special ink.
In addition, IRS may be able to do certain longitudinal analyses of
whether taxpayers assessed a penalty in one year become more compliant
in future years. For example, IRS may be able to determine whether
taxpayers that were assessed an underpayment penalty one year were
assessed the same penalty in years that followed. Although multiple
factors would influence the result, the data might help IRS better
understand whether the penalty may have any effect on future
compliance.
Currently, SB/SE's Research group is working on a project reviewing the
First Time Abate policy that may provide some information related to
certain penalties' effect on compliance.[Footnote 17] IRS did not know
some information about the results of the policy, including the number
of penalties abated under the policy, the amount of money involved, and
the number of taxpayers qualifying for the abatement but not receiving
it. Additionally, other questions have surfaced, including whether the
policy is fair, whether taxpayers receiving the abatement "game" the
system by complying for 3 years and then getting the abatement again,
and, ultimately, whether the policy should be continued. Results of the
project are expected in the summer of 2010.
In addition to analyses related to voluntary compliance that could be
done internally, by developing a plan, OSP may be able to identify
other means of developing information useful to gauging penalties'
effect on voluntary compliance. Taxpayer surveys or focus groups, for
instance, could provide information on taxpayers' perceptions about the
fairness of penalties.
IRS could also explore other avenues for supporting research of penalty
effectiveness, such as encouraging others to examine the relationship
between penalties and voluntary compliance. For example, IRS hosts an
annual research conference and 6 forums across the country used to
discuss tax administration issues with experts and practitioners. These
conferences and forums have been used to discuss compliance issues. At
the 2008 IRS Research Conference, papers on measuring or improving tax
compliance were presented. These types of studies, done independently,
can potentially add valuable thoughts and information to the discussion
on how best to encourage and increase taxpayer compliance with tax
laws.
Data Limitations Could Be Addressed in a Plan:
Finally, in developing a plan, OSP could assess options for overcoming
the limitations in available data that officials say impede its ability
to both assess the effect of penalties on voluntary compliance and
perform more sophisticated reviews of IRS's administration of
penalties. The 1989 IRS Task Force report said IRS needed to develop an
interactive database available for all management levels to perform ad
hoc analysis of penalty administration and voluntary compliance. One of
the task force's recommendations was to develop a database that
captured the maximum amount of data in order to avoid the expense and
delay for special master file extracts. With this database, IRS would
evaluate the equitable treatment of taxpayers with respect to all
aspects of penalties (e.g., penalty waivers and taxpayer demographic
information, such as income).
The Enforcement Revenue Information System (ERIS) contains substantial
data on all IRS enforcement activities, including penalties. However,
ERIS does not meet several of the task force's recommendations. For
example, ERIS does not include readily usable information related to
taxpayer income or practitioner representation that could be used to
determine equitable treatment, develop employee training, or provide
taxpayer education outreach. ERIS is not available at all management
levels. While the system is used to develop many standard reports,
officials say a lack of resources has prevented it from producing
additional reports that could increase understanding of penalties. For
example, the First Time Abate policy research project is using master
file extracts instead of ERIS.
In addition, IRS does not routinely use existing penalty data to
evaluate the administration of penalties. For example, IRS does not
identify:
* penalties with low or high assessment and abatement rates,
* whether significant differences exist in the abatement rate for high-
income taxpayers relative to lower-income taxpayers,
* whether significant differences exist in penalty size between
taxpayers that negotiate an installment agreement relative to those who
pay cash,
* whether returns prepared by a paid preparer are more or less likely
to have penalties abated,
* whether penalties are assessed or abated at different rates based on
the geographic location where the case is worked,
* whether individual taxpayers receive more or fewer abatements than
businesses for the same penalties, and:
* whether the rate of erroneous penalty assessments is increasing or
decreasing.
Analyses of trends in penalty data could help IRS identify areas that
need further investigation and when penalties may not be applied
consistently and fairly. For example, a low assessment rate could
indicate that a penalty is effectively deterring noncompliance and that
the infrequency of its assessment is appropriate. However, a low
assessment rate might also indicate that a penalty has become outdated
or is deemed too burdensome to assess. Similarly, a high abatement rate
could indicate that IRS officials are hesitant to sustain a penalty
because they deem it too harsh for the infraction.
IRS changed the process it follows to assess the penalty for an
employer's failure to deposit the correct amount of taxes for
employees, known as the Failure to Deposit (FTD) penalty,[Footnote 18]
based on a trend analysis done by others. The Taxpayer Advocate Service
(TAS) noted in its 2003 report[Footnote 19] that IRS abated a
substantial number of FTD penalties and that the higher the penalty,
the more likely the penalty was to be abated. According to IRS, 24
percent of FTD penalties had been abated in 2002 accounting for 62
percent of the assessed dollars. Based in part on TAS's data analysis,
IRS changed the procedures it follows to assess the FTD penalty by
sending a notice to taxpayers warning them of possible assessment if
they did not deposit what they owed. According to a report by the
Treasury Inspector General for Tax Administration,[Footnote 20] this
procedural change helped lead to a decrease in penalty assessments and
abatements.
Reportable Transaction Guidance Was Timely Issued, but Could Be More
Useful to Affected Parties:
IRS issued guidance to implement a new penalty for taxpayers that fail
to disclose a reportable transaction in a timely manner and began
assessing penalties after audits had been conducted. The reportable
transaction penalty was effective immediately after its passage in
October 2004,[Footnote 21] making the development of guidance on how
IRS would interpret and implement the law important. Within 3 months,
in January 2005, IRS issued interim guidance to alert taxpayers and
practitioners to the reportable transaction penalty and how IRS planned
to implement it.[Footnote 22] For example, the interim guidance
explains the conditions under which IRS would impose the penalty and
how it would use the authority to abate the penalty. Officials in the
Office of Chief Counsel told us that their criterion for issuing
guidance successfully is whether it was released in time to meet their
customers' needs. The practitioners we spoke with from two leading
practitioner organizations said that issuing the interim guidance in
only 3 months was quick and the guidance included the information they
needed to understand how IRS would implement the penalty.
Those same practitioners were concerned that other practitioners may
lack an understanding of all of the requirements for disclosing
reportable transactions and suggested that more targeted outreach
regarding the reportable transaction penalty was needed, since the
penalty is large and the process to get the penalty abated is
difficult. As mentioned earlier, the Commissioner of Internal Revenue,
or the Commissioner's delegate, can abate the penalty for most types of
reportable transactions, but if a taxpayer is penalized for a listed
transaction there is no abatement option. These practitioners said that
it would be easy to inadvertently violate the provision because
taxpayers and practitioners may not realize that transactions that seem
reasonable to them and have resulted in no net gain are considered
reportable. They noted that if some practitioners or taxpayers are
associating this penalty only with abusive tax shelters, they may not
realize all of the situations where the requirement to disclose a
transaction applies. They added that in the current economic climate
there are likely to be many transactions that result in a loss that do
not get disclosed on the required form.[Footnote 23] The practitioners
said that they were concerned because taxpayers and other practitioners
may not have been in such situations before, and it is likely that IRS
will see a significant increase in undisclosed transactions of this
nature.
In the 2008 Annual Report,[Footnote 24] TAS also expressed concerns
that the reportable transaction penalty is being assessed against
taxpayers for which it was not intended and that the penalty is
unfairly harsh. According to TAS, the purpose of the penalty is to
combat tax shelters by penalizing taxpayers that failed to disclose
that they have entered into transactions deemed aggressive by IRS.
Because the reportable transaction penalty applies without exception to
the failure to include disclosure on a return when required, an
improper tax benefit is not required as long as the tax return reflects
tax consequences or a tax strategy described in public guidance.
IRS officials said they conducted standard educational outreach to the
practitioner community regarding the specifics of the reportable
transaction penalty. This included sending updates to e-mail groups
regarding notices and revenue procedures implementing the new penalty
requirements, postings of the latest news to IRS's Web site, and
requesting comments on proposed regulations. In addition, officials in
OTSA said that they had presented information on the penalty to
practitioner groups as part of larger presentations on civil penalties.
However, some of the practitioners we spoke with said that in the
current substantially altered economic climate, some taxpayers may be
caught unaware of the need to disclose a reportable loss transaction
and be penalized without a ready avenue for relief. Further, there is
little basis to reliably predict which taxpayers might be caught in
this situation.
IRS officials recognize the need to further raise awareness with
taxpayers. They plan to use the National Tax Forums[Footnote 25] during
the summer of 2009 to hold focus groups regarding the reportable
transaction penalty. The goal of the focus groups is to reach out to
practitioners who may not understand the disclosure requirements and
get the thoughts of those who have had experience with the reportable
transaction penalty. However, at best, IRS would only reach a small
portion of the tax return preparer community in this fashion even
though many preparers may end up with clients susceptible to the
penalty. Using its standard, low-cost outreach methods to again focus
tax preparers and the public's awareness on the disclosure requirements
for the reportable loss transaction could reach a wider audience.
IRS officials said that the majority of tax returns eligible for
assessment of the penalty were not filed until fall 2005, well after
the interim guidance had been released, and would not have been audited
until 2006. IRS officials said that development of these cases takes
time and that IRS could not assess the penalty until there was
sufficient basis to believe that a taxpayer had participated in a
reportable transaction during a specific taxable year, had a disclosure
requirement, and failed to complete the required form. IRS receives the
required forms at its Ogden facility but does not assess penalties
until after referring cases to an examiner. A penalty is only assessed
after an examiner reviews the case because examiners develop related
issues that may not be apparent from the face of the form itself. If a
taxpayer failed to report participation in a reportable transaction,
IRS would not know of the taxpayer's participation until it examined
the tax return or investigated the promoter of the transaction.
Therefore, the majority of cases for which a penalty may have been
appropriate would not have been identified until late 2006 and 2007.
According to IRS officials, as of January 2009, IRS had assessed 98 of
the penalties for $13.7 million and collected $2.7 million. In
addition, 1,188 returns had been assigned to field groups and 50
returns were being reviewed by IRS's Appeals Division.
Conclusions:
Civil tax penalties play an important role in helping ensure that
taxpayers make an honest effort to pay the taxes that they owe. Twenty
years after Congress and an IRS Task Force said that IRS needs to
conduct more continuous and comprehensive analyses of the penalties it
administers and their effect on voluntary compliance, and after having
designated an office with those responsibilities, IRS is not meeting
this expectation. IRS does not have a plan that identifies how it will
carry out these responsibilities and address the resource,
methodological, and data limitations that officials say impede its
progress. IRS should develop and execute such a plan to better focus
its efforts and ensure that penalties are being administered
efficiently, effectively, fairly, and consistent with encouraging
taxpayers' voluntary compliance.
IRS issued guidance for the reportable transaction penalty in a timely
manner following its passage in 2004. However, in the current economic
climate certain transactions involving losses may subject many
unsuspecting taxpayers to a harsh penalty. They may be unaware of
reporting requirements because they have never been in such situations
before. IRS's planned additional outreach on this penalty is not
sufficient. IRS should use its standard, low-cost outreach methods to
alert as many tax return preparers and taxpayers as possible about the
need to properly report loss transactions to avoid penalties.
Recommendations for Executive Action:
In order to ensure the most efficient, fair, and consistent
administration of civil tax penalties, and that penalties are achieving
their purpose of encouraging voluntary compliance, the Commissioner of
Internal Revenue should direct OSP to evaluate penalty administration
and penalties' effect on voluntary compliance. The Commissioner also
should direct OSP to develop and implement a plan to collect and
analyze penalty-related data. The plan should address the constraints
officials have identified as impeding progress in analyzing penalties.
In addition, the Commissioner of Internal Revenue should use IRS's
standard, low-cost methods of outreach to again alert as many tax
return preparers and taxpayers as possible about the need to properly
report loss transactions to avoid penalties.
Agency Comments and Our Evaluation:
The Deputy Commissioner for Services and Enforcement provided written
comments in a May 26, 2009, letter, which is reprinted in appendix I.
IRS staff also provided technical comments that we incorporated as
appropriate.
IRS agreed that OSP will develop a plan to comprehensively evaluate
penalty administration and the impact of penalties on voluntary
compliance. IRS said that such a plan was important in understanding
the relationship between penalty administration and voluntary
compliance and in identifying priorities and potential resource needs.
Developing a comprehensive plan may take time. In the interim, we
believe that the data IRS currently collects can be used to begin
useful penalty analyses. For example, IRS could evaluate whether
penalties are assessed or abated at different rates based on the
geographic location of the office responsible for the case or whether
significant differences exist in the abatement rate for high-income
taxpayers relative to lower-income taxpayers. Such analyses could be
done now and help IRS determine whether penalties are being applied
consistently.
IRS also agreed to undertake outreach to ensure that taxpayers are
again alerted to the situations where disclosure of reportable
transactions is needed.
As agreed with your offices, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from the report date. At that time, we will send copies to the Chairman
and Ranking Member, House Committee on Ways and Means; the Secretary of
the Treasury; the Commissioner of Internal Revenue; and other
interested parties. This report also will be available at no charge on
the GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff have any questions concerning this report, please
contact me on (202) 512-9110 or brostekm@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. Key contributors to this report are
listed in appendix II.
Signed by:
Michael Brostek:
Director, Tax Issues Strategic Issues Team:
[End of section]
Appendix I: Comments from the Internal Revenue Service:
Department Of The Treasury:
Internal Revenue Service:
Deputy Commissioner:
Washington, D.C. 20224:
May 26, 2009:
Mr. Michael Brostek:
Director, Strategic Issues:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Brostek:
Thank you for the opportunity to review the Government Accountability
Office's (GAO) draft report entitled "Tax Administration - IRS Should
Evaluate Penalties and Develop a Plan to Focus Its Efforts (Job Code
GAO-09-567)."
We recognize that civil tax penalties are an important tool for
encouraging compliance with tax laws. Effective administration of
penalty application is critical in ensuring fair and equitable
treatment of taxpayers and ensuring voluntary compliance.
The Office of Servicewide Penalties (OSP) has overall responsibility
for the Internal Revenue Service's (IRS) civil penalty program. We
concur that an OSP comprehensive plan to evaluate the administration of
civil tax penalties to understand the relationship between penalty
administration and voluntary compliance is important. Additionally,
such a plan will be useful in identifying priorities and in determining
additional potential resource needs. We agree that this analysis would
likely result in a better understanding of the effect of IRS penalties
on taxpayers' voluntary compliance.
Your report also stresses the importance of collecting information to
evaluate penalty administration. OSP is in agreement and has already
commissioned IRS Research to conduct an analysis using Masterfile data
on its behalf. For example, OSP requested that IRS Research complete a
project on the First Time Abatement policy for Failure to File, Failure
to Pay, and Failure to Deposit penalties.
We appreciate the suggestions that you provided in your report and will
carefully consider the findings as we develop the OSP plan.
The enclosed response addresses each recommendation separately.
If you have any questions, please contact Christopher Wagner,
Commissioner, Small Business/Self-Employed Division at (202) 622-0600.
Sincerely,
Signed by:
Linda E. Stiff:
Enclosure:
[End of letter]
Enclosure:
Recommendation:
In order to ensure the most efficient, fair, and consistent
administration of civil tax penalties, and that penalties are achieving
their purpose of encouraging voluntary compliance, the Commissioner of
Internal Revenue should direct OSP to evaluate penalty administration
and penalties effect on voluntary compliance. The Commissioner also
should direct OSP to develop and implement a plan to collect and
analyze penalty related data. The plan should address the constraints
officials have identified as impeding progress in analyzing penalties.
Comment:
IRS's OSP will develop a plan to comprehensively evaluate penalty
administration and the impact of penalties on voluntary compliance.
Such a plan will be useful in identifying priorities and in determining
additional potential resource needs.
Recommendation:
In addition, the Commissioner of Internal Revenue should use IRS's
standard, low cost methods of outreach to again alert as many tax
return preparers and taxpayers as possible about the need to properly
report loss transactions to avoid penalties.
Comment:
We will work with our Communications staff to use the standard outreach
methods to again alert taxpayers of the situations where disclosure is
needed.
[End of section]
Appendix II: GAO Contact and Staff Acknowledgments:
GAO Contact:
Michael Brostek, (202) 512-9110 or brostekm@gao.gov:
Acknowledgments:
In addition to the contact named above, Jonda R. Van Pelt, Assistant
Director; Julia T. Coulter; Benjamin C. Crawford; Alison Hoenk; Ellen
M. Rominger; Elwood D. White; and John M. Zombro made key contributions
to this report.
[End of section]
Footnotes:
[1] FTA provides services to state tax authorities and administrators.
These services include research and information exchange, training, and
intergovernmental and interstate coordination. FTA staff members
regularly monitor the activities of state tax agencies and the federal
government in order to serve as a clearinghouse on topics important to
tax administrators.
[2] We spoke with officials from Alabama, Arizona, California,
Delaware, Florida, Hawaii, Illinois, Iowa, Indiana, Louisiana, Maine,
Massachusetts, Minnesota, Montana, Nebraska, New York, North Carolina,
Oklahoma, Oregon, Tennessee, Texas, Utah, Vermont, Washington, and
Wisconsin. To select the states, we reviewed information contained on
state tax bureau Web sites, such as press releases related to
penalties, and contacted FTA for recommendations.
[3] 26 U.S.C. § 6707A.
[4] See Executive Task Force for the Commissioner's Penalty Study,
Report on Civil Tax Penalties (Washington, D.C.: Feb. 22, 1989).
[5] The Improved Penalty Administration and Compliance Tax Act was
enacted as part of the Omnibus Budget Reconciliation Act of 1989. Pub.
L. No. 101-239 (1989).
[6] Treasury Regulation § 1.6011-4.
[7] Currently, reportable transactions include: (1) listed
transactions, which are the same as or substantially similar to one of
the types of transactions that IRS has determined to be tax avoidance
transactions; (2) confidential transactions, which are transactions
that are offered to a taxpayer or a related party under conditions of
confidentiality and for which a taxpayer or a related party paid an
advisor a minimum fee; (3) transactions with contractual protection,
which are transactions for which a taxpayer has, or a related party
has, the right to a full refund or partial refund of fees if all or
part of the intended tax consequences from the transaction are not
sustained; (4) loss transactions, which are transactions that result in
a taxpayer claiming a loss under IRC section 165 exceeding specified
amounts; and (5) transactions of interest, which are the same as or
substantially similar to one of the types of transactions that IRS has
identified by notice, regulation or other form of published guidance as
transactions of interest. The regulations state that the fact that a
transaction is a reportable transaction does not affect the legal
determination of whether the taxpayer's treatment of the transaction is
proper.
[8] IRS Form 8886, Reportable Transaction Disclosure Statement. When
IRS identifies a transaction as a listed transaction after a taxpayer
has filed a return reflecting participation in the transaction, the
taxpayer has 90 days to file a disclosure statement with OTSA.
[9] Pub. L. No. 108-357 (2004).
[10] 26 U.S.C. § 6707A.
[11] As of May 2009, there is a bill in the Senate and a bill in the
House of Representatives that would eliminate the abatement provisions
and add an exception to the penalty for failure to disclose reportable
transactions when there is reasonable cause for such failure. See S.
765, April 1, 2009, and H.R. 2143, April 28, 2009.
[12] National Taxpayer Advocate, 2008 Annual Report to Congress, vol. 2
(Washington, D.C.: Dec. 31, 2008).
[13] Pub. L. No. 103-62 (1993).
[14] Department of the Treasury, Office of Tax Policy, A Comprehensive
Strategy for Reducing the Tax Gap (Washington, D.C.: Sept. 26, 2006).
[15] Examples include Form 1096, Annual Summary and Transmittal of U.S.
Information Returns, and Form 1099, Miscellaneous Income.
[16] The special ink is a red drop-out ink. It is colored in such a way
as to be invisible to optical scanning devices, increasing the
efficiency of data processing by allowing the scanner to skip
nonessential information.
[17] The First Time Abate policy is an exam program that grants relief
to certain taxpayers who receive a failure to file, pay, or deposit
penalty. Taxpayers with a clean history for the 3 years prior to
receiving the penalty may have it abated. No reason is required. The
only caveat is that they must contact IRS regarding the penalty.
[18] 26 U.S.C. § 6656.
[19] Taxpayer Advocate Service, National Taxpayer Advocate 2003 Annual
Report to Congress (Washington, D.C.: Dec. 31, 2003).
[20] Treasury Inspector General for Tax Administration, Federal Tax
Deposit Penalties Have Been Significantly Reduced, but Additional Steps
Could Further Reduce Avoidable Penalty Assessments, Reference Number
2005-30-136 (Washington, D.C.: September 2005).
[21] Pub. L. No. 108-357 (2004).
[22] Notice 2005-11.
[23] Specifically, these transactions are loss transactions resulting
in a claim for a loss under I.R.C. § 165 of at least $10 million in any
single taxable year or $20 million in any combination of taxable years
for corporations or partnerships that have only corporations as
partners; $2 million in any single taxable year or $4 million in any
combination of taxable years for all other partnerships and
individuals, S corporations, or trusts; and $50,000 in any single
taxable year for individuals or trusts if the loss arises with respect
to I.R.C. § 988 relating to foreign currency transactions.
[24] Taxpayer Advocate Service, National Taxpayer Advocate 2008 Annual
Report to Congress (Washington, D.C.: Dec. 31, 2008).
[25] The National Tax Forums are held annually in multiple locations
across the United States. Many groups, including the AICPA, the ABA,
the NAEA, the National Association of Tax Professionals, the National
Society of Accountants, and the National Society of Tax Professionals
participate in the forums.
[End of section]
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