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Another year, another penalty; the ever-changing state of civil penalties.

Another Year, Another Penalty

The Ever-Changing State of Civil Penalties

The decade of the '80s saw continuous congressional tinkering with the civil penalty provisions of the Internal Revenue Code in an effort to curb what were perceived to be widespread abuses of our tax system. The result was a clearly bewildering explosion of penalties, topping out in 1987 with 150 different categories which left taxpayers and their advisers in a state of confusion and consternation. While the Revenue Reconciliation Act of 1989's reform package embodied in the Improved Penalty Administration and Compliance Tax Act (IMPACT) will put to rest many of these problems with its revision and simplification of the structure of tax penalties, the practitioner must still be knowledgeable about the rules that came before because those "old" penalties will still be applicable to some returns.

In addition to tax years that are still open for examination under the normal three-year statute of limitations [Sec. 6501(a)], there are other returns which may still be live for assessment purposes. For example, if a return contains a fraudulent item, there is no time bar [Sec. 6501(c)(1)]. Other returns may be subject to the six-year statute under Section 6501(e) if there has been a substantial omission of items of income. And finally, some tax years remain open due to the taxpayer's agreement for extension [Sec. 6501(c)(4)]. Thus, even returns from the early and mid-1980s may still be the subject of IRS audits.

In light of this continuing relevance of the pre-IMPACT penalty sections, the purpose of this article is to summarize the civil penalties which have existed throughout the 1980s, focusing principally on the "big three" -- negligence, fraud and delinquency -- and using as illustrations of the changing nature of these penalties examples of how the various versions of the Code would result in different assessments.

Which Year Is It?

Before turning to the evolution of specific civil penalties, it is important to be able to identify which statutory provision applies to which return. In other words, which year are we talking about? The key is the due date for the return. In short, the applicability of a particular penalty is determined by when the return in question should have been filed (without regard to extensions), not when it actually was filed.

During the 1980s, there were five pieces of tax legislation which substantially affected the civil penalty system. Each was (and still is) effective for returns whose due date falls after a particular date. Accordingly, the Economic Recovery Tax Act of 1981 (ERTA) applies to returns after December 31, 1981; the Tax Equity & Fiscal Responsibility Act of 1982 (TEFRA) controls returns after December 31, 1982; the Tax Reform Act of 1986 is relevant for returns after December 31, 1986; the Technical & Miscellaneous Revenue Act of 1988 (TAMRA) governs returns after December 31, 1988; and finally, IMPACT, as part of the Revenue Reconciliation Act of 1989, will be applicable for returns whose due date falls after December 31, 1989. (See Exhibit 1, organized by the controlling return dates, for a summary of the penalty provisions that have applied throughout the last decade.)

Negligence

During the first part of the '80s, an "addition to tax" was imposed for negligence or intentional disregard of the rules and regulations relating to taxation. TRA '86 dropped the requirement of intentionality, making merely careless disregard sufficient to assess the so-called negligence penalty. IMPACT continues this formulation of disregard, along with the TRA's definition of negligence, by providing a penalty when there has been a "failure to make a reasonable attempt to comply with the provisions" of the Code [Sec. 6662(b)(1) & (c), previously, TRA Sec. 6653(a)(1) & (3)]. Despite this continuity in the concept of negligence, IMPACT has brought three important modifications to the previous penalties for negligent tax returns.

Perhaps the most obvious change is the increase in the percentage rate of the penalty from 5% to 20% [previously Sec. 6653(a)(1), now, Sec. 6662(a)]. Just as important as this rate change is the transition from a "stackable," non-targeted penalty to a non-cumulative and targeted one. Under pre-IMPACT statutes, the civil penalties for delinquency, substantial understatement of income tax and/or negligence could be accumulated and assessed against a taxpayer, resulting in multiple penalties stemming from the same act or omission. In addition, once any portion of an underpayment was found to be due to negligence, the entire amount of the underpayment was subject to the 5% negligence penalty [TRA Sec. 6653(a)(1)].

The new Section 6662 changed both of these aspects. Not only are penalties not stacked-up on top of one another, but only that portion of the underpayment attributable to negligence is subject to the 20% penalty [Sec. 6662(a) & (b)(1)]. Thus, although the rate is substantially higher, the penalty is only imposed once for a particular item and is limited to the amount of that item. It should be noted, however, that even though the negligence penalty is now targeted, it is the taxpayer who bears the burden of proving what amount of the understatement of tax is not the result of a failure to make a reasonable effort to comply nor due to the disregard of rules and regulations and, therefore, not subject to the 20% penalty.

Repealed by TAMRA and consequently no longer a component of the penalty, an additional amount was levied on returns with due dates after December 31, 1981, and before January 1, 1988. This time sensitive negligence penalty was equal to 50% of the interest accruing under Section 6601 between the due date of the return and the date of assessment on that portion of the underpayment attributable to negligence [ERTA Sec. 6653(a)(2); TRA Sec. 6653(a)(1)(B)]. While certainly a substantial piece of the old negligence penalty, the continuing significance of this interest add-on should be minor since, given the normal three-year statute of limitations on assessment, few negligent returns for the years to which it applied will remain open into the 1990s. As will be discussed later, this is not true for a similar provision which applies to the civil fraud penalty. With fraud, owing to the fact that there is no time bar for assessment, this component of the penalty should have much broader importance and applicability.

The elimination of the 50% interest add-on did involve a trade-off in respect to how interest on the negligence penalty would accrue under Section 6601. Under the old, pre-TAMRA law, interest on the negligence penalty (as well as on fraud and most other penalties) began to run only after the assessment or, more accurately, after the notice and demand for payment [ERTA, TEFRA & TRA Sec. 6601(e)(3)]. Consequently, if a taxpayer paid the entire amount of the deficiency including the penalty within 10 days of the notice and demand for payment, no additional interest would be charged on the penalty itself. Subsequent to TAMRA (and continuing under IMPACT), interest on the negligence penalty starts accruing on the due date of the return (including extensions) [Sec. 6601(e)(2)(B)]. The accrual of interest during this additional period between the due date and date of assessment, when coupled with the increase in the percentage rate on the penalty itself, makes a judgment of whether the taxpayer or the government comes out ahead under the new rules problematic.

One other change in the provisions relating to the negligence penalty deserves to be mentioned -- the presumption of negligence arising from non-reporting of items. Originally limited to the non-reporting of interest and dividend income, Section 6653(g) was expanded by TRA to cover any amount reported on an informational return (e.g. Form 1099) which was not included in the taxpayer's return. Once the fact of nonreporting was established, a presumption of negligence arose -- which could only be rebutted by clear and convincing evidence offered by the taxpayer. If he or she were not able to satisfy this higher than the usual "preponderance of the evidence" standard of proof, the taxpayer was subject to the 5% penalty which was targeted to the unreported amount. For returns after December 31, 1989, IMPACT has eliminated this presumption of negligence.

Other Accuracy Penalties

One of the principal contributions of IMPACT is the simplification and rationalization of the various penalties for negligence, substantial understatements of income tax and various misvaluations. All of these are now found in Section 6662, all are subject to a uniform 20% penalty (except for gross misvaluations, discussed below), and all are targeted in the sense that the penalty is only assessed on that part of the understatement attributable to the particular infraction [Sec. 6662(a) & (b)]. Furthermore, these penalties cannot be stacked one upon another, applied to any portion of the underpayment on which the civil fraud penalty of Section 6663 is imposed, nor assessed where a return has not been filed [Sec. 6662(b); Sec. 6664(b)]. Such was not always the case during the 1980s.

Substantial Understatement of Tax

Beginning with TEFRA, a separate penalty was imposed for a substantial understatement of income tax. Originally a 10% targeted amount, it increased to 20% under TRA and then, even before the 20% rate could take effect, to 25% under the Omnibus Budget Reconciliation Act of 1986 (OMBRA) (for penalties assessed after October 21, 1986) [TEFRA, TRA, OMBRA & TAMRA Sec. 6661(a)]. The penalty was, and still is, applied in situations in which the amount of the understatement, defined as the excess of the correct tax over the tax shown on the return, exceeded the greater of 10% of the correct tax or $5,000 ($10,000 for most corporations) [previously, Sec. 6661(b)(1) & (2); now, Sec. 6662(d)(1) & (2)].

A major difference between the pre-IMPACT provision and the current Section 6662(b)(2) is that the former was in essence a no fault or strict liability penalty. If a substantial understatement occurred, then the penalty was imposed. With the possible exception of the disclosure situations discussed below, the taxpayer's good faith or reasonable efforts to comply with the statute were irrelevant. Accordingly, in many instances, even when a taxpayer was able to successfully defend against the negligence penalty, he or she was still stuck with a substantial understatement addition to his or her tax.

The most insidious aspect of the old understatement penalty, at least from a taxpayer's point of view, was the way in which it could be stacked with other penalties. A fairly common scenario would involve a failure to file a return. Upon examinations, IRS would attempt to slap a taxpayer with a delinquency penalty under Section 6651, a negligence penalty under old Section 6653(a) and the substantial understatement under Section 6661. As case law indicates (see, for example, Woods v. Commissioner, 91 T.C. 88 (1988)), there was nothing in the pre-IMPACT statute to prevent this multiplication of penalties for what was essentially only one transgression.

Overvaluations

Beginning with returns due after December 31, 1981, penalties have been imposed for the underpayment of income tax due to the overstatement of property values [ERTA Sec. 6659]. Primarily related to excessive deductions for depreciation, investment tax credits and charitable contributions, the penalties under old Section 6659 were stepped in relation to amount of overvaluation. Subject to a de minimis exception that there had to be at least a $1,000 underpayment of tax, a 10% penalty was levied on valuations which were between 150% and 200% of the true value of the property, 20% if the valuations were between 2 and 2 1/2 times the correct value, and 30% if the valuation was more than 250% of the correct value of the property. (Special rules were applied in the case of charitable deduction property where, in absence of a qualified appraisal, the 30% penalty was imposed even if the reported valuation was not in excess of 250% of the true value of the property.) Similar penalties for understatements of tax due to the deduction of overvalued pension liabilities were added for overstatements after October 22, 1986 [TRA Sec. 6659A].

Interest also played a part in the overvaluation penalty. Pre-dating the change for the accrual of interest on the negligence/fraud penalties by some five years, interest began to run on these misvaluations from the due date of the return [Deficit Reduction Act of 1984 (DRA), Sec. 6601(e)(2), applicable for returns after December 31, 1984]. Furthermore, adding salt to the wound, the rate charged would usually be 120% of the normal interest rate determined under Section 6621 since valuation overstatements were one of the specified tax motivated transactions to which this additional interest applied [DRA Sec. 6621(d); TRA Sec. 6621(c)(3)(i)].

In addition to moving these overvaluations penalties from their own individual code provisions into the consolidated Section 6662, IMPACT also simplified their step structure by creating a two tier penalty: 20% for valuations 200-400% of true value and 40% for valuations over 400% of the correct property value [Sec. 6662(e),(f) & (h)]. It also raised the de minimis amount of underpayment to $5,000 for individuals, $10,000 for corporations (the $1,000 floor remains intact for understatements due to overstatements of pension liabilities) [Sec. 6662(e)(2) & (f)(2)]. And, last but not least, it repealed the 120% interest rate.

Undervaluations

While it had earlier attempted to counteract the effects of overvaluations, Congress did not address the problem of understatement of property values for purposes of gift and estate taxes until it passed Section 6660, applicable for returns after December 31, 1984. This provision was an analogue to the step structure of Section 6659 in that it imposed a 10% penalty on valuations which were between one-half and two-thirds of the true value of the property, 20% on valuations which were 40-50% of the correct value and 30% on valuations less than 40% of true value, subject to the $1,000 de minimis understatement of tax, and accruing interest from the date of the return [DRA Sec. 6660; 6601(e)(2)].

Once again, IMPACT has simplified this misvaluation by moving it into Section 6662 and providing a similar two-tier system for undervaluation (less than 50% of correct value, subject to a 20% penalty) and gross undervaluation (less than 25% of the true property value, subject to a 40% penalty) [Sec. 6662(g) & (h)].

Defenses to Accuracy-Related Penalties

With all the Section 6662 accuracy-related penalties, taxpayers now have available the statutorily explicit defense provided under IMPACT's Section 6664 that there was a reasonable cause for the underpayment of tax and that they acted in good faith. Additional defenses under IMPACT based upon adequate disclosure (e.g. for tax shelter or other items for which the taxpayer believes there is substantial authority [Sec. 6662(d)(2)(B) & (C)]) or reliance on a qualified appraisal (e.g. valuation of charitable deduction property [Sec. 6664(c)(2)]) have generally been available throughout the 1980s in earlier versions of the civil penalty provisions. (See, for example, the waiver of the penalties under old Sections 6659(e), 6660(e), and 6661(b)(2)(B).) Pending the promulgation of new regulations, IRS Notice 90-20 (IRB 1990-10, p.17) outlines the item specific disclosure of the position taken by the taxpayer which should be followed in order to avoid the various penalties.

Fraud

Throughout most of the '80s, the civil fraud penalty was embodied in Section 6653(b) [ERTA, TEFRA, TRA, & TAMRA]. During the first part of the decade, it stood at 50% and was not targeted to the fraudulent amount. Instead, once fraud was proven by clear and convincing evidence on any part of the underreporting of tax (and here, for once, the burden of proof is on the government), the entire amount of the understatement (nonfraudulent as well as fraudulent) was subject to the 50% penalty [ERTA, TEFRA, Sec. 6653(b)(1)]. TRA '86 (returns after 12/31/86) increased the rate of the penalty to 75% but also targeted it to only that portion of the underpayment due to fraud. However, as with the targeting of the negligence penalty, the burden of proving by a preponderance of the evidence what portion of the understatement is not due to fraud is upon the taxpayer [TRA Sec. 6653(b)(1) & (2)]. IMPACT continues the targeting of the 75% penalty with the only difference being a change of address now Section 6663.

As was mentioned earlier, under ERTA, TEFRA and TRA, an additional time-sensitive penalty of 50% of the interest due on the amount attributable to fraud was imposed for returns due after September 3, 1982, and before December 31, 1988 [ERTA Sec. 6653(b)(2); TEFRA Sec. 6653(b)(2); TRA Sec. 6653(b)(1)(B)]. Although repealed by TAMRA, this interest add-on has continuing relevance due to the fact that all returns for these periods are still open to examination and assessment due to the fact that there is no statute of limitations on fraudulent returns [Sec. 6501(c)(1)]. As such, this interest-related component of the fraud penalty could prove to be quite weighty, particularly where the time between the due date of the return and the date of assessment is lengthy.

Delinquency

The most consistent penalty throughout the '80s has been that assessed for failing to file a tax return in a timely manner. Not only has it stayed in the same Code section [Sec. 6651], but it also has remained the same in imposing a penalty of 5% per month on the tax due, up to a maximum of 25% for failure to file a return. The only change to this section throughout the entire decade was the addition, under IMPACT, of a new fraudulent failure to file penalty of 15% per month up to a maximum of 75% [Sec. 6651(f)].

Despite this apparent consistency, there has been a difference in how the delinquency penalty is applied, more specifically, in respect to the stacking of this penalty with negligence and substantial understatement of income tax. As was mentioned earlier, such accumulation of the various penalties was perhaps the most odious aspect of the pre-IMPACT civil penalty structure where the fact of the non-filing of a return triggered the three penalties. As the IRS successfully argued, clearly such a taxpayer was delinquent. He was also negligent in that the failure to file the return was a disregard of the rules and regulations. And lastly, there could be little doubt that the tax was substantially understated since the taxpayer did not show any tax at all.

For returns after December 31, 1989, the doubling or tripling up of penalties is no longer available since the negligence and other accuracy related penalties are targeted to specific amounts and, in any case, can only be applied where a return has been filed [Sec. 6664(b)]. Of course, if a return is filed after the due date, the delinquency penalty can be assessed along with the accuracy-related penalties.

Example One: A Delinquent, Negligent Return

The effect of the different penalties which have been in existence during the 1980s is perhaps best illustrated by way of a relatively simple fact pattern. Assume that X is a calendar year taxpayer. For the 1985 tax year, X files a return on November 15, 1986. No extension had been requested and so none was granted. The amount of tax shown on the return is $50,000, and X includes payment for this amount with his return. The correct tax for 1985 is $95,000. Of the $45,000 understatement, $2,000 is attributable to the non-reporting of dividend income, and an additional $10,000 was caused by X's careless disregard of the rules and regulations relating to income taxation. X's return is audited by IRS in 1988, the normal deficiency procedures are followed and the deficiency is assessed on April 15, 1989, just as the three-year statute of limitations is about to lapse. X pays the entire amount due within 10 days of the notice and demand for payment.

As a first step, it must be noted that the applicable statute is TEFRA as modified by the DRA of 1984 since X's return is due after 12/31/82 but before 1/1/87. (See Exhibit 1.) Consequently, as summarized in Exhibit 2, in addition to the $45,000 understatement, X will be liable for a delinquency penalty under Section 6651 of $23,750 (seven-month delay in filing @ 5% per month but limited to a maximum of 25%), a 10% substantial understatement penalty under Section 6661 of $4,500 (since the understatement is in excess of the greater than 10% of the correct tax or $5,000), the 5% penalty under Section 6653(a)(1)(A) which will be applied to the entire $45,000 of the understatement, not just to the $12,000 attributable to negligence, and the 50% interest add-on under Section 6653(a)(1)(B) targeted to the $12,000 negligent amount, running for the three-year period between the due date of the return and the assessment of the penalty.

There are two other points concerning this 1985 tax return. First, had X contested the negligence, he would have been presumed negligent for the $2,000 unreported dividend income {Sec. 6653(g)}. Secondly, while no interest would accrue on the negligence or substantial understatement penalties since X paid the deficiency within 10 days of the notice and demand for payment, interest on the original $45,000 understatement began to accrue on the due date of the return {Sec. 6601(a) & (e)(2)(B)}.

Example Two: A Delinquent, Negligent Return Revisited

Now assume the same facts in regards to the amount shown on the return. The only change is that the relevant tax year is 1989 with a resulting due date of April 15, 1990. The return is filed on November 15, 1990, audited in 1992, and a timely assessment is made on April 15, 1993. The penalty provisions of IMPACT would now govern this return. X would be liable for the 20% penalty under Section 6662(b)(1), but this penalty would be targeted to the $12,000 understatement attributable to the negligence. There would no longer be the 50% interest add-on (repealed by TAMRA) nor a presumption of negligence for the omission of dividend income (repealed by IMPACT). The substantial understatement penalty would only be imposed on the $33,000 of understatement not attributable to negligence. Additionally, since X did file a return, he would still be assessed a delinquency penalty of 5% per month, but limited to 25%. And finally, interest on both the $45,000 understatement and the accuracy-related penalties (negligence of $2,400 and substantial understatement of $6,600 for a total amount of $54,000 accruing interest) would begin to run on April 15, 1990. See Exhibit 2 for the numerical calculations of this assessment.

Example Three: A Negligent, Fraudulent Return

The fact pattern from the above example continues except that instead of $2,000 from non-reported dividend income, this understatement is due to fraud. If the tax year in question is 1985, then X will be assessed the 50% fraud penalty which will apply to the entire $45,000 understatement. In addition, the 50% interest add-on will be targeted to the $2,000 portion attributable to fraud. It should be noted that because the fraud penalty was not targeted for years before 1987, the negligence penalty cannot also be imposed on the understatement {TEFRA Sec. 6653(b)(3)}. Also, no delinquency penalty can be assessed when fraud is found {e.g. TEFRA Sec. 6653(d)}. As was the case before, interest would not run on the fraud penalty until after the assessment was made, but X would be liable for the interest on the original $45,000 deficiency, accruing from the due date of the return, probably at 120% of the normal rate since this increased rate applies to sham or fraudulent transactions as well as misvaluations {Sec. 6621(c)(3)(v)}.

Example Four: A Negligent, Fraudulent Return Revisited

If the relevant tax year is 1989, then under IMPACT, X would be assessed a 20% penalty on the $10,000 negligent understatement {Sec. 6662(b)(1)}, a 75% penalty on the $2,000 fraudulent amount {Sec. 6663} and another 20% penalty on the remaining $33,000 substantial understatement {Sec. 6662(b)(2)}. In addition to the interest that would begin to run from the due date of the return on the entire amount of the deficiency (including the penalties of $10,000) {Sec. 6601(e)(2)(B)}, a delinquency penalty of 25% would be imposed (5% per month but limited to a maximum of 25%) under Section 6651. Had no return been filed, then none of the accuracy-related or fraud penalties could be assessed, but X would most likely be liable for the increased fraudulent delinquency penalty of 15% per month, up to a maximum of 75% {Sec. 6664(b) & 6651(f)}. Exhibit 3 summarizes the treatment of a return which contains both negligent and fraudulent items.

Conclusion

The Revenue Reconciliation Act of 1989 has greatly simplified and rationalized the civil penalties relating to the understatement of taxes. This is good news insofar as returns with due dates after December 31, 1989, are concerned. However, it is important to recognize that this new and improved system does not eliminate the need to understand the penalties which had existed under previous legislation. Many returns for tax years in the '80s will still be subject to those old rules and will remain open for examination and assessment well into the '90s due to extended statutes of limitations that apply in cases of fraud, substantial omission of items of income or taxpayer agreement.

As this article has shown, the impact of the various penalty provisions can be quite different and, at times, bewilderingly complex. With the end of the decade, hopefully, the congressional tinkering so prevalent during the 1980s will also have come to an end. If so, at least for future tax returns, taxpayers and their advisers will no longer have to worry about another year, another penalty. [Exhibits 1 to 3 Omitted]

W. Richard Sherman, Esq., CPA, assistant professor of accounting at Saint Joseph's University in Philadelphia, PA.; received his BA and JD from the University of Pennsylvania, his MBA from Temple University. Recipient of awards for teaching excellence, Professor Sherman's articles have appeared in numerous accounting journals. He is a member of the Academy of Accounting Historians, American Accounting Association, American Business Law Association, AICPA, British Accounting Association, International Association for Accounting Education & Research and National Association of Accountants.
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Author:Sherman, W. Richard
Publication:The National Public Accountant
Date:Nov 1, 1990
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