Frequent commenter/guest blogger Bob Kamman brings us a post about the weird way the IRS is choosing to impose the substantial understatement penalty. He brought a couple of Tax Court cases seeking to establish some precedent in the area but the Chief Counsel attorneys handling the cases conceded and prevented him from obtaining court review of the IRS practice in this area. Because the fact pattern he has identified usually involves a relatively small amount of money, taxpayers will struggle to find representation in these cases and may find it easier to concede than to fight. A case in which the taxpayer contests all or part of the underlying tax may provide the more likely vehicle for a test. If you see this issue in your client’s case, consider following Bob’s example and seek to set precedent. Even if Chief Counsel’s office continues to concede the issue, maybe someone in that office will speak to the IRS about the bad practice that may be a result of computer programming or maybe just an unusual view of the type of behavior that should be penalized. Keith
I won a couple of Tax Court cases in 2018 that I had expected to lose. My clients are happy that IRS settled. But I’m disappointed, because I hoped a Tax Court opinion would at least highlight the issue. At least along the way I learned a few things. For example, there is the Doctrine of Absurdity.
But first, some background. Suppose that you are a Member of Congress and on a committee that oversees tax laws and IRS. You think penalties are sometimes needed to encourage tax compliance. You consider two cases:
Taxpayer A, in a 15% bracket, wins $32,000 on a slot machine, has no tax withheld when the casino issues Form W-2G, and does not report the income on Form 1040. The IRS computer-matching system eventually discovers the omission and assesses $4,800 tax.
Taxpayer B, in a 25% bracket, withdraws $20,000 from a retirement account, requests federal tax withholding at a 20% rate, and thinking like many others that “I already paid tax on it,” does not report the income on Form 1040. IRS document matching catches this error also, and sends a bill for $1,000 because the withholding is not sufficient to cover the additional tax.
Not as someone with a sense of fairness and logic, but as a Member of Congress you would reach the same result that according to IRS was enacted nearly thirty years ago. Taxpayer A pays $4,800 but no penalty. Taxpayer B pays not only $1,000 but an additional $200 penalty.
That’s how Section 6662, together with Section 6664, operates. These Internal Revenue Code penalty provisions come up frequently, and deserve a closer look. They require findings of an “underpayment” and an “understatement,” which IRS tells us are not the same thing.
Section 6662 assesses a 20% penalty on several varieties of “underpayment.” The two seen most frequently are those due to “negligence or disregard of rules or regulations,” and to “any substantial understatement of income tax.”
IRS computers, lacking human interaction with taxpayers, don’t yet have the intelligence to make accusations of “negligence or disregard.” So the “substantial understatement” clause is invoked when proposed assessments are based only on matching information returns to a Form 1040.
And acknowledging the legal maxim de minimis non curat lex – “the law does not deal with trifles” – Section 6662(d)(1)(A) adds that on individual returns, a “substantial understatement” occurs only if the amount exceeds the greater of—
(i) 10 percent of the tax required to be shown on the return for the taxable year, or
In most cases, the $5,000 minimum rule applies. So you might ask, why will IRS assess a penalty to our Taxpayer A, who only owed $1,000? The answer is that no credit is given for withholding, when determining if there is an “understatement,” even though the withholding is considered when figuring the “underpayment” amount on which the 20% penalty is calculated.
At least, that is how IRS interprets the Regulations to these two sections. I am not sure the IRS understands the Regulations, nor am I confident the Regulations correctly describe what Congress enacted. Some day perhaps a Tax Court judge will reach the same conclusions.
Here is an example from a Tax Court case in which IRS decided it was not worth arguing with me. My client withdrew money from a retirement account, and had tax withheld. Because she thought the taxes had already been paid, she did not mention it to her tax preparer or report it on her return. The additional tax was $9,158. The withholding was $7,325. The difference was $1,833, which when contacted by IRS she gladly paid with interest. But IRS still wanted $367 “substantial tax understatement penalty.”
(Had the return been filed late, a penalty of $458 would also have been proposed, but under the IRS “one time free pass” policy, it could be abated.)
My client is not a low-income taxpayer but she had a high-respect government career. I did not charge a fee for filing the Tax Court petition, or for several phone conversations with a Chief Counsel paralegal (in Phoenix) who handled settlement of the case in our favor. I did furnish reasons that this case might qualify under the “reasonable cause” exception of Section 6664(c) because my client had acted “in good faith.” These arguments seldom prevail at IRS administrative levels. The settlement process took more than four months, from petition filing to stipulation signing.
And here is another example from a Tax Court case. My clients unintentionally omitted some W-2 income from their joint return. They and their preparer had rushed to meet the April 15 deadline after receiving a complex, high-dollar Schedule K-1 on April 10. The additional tax was $6,230 and the withholding only $2,012. The difference of $4,218 was not quite as substantial as the $5,000 minimum contemplated by Section 6662(d)(1)(A). Nevertheless, IRS proposed a “substantial understatement” penalty of $844, because the deficiency before withholding exceeded $5,000.
This case was settled by a Chief Counsel attorney (in Dallas) in less than six weeks after the petition was filed. I did not earn a fee on this case either, but as the preparer I avoided reimbursing my clients for an error for which I shared responsibility.
I did not have to ask the Dallas attorney for a copy of the signed managerial approval now required for such assessments. It might not have existed. In Phoenix, the paralegal showed me what the Service Center considers adequate. I thought it was ambiguous.
In researching these cases, I came across the “Doctrine of Absurdity,” which is discussed in a 2017 Tax Court opinion, Borenstein, in which Keith Fogg of the “Harvard Clinic” filed an amicus brief. (The opinion does not state whether he supported the anti-absurdity argument, which was just one of several.) The opinion explains:
The “anti-absurdity” canon of construction dates back many years. See Rector of Holy Trinity Church v. United States, 143 U.S. 457, 460 (1892) (“If a literal construction of the words of a statute be absurd, the act must be so construed as to avoid the absurdity.”); Scalia & Garner, supra, at 234-239 (“A provision may be either disregarded or judicially corrected as an error * * * if failing to do so would result in a disposition that no reasonable person could approve.”); 2A Sutherland Statutes and Statutory Construction, sec. 46:1 (7th ed.).
The “anti-absurdity” canon, while of ancient pedigree, is invoked by courts nowadays quite rarely. In order for a party to show that a “plain meaning” construction of a statute would render it “absurd,” the party must show that the result would be “so gross as to shock the general moral or common sense.” Crooks v. Harrelson, 282 U.S. 55, 60 (1930); see Tele-Commc’ns, Inc. & Subs. v. Commissioner, 95 T.C. 495, 507 (1990) (citing Harrelson as supplying the relevant standard but upholding the plain language construction of the statute), aff’d, 12 F.3d 1005 (10th Cir. 1993).
Of course the application of the “substantial understatement” penalty to taxpayers who owe small amounts is absurd. But is it more so than many other IRS procedures? Eventually a Tax Court judge may decide that question, if Chief Counsel stops conceding before trial.
Otherwise, it’s unlikely that Congress will revisit the Section 6662 penalty procedures and make sense of a rule where now there is none.