Management Advisory Report: Ineffective Administration of the Individual
Taxpayer Penalty Program Creates Inequity
April
2001
Reference
Number: 2001-40-069
April 18, 2001
MEMORANDUM FOR COMMISSIONER, WAGE AND
INVESTMENT DIVISION
COMMISSIONER,
SMALL BUSINESS/SELF-EMPLOYED
DIVISION
FROM: Pamela
J. Gardiner /s/ Pamela J. Gardiner
Deputy
Inspector General for Audit
SUBJECT: Final Management Advisory
Report - Ineffective Administration of the Individual Taxpayer Penalty Program
Creates Inequity
This
report presents the results of our review of the Internal Revenue Service’s
(IRS) process to administer penalties (assessments and abatements) affecting
individual taxpayers. In summary, we
found that the IRS is unable to effectively administer the individual taxpayer
penalty program, resulting in inequitable treatment of taxpayers.
We
recommended that the IRS designate an executive in each business unit to
coordinate with the Office of Interest and Penalty Administration to ensure
functional compliance with the IRS’ penalty policy. In addition, the IRS needs to provide
sufficient resources and to develop a management information system, a
recommendation analysis and implementation system, and a formal review program
to assess its compliance with the penalty policy.
Management
agreed to the recommendations we presented.
Management’s comments have been incorporated into the report where
appropriate, and the full text of their comments is included as an appendix.
Copies
of this report are also being sent to the IRS managers who are affected by the
report recommendations. Please contact
me at (202) 622-6510 if you have questions, or your staff may call Walter
Arrison, Associate Inspector General for Audit (Wage and Investment Income
Programs), at (770) 936-4590.
Appendix
I – Detailed Objective, Scope, and Methodology
Appendix
II – Major Contributors to This Report
Appendix
III – Report Distribution List
Appendix
IV – Penalty Policy Statement (P-1-18)
Appendix V
– Management’s Response to the Draft Report
The purpose of penalties in tax
administration is to punish noncompliant taxpayers and to deter compliant
taxpayers from noncompliant behavior.
Despite the impact that penalties have on individual taxpayers, the
Internal Revenue Service (IRS) cannot ensure that penalties are fairly,
accurately, or consistently assessed and/or abated.
In Tax Year (TY) 1996,[1]
approximately 1.4 million individual taxpayers were assessed penalties totaling
almost $1.3 billion. However, over
417,000 of the 1.4 million taxpayers had over $250 million of their penalties
abated.[2]
In both Fiscal Years 1998 and 1999, the Taxpayer Advocate
reported to the Congress that penalty administration was the fifth most serious
problem facing taxpayers. According to
the Taxpayer Advocate, “Penalty administration is inconsistent….”
The overall objective of this
audit was to determine if the IRS had an effective process to administer
penalties affecting individual taxpayers.
The IRS needs to improve its
administration of the individual taxpayer penalty program to ensure equitable
treatment of taxpayers. Individuals who
are assessed penalties by the IRS cannot be assured that the IRS will
consistently address their requests for abatements of those penalties. In fact, the IRS does not know why 29 percent
of the penalties that were assessed for TY 1996 were later abated for these
same taxpayers. The IRS also does not
know if these penalty abatements were fairly, accurately, or consistently
performed.
Insufficient and inconsistent
management oversight of penalty administration, unclear lines of accountability
and responsibility, lack of available or accurate data to evaluate penalty
administration, and scarce resources along with competing priorities
contributed to the ineffectiveness of the IRS’ administration of the individual
taxpayer penalty program.
Some of the issues presented in
this report have been repeatedly brought to the IRS’ attention during the last
10 years with little or no action being taken by the IRS to correct the
identified problems.
The IRS cannot ensure that
penalties for individual taxpayers are fairly, accurately, or consistently
assessed and/or abated. Statistical and
demographic information captured by the IRS was not used to evaluate the impact
of the individual taxpayer penalty program on compliance. In addition, recommendations[3]
made to revise the individual taxpayer penalty program to ensure consistent and
accurate penalty assessments and abatements were not implemented.
Without effective administration
of the individual taxpayer penalty program, the IRS does not know if the
penalties assessed on approximately 1.4 million individual taxpayers or the
penalties abated for over 417,000 of these individual taxpayers for TY 1996
were done appropriately and consistently.
Although IRS does not know whether penalties overall are being applied
consistently, a recent Treasury Inspector General for Tax Administration audit
report[4]
involving one type of penalty found that taxpayers were being assessed
penalties inconsistently.
To ensure equitable treatment of taxpayers and effective
penalty administration, the IRS needs to designate an executive in each
business unit to coordinate with the Office of Interest and Penalty
Administration to ensure functional compliance with the IRS’ penalty policy. In addition, the IRS needs to provide
sufficient resources and to develop a management information system, a
recommendation analysis and implementation system, and a formal review program
to assess its compliance with the penalty policy.
Management’s Response:
IRS management agreed with our recommendations. The IRS plans to select liaisons within the
various operating divisions, fill vacancies and determine the need for
additional resources, use a management information system to develop reports by
business unit, and begin periodic reviews of the penalty program. It also recently developed a database that
includes a catalog of recommendations from various sources.
The objective of this audit was to determine if the IRS had an
effective process to administer penalties affecting individual taxpayers.
The objective of this audit was
to determine if the Internal Revenue Service (IRS) had an effective process to
administer penalties (assessments and abatements[5])
affecting individual taxpayers. To
accomplish our objective, we reviewed documentation and interviewed IRS
management officials and personnel involved with penalty administration.
We conducted work at the
National Headquarters from December 1999 through October 2000. Our review was performed in accordance with
the President’s Council on Integrity and Efficiency’s Quality Standards for Inspections.
Details of our objective, scope,
and methodology are presented in Appendix I.
Major contributors to this report are listed in Appendix II.
The purpose of penalties in tax
administration is to punish noncompliant taxpayers and to deter compliant
taxpayers from noncompliant behavior.
Despite the impact that penalties have on individual taxpayers, the IRS
cannot ensure that penalties are fairly, accurately, or consistently assessed
and/or abated.
Penalties constitute one important tool for the IRS in collecting the
proper amount of tax revenue at the least cost.
Penalties constitute one
important tool for the IRS in collecting the proper amount of tax revenue at
the least cost. The IRS uses penalties
to encourage voluntary compliance by:
·
Helping taxpayers understand that compliant
conduct is appropriate and that noncompliant conduct is not.
·
Deterring noncompliance by imposing costs on it.
·
Establishing the fairness of the tax system by
justly penalizing the noncompliant taxpayer.
The Congress establishes laws
for assessing monetary penalties on individual taxpayers. The IRS is responsible for the development
and administration of a penalty policy that complies with the laws.
Responsibility for the penalty program is assigned to the OIPA.
In response to an IRS task force
recommendation, the IRS created the Office of Interest and Penalty
Administration (OIPA) in 1992. The OIPA
oversees the individual taxpayer penalty program. This responsibility includes developing and
implementing a comprehensive strategy for penalty administration and
administering the IRS’ Penalty Policy (P-1-18), which sets forth the objectives
and the manner in which the IRS will administer its individual taxpayer penalty
program fairly and consistently (see Appendix IV).
Most penalty assessments for
individuals are computer generated, including when the IRS detects that a tax
return has not been timely filed or when an individual has not provided full
payment of taxes when the tax return is filed.
The IRS has procedures in place that allow individuals to request that
an assessed penalty be abated (monetary amount will be reduced or
eliminated). The IRS grants penalty
abatements for various reasons, including the taxpayer showing legitimate,
uncontrollable reasons why the situation occurred that led to the penalty
assessment.
As noted in Table 1, in TY 1996,[6]
approximately 1.4 million individual taxpayers had almost $1.3 billion in
penalties assessed. Of these, over
417,000 individual taxpayers had over $250 million of their penalties abated.
Table 1
Tax Year 1996
Individual Taxpayer Penalty
Assessments/Abatements
|
Type of
Penalty Action |
Total
Taxpayers |
Total Dollars |
|
Penalty Assessments |
1,445,188 |
$1,298,262,724 |
|
Penalty Abatements |
417,465 |
$254,856,162 |
Source: Data extract from the IRS TY 1996 Masterfile.
In both Fiscal Years 1998 and 1999, the Taxpayer Advocate
reported to the Congress that penalty administration was the fifth most serious
problem facing taxpayers. According to
the Taxpayer Advocate, “Penalty administration is inconsistent….”
The IRS’ administration of the individual taxpayer penalty program does
not ensure equitable treatment of taxpayers.
The IRS needs to improve its
administration of the individual taxpayer penalty program to ensure equitable
treatment of taxpayers. Individuals who
are assessed penalties by the IRS cannot be assured that the IRS will
consistently address their requests for abatements of those penalties.
Some of the issues presented in
this report have been brought to the IRS’ attention repeatedly during the last
10 years. The IRS has taken little or no
action to correct the identified problems because IRS management has not
developed a system to track and monitor these recommendations. As part of the current reorganization of the
IRS into separate business units by type of taxpayer, it is imperative that
penalty administration maintains a focus on individual taxpayers, where there
is a large potential impact.
Ineffective Administration of the
Individual Taxpayer Penalty Program Results in Inequitable Treatment of
Taxpayers
Without effective administration
of the individual taxpayer penalty program, the IRS does not know if the
penalties assessed on approximately 1.4 million individual taxpayers or the
penalties abated for over 417,000 of these individual taxpayers for TY 1996
were applied appropriately and consistently.
For example:
· In August 2000, we issued a Limited Official Use audit report[7] that detailed inconsistencies in the assessment of the estimated tax (ES) penalty. ***(b)(3): 26 U.S.C. 6103, (b)(7)(E)***
In addition, over 417,000 (29
percent) of the 1.4 million individual taxpayers received abatements of over
$250 million. The IRS does not know if
these penalty abatements were fairly, accurately, or consistently
performed.
An example of the inconsistency
in abatements involves those made due to reasonable cause. As a hypothetical example:
·
Taxpayer #1 is assessed a failure to file penalty
(tax return was not filed with the IRS when due). The taxpayer calls his/her local IRS office
to have the penalty abated because the taxpayer was unable to timely file
his/her tax return due to a serious illness in his/her family. The taxpayers’ request is denied. The IRS employee reviewing this request
concludes that the taxpayer should have been able to comply with the timely
filing of the tax return.
·
Taxpayer #2, with the same circumstances as
above, gets the failure to file penalty abated.
This taxpayer calls an IRS office other than the one above, and the IRS
employee reviewing the request concludes that the taxpayer had reasonable cause
to not timely file his/her tax return and abates the penalty.
According to IRS statistics, only 54 percent of reasonable cause
abatements are accurately based on IRS’ abatement criteria.
As detailed in the example
above, penalty abatements can result in different outcomes depending on the
opinion of the IRS employee working the case.
According to IRS statistics, only 54 percent of reasonable cause
abatements are accurately based on IRS’ abatement criteria.[8] As a result, the IRS cannot ensure that
penalties for individual taxpayers are fairly, accurately, or consistently
assessed and/or abated.
The Taxpayer Advocate has noted
that, “…the imposition or abatement of a penalty is a judgement call, which
often translates into lack of consistency when applying criteria.” Charles Shewbridge of the Tax Executives
Institute, Inc., stated that, “To further the goal of consistency, Tax
Executives Institute recommends that some form of coordinated review of penalty
application be established, perhaps in conjunction with the new IRS business
units.”
In an attempt to ensure the
consistency of penalty abatements, the IRS has developed the Reasonable Cause
Assistant (RCA) computer system that is designed to assist IRS employees in
delivering a fair and consistent approach to penalty abatements. The IRS intends to begin implementation of the
RCA in April 2001.
IRS policy requires the collection of statistical and demographic
information to evaluate penalties and penalty administration and how they
relate to the goal of compliance.
The IRS is required to follow
Policy P-1-18, Penalty Policy Statement, which provides that the IRS will
collect statistical and demographic information to evaluate penalties and
penalty administration and how they relate to the goal of compliance. The Policy also requires that the IRS
maintain an ongoing effort to develop, monitor, and revise programs designed to
assist taxpayers in complying with legal requirements and thus avoid penalties
(see Appendix IV).
The IRS is unable to effectively
administer the individual taxpayer penalty program for several reasons,
including:
·
Scarce resources, competing priorities, and a
lack of management continuity. The OIPA
stated, and we agree, that OIPA has struggled to balance scarce resources with
competing priorities and has focused on higher priority issues such as new
legislation affecting penalties. For
example, business taxpayer penalty issues have had greater program emphasis
than individual taxpayer issues. Also,
the OIPA has had 5 directors in just over 2 years (April 1998 to October 2000).
The OIPA does not have direct authority over the functional areas
performing penalty assessments and abatements.
·
Unclear lines of accountability and
responsibility. The OIPA does not have
direct authority over the functional areas that perform penalty assessments and
abatements. Therefore, the OIPA does not
have the authority to ensure that the functional areas comply with established
penalty policy procedures and guidelines.
For example, penalty guidelines[9]
require functional areas to input a code describing the reason why a penalty is
abated. We found that in the majority of
cases, the functional areas were not entering this code.
·
Lack of available data to evaluate penalty
administration. Statistical and
demographic information captured by the IRS was not used to evaluate the impact
of the individual taxpayer penalty program on compliance. The OIPA was not aware that functional areas,
such as Correspondence Examination and Customer Service, collect quality
information on penalty abatements, including the accuracy of penalty
adjustments and reason codes.
·
Limited information captured was inaccurate and
was not used. For example:
1.
Our analysis showed that information available to the
OIPA on the reasons why penalties were abated was inaccurate because in 70
percent of the cases there was no reason input for the penalty abatement.
2.
Information on the number of penalties assessed and
abated is generated quarterly. However,
the OIPA last requested this information in March 2000.
·
Lack of a system to monitor and track
recommendations. Over the past 10 years,
internal and external reviews have resulted in 124 administrative[10]
recommendations, many of which, if implemented, would improve the consistency
and accuracy of penalty administration.
Four recommendations related to the need for the IRS to develop a
penalty management information system.
One of the four recommendations was made as early as 1989. Three other recommendations identified the
need for the IRS to develop a system to monitor the quality of penalties.
When taxpayers become aware of
the IRS’ inconsistencies in assessing and abating penalties, voluntary
compliance may be affected. The IRS’
lack of understanding of the effect of penalty administration does not serve
all taxpayers fairly. The IRS is inappropriately placing burden on
some taxpayers in the abatement of some penalties.
1.
The IRS should strengthen management oversight and
accountability of the individual taxpayer penalty program by designating
executives in each business unit to coordinate with the OIPA to ensure
functional compliance with the IRS’ penalty policy.
2.
Management’s Response: The IRS responded that, “To ensure consistent
and accurate treatment for all taxpayers, the Office of Penalties and Interest
will be the primary point of guidance on issues involving penalty and
interest. Within this fiscal year, they
will select liaisons within the other operating divisions to implement approved
policy/guidance.”
2.
The IRS should provide sufficient resources and develop
a management information system, a recommendation analysis and implementation
system, and a formal review program to assess its compliance with the penalty
policy.
Management’s Response: The IRS responded that,
(a)
“The Office of Penalties and Interest is filling all
current vacancies. When they are filled,
we will review their workload and decide if they need additional resources.”
(b)
“The Office of Penalties and Interest recently
identified the requirements for a management information system using data from
the Enforcement Revenue Information System (ERIS). We expect to start receiving data by July 1,
2001 and developing reports by business operating divisions by the first
quarter of FY 2002.”
(c)
“The Office of Penalties and Interest recently
developed a database that includes a catalog of recommendations from various
internal and external sources. The
database also includes responses or actions the Office of Penalties and
Interest has taken to address many of the recommendations.”
(d)
“The Office of Penalties and Interest plans to begin
periodic reviews of the penalty program after we start receiving statistical
data and developing reports.”
Penalty administration affects
over 1 million individual taxpayers each year and has received considerable
attention by the Taxpayer Advocate.
Despite this, the IRS is still unable to effectively administer the
penalty program affecting individual taxpayers, and it cannot ensure that
taxpayers are being treated consistently.
Additionally, the IRS does not
know if the individual taxpayer penalty program is achieving its objective of
encouraging voluntary compliance.
Appendix I
Detailed Objective, Scope, and Methodology
The overall objective of this review was to determine if the
Internal Revenue Service (IRS) had an effective process to administer penalties
(assessments and abatements[11])
affecting individual taxpayers. To
accomplish this objective, we:
I. Determined if penalty administration
responsibilities were effectively organized to ensure effective program
oversight and accountability.
A.
Determined if the Office of Interest and Penalty
Administration (OIPA) had a mission or functional statement that clearly
identified its role and responsibilities.
B.
Determined if the OIPA had an effective process to
ensure a consolidated and consistent approach to penalty administration.
C.
Determined if the OIPA had the authority to ensure that
the policies and procedures over penalties for individual taxpayers were
followed.
II. Determined if
the IRS had an effective process to monitor, evaluate, and improve the penalty
administration process to ensure consistency and accuracy in the administration
of penalties for individual taxpayers.
A.
Determined if the OIPA had an effective process to
ensure that Penalty Reason Codes[12]
were used on all individual taxpayer cases.
B.
Determined if the OIPA had an effective program in
place to measure the quality of the penalty program affecting individual
taxpayers.
C.
Determined if the OIPA had an effective and efficient
process in place to evaluate recommendations (from both internal and external
sources) affecting individual taxpayers.
D.
Determined if the OIPA had an effective process in
place to improve penalty administration affecting individual taxpayers.
E.
Determined if the OIPA had an effective management
information system to track and monitor penalty assessments and abatements for
individual taxpayers.
Appendix II
Walter E. Arrison, Associate Inspector General for Audit
(Wage and Investment Income Programs)
Michael Phillips, Director
Donald Butler, Audit Manager
Russell Martin, Audit Manager
Edith Lemire,
Senior Auditor
John Piecuch,
Senior Auditor
Grace Terranova, Auditor
Kevin O’Gallagher, Computer Specialist
Commissioner N:C
Director, Compliance
S:C
Director, Compliance Policy
S:C
Director, Reporting Compliance S:C
Director, Office of Interest and Penalty Administration S:C:CP:CR:IP
Director, Strategy and
Finance W:S
Director, Legislative Affairs CL:LA
Chief Counsel CC
National Taxpayer Advocate TA
Office of Management Controls N:CFO:F:M
Director, Office of Program
Evaluation and Risk Analysis N:ADC:R:O
Penalty Policy Statement (P-1-18)
Penalties constitute one
important tool of the Internal Revenue Service (IRS) in pursuing its mission of
collecting the proper amount of tax revenue at the least cost. Penalties support the IRS’ mission only if
they enhance voluntary compliance. Even
though other results, such as raising of revenue, punishment, or reimbursement
of the costs of enforcement, may also arise when penalties are asserted, the
IRS will design, administer, and evaluate penalty programs solely on the basis
of whether it does the best possible job of encouraging compliant conduct.
In the interest of an effective
tax system, the IRS uses penalties to encourage voluntary compliance by:
(1) Helping taxpayers understand
that compliant conduct is appropriate and that non-compliant conduct is not.
(2) Deterring noncompliance by
imposing costs on it.
(3) Establishing the fairness of
the tax system by justly penalizing the non-compliant taxpayer.
To this end, the IRS administers
a penalty system that is designed to:
--Ensure consistency.
--Ensure accuracy of results in light of the facts and the
law.
--Provide methods for the taxpayer to have his/her interests
heard and considered.
--Require impartiality and a commitment to achieve the
correct decision.
--Allow
for prompt reversal of initial determinations when sufficient information has
been presented to indicate that the penalty is not appropriate.
--Ensure that penalties are used for their proper purpose and
not as bargaining points in the development or processing of cases.
The IRS maintains an ongoing
effort to develop, monitor, and revise programs designed to assist taxpayers in
complying with legal requirements and, thus, avoid penalties.
To ensure consistency, the IRS
prescribes and uses a single set of guidelines in a Penalty Handbook which will
be followed by all operational and processing functions. Prior to implementation, changes to the
Penalty Handbook must be reviewed for consistency with IRS policy and approved
by the Office of Interest and Penalty Administration.
The IRS collects statistical and demographic information to
evaluate penalties and penalty administration and how they relate to the goal
of voluntary compliance. The IRS
continually evaluates the impact of the penalty program on compliance and
recommends changes when the statutes or administration of penalties are not
effectively promoting voluntary compliance.
Management’s Response to the Draft Report
The response was
removed due to its size. To see the
response, please go to the Adobe PDF version of the report on the TIGTA Public
Web Page.
[1] TY 1996 is the latest complete penalty assessment and
abatement data available. This is
because the IRS can assess penalties up to 3 years after the due date of the
return or 3 years after the IRS received date, whichever is later.
[2] An “abatement” occurs when an assessed monetary
penalty amount is reduced or eliminated.
[3] Recommendations were from internal and external
sources, including IRS Task Force studies, a Treasury Department review, and a
review that was part of the Vice President’s National Partnership on
Reinventing Government.
[4] Estimated Tax
Penalty Assessment Processes Create Significant Taxpayer Inequity (Reference
Number 2000-30-112, dated August 2000).
[5] An “abatement” occurs when an assessed monetary
penalty amount is reduced or eliminated.
[6] TY 1996 is the latest complete penalty assessment and
abatement data available. This is
because the IRS can assess penalties up to 3 years after the due date of the
return or 3 years after the IRS received date, whichever is later.
[7] Estimated Tax
Penalty Assessment Processes Create Significant Taxpayer Inequity
(Reference Number 2000-30-112, dated August 2000).
[8] Internal Revenue Manual 120.1.1.3, Penalty Handbook
[9] Internal Revenue Manual 120.1.1.5.1, Penalty Handbook, and Memorandum issued by the Chief Operating Officer, dated 8/14/98.
[10]
“Administrative” refers to recommendations from
internal and external sources (such as IRS Task Force studies, a Treasury
Department review, and a review that was part of the Vice President’s National
Partnership on Reinventing Government) that do not require legislation to
complete. It does not include individual
employee or taxpayer recommendations.
[11] An “abatement” occurs when an assessed monetary
penalty amount is reduced or eliminated.
[12] Penalty Reason Codes are intended to provide the IRS
with an explanation as to why a penalty abatement was performed.