Tax Administration:

Negligence and Substantial Understatement Penalties Poorly Administered

GGD-91-91: Published: Jul 3, 1991. Publicly Released: Jul 3, 1991.

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Pursuant to a congressional request, GAO reviewed the Internal Revenue Service's (IRS) administration of the negligence and substantial understatement penalties, focusing on whether IRS: (1) correctly assessed such penalties when warranted; and (2) adequately explained to taxpayers the reasons for assessing those penalties.

GAO found that: (1) one-third of the cases reviewed included erroneous penalty determinations, and IRS reviewed over 60 percent of the cases at least once without correcting errors; (2) such IRS internal controls as supervisory and quality assurance reviews and district office penalty screening committees did not effectively detect or correct inadequate and incorrect penalty decisions; (3) 85 percent of the erroneous cases reviewed were in the taxpayers' favor; (4) there appeared to be little, if any, incentive for examiners, supervisors, and others accountable for penalty decisions to make correct decisions or to document the bases for decisions; (5) IRS cited such factors as heavy work load, emphasis on other areas of examination, employee turnover, quality, and inexperience, and the limited scope of penalty screening committee reviews to explain why employees did not always follow IRS guidelines on penalty administration; (6) in 76 percent of the cases assessed penalties, the penalty explanations in IRS examination reports provided to taxpayers did not adequately explain why they were assessed penalties or how to avoid future penalties; and (7) standard paragraphs in examination reports were too general to effectively relate the negligence penalty to the circumstances of specific cases and omitted important information about the penalty's criteria and the adequate disclosure and substantial authority provisions.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: IRS has a major task force in Examination working on these issues, so it is using this group instead of establishing a quality improvement program project. Any directives will be screened by this task force.

    Recommendation: The Commissioner of Internal Revenue should establish a national quality improvement program project in the exam function to clarify the root causes of the problems found and identify and implement effective solutions.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  2. Status: Closed - Implemented

    Comments: The July 1992 "IRS Penalty Handbook" addresses the need for more-accurate and better-documented negligence and substantial understatement penalties. No data were readily available to determine whether these corrective measures were successfully implemented across IRS.

    Recommendation: The Commissioner of Internal Revenue should determine the effectiveness of the solutions through a subsequent review of selected exam cases, both with and without penalty assessments. These reviews should focus on the documentation and appropriateness of the penalty decisions so as to determine how well penalties are being administered by the district and the effectiveness of existing internal controls.

    Agency Affected: Department of the Treasury: Internal Revenue Service

  3. Status: Closed - Implemented

    Comments: Portions of the IRS Penalty Handbook issued in July 1992 addressed this recommendation. The paragraphs have been augmented and expanded for field offices and office audit functions. Service Center letters, which are computer generated, were changed in December 1992.

    Recommendation: The Commissioner of Internal Revenue should take actions to ensure that the negligence and substantial understatement penalty explanations in IRS examination reports provide taxpayers with the specific facts, circumstances, and criteria that warrant the assessment of the penalty. Standard paragraphs should be augmented with written comments that relate the specific conduct and circumstances of taxpayers to the assessment of the penalty. The substantial understatement penalty standard paragraph should be expanded to include information on the penalty's criteria and the substantial authority and adequate disclosure provisions.

    Agency Affected: Department of the Treasury: Internal Revenue Service


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