The Treasury Inspector General for Tax Administration (TIGTA) issued a report that found the IRS is imposing accuracy-related penalties on businesses covered by the IRS Large Business and International Division (LB&I) less often that it does on businesses examined by the Small Business/Self-Employed Division (SB/SE). The report looked at accuracy related penalties imposed under IRC §§6662 and 6662A.
The report seemed particularly interested in the fact that LB&I examiners assess proportionately fewer accuracy-related penalties than do SB/SE examiners. The report found that for fiscal year 2015-2017, for returns that ended up with additional tax assessments of $10,000 or more, 6% of LB&I cases had an accuracy-related civil penalty assessed, while 25% of SB/SE cases with such taxes assessed also have an accuracy-related civil penalty assessed.
The report does note that are reasons why the two rates may vary that do not relate to issues on how those cases are handled:
The disparity may be attributable to the differences in LB&I and SB/SE business taxpayers. For example, the LB&I Division examines businesses with assets of more than $10 million, while the SB/SE Division examines businesses with assets of $10 million or less. Therefore, LB&I business cases are larger and more complex than SB/SE cases. In addition, IRS management stated that LB&I taxpayers are sophisticated business owners or publicly traded companies, with the majority having their own internal tax department, a tax director or controller, etc., and that SB/SE taxpayers may be less likely to employ full-time tax expertise. Another factor, according to IRS management, is that substantial understatement accuracy-related penalties in large business returns may be less likely to apply when tax understatements are less than 10 percent of the corrected tax liability, even though the additional tax exceeds $10,000.
But TIGTA’s report also found that other issues may be involved that could also explain some of this disparity, noting:
Another reason for the disparity between LB&I Division and SB/SE Division assessment of accuracy-related penalties may also be attributable, at least in part, to other conditions we identified during this audit. Specifically, LB&I examiners did not always consider or justify the penalty decision, and supervisors were not always involved in the decision to propose, or not propose, the penalty. In addition, the IRS’s quality review systems do not address all required actions that examiners must take for proper consideration of civil penalties.
The report contains a series of recommendations to the IRS in these areas. The first one provides:
Recommendation 1: The Commissioner, LB&I Division, should conduct a study to: 1) understand the reason why examiners’ proposed tax assessments and accuracy-related penalties are not being sustained by Appeals and 2) evaluate whether examiners are taking into account all the relevant facts and circumstances before proposing the tax adjustments and accuracy-related penalties.
This was a recommendation that the IRS only partially agreed with. The agency noted that Appeals and exam serve two different functions, which could impact the rate at which penalties are or are not sustained on appeals. That includes the hazards of litigation.
While the IRS does not say so, given the relatively larger size of the taxpayers involved, the risk of litigation is likely quite a bit more significant to the agency in the average LB&I case. So any consideration of the risk of litigation in such a context would seem to be subject to at least some influence based on the knowledge that the evaluation of such risks would likely be subject to evaluation based on actual results.
The IRS also notes that penalty resolution varies from case to case and issue to issue. Appeals is looking at settling the case as a whole, and which does not necessarily provide insight to examiners regarding why a specific penalty was or was not ultimately sustained in a settlement.
TIGTA issued a comment with regard to the IRS’s response:
We believe that the IRS should have a single approach to penalty issuance and that large corporations should be subject to the accuracy-related penalty to the same extent as small businesses. The LB&I Division should understand whether there is a reluctance among its revenue agents to impose the accuracy-related penalties on large corporations and, in the instances in which the penalty is proposed, to understand the specific factors Appeals will rely upon to sustain the penalty.
TIGTA’s report noted that they also found that LB&I examiners did not document their consideration of accuracy-related penalties or their justification for decisions related to such penalties and that documentation did not show that supervisors were always involved in penalty development or approval.
Thus, TIGTA made the following recommendations with which the IRS agreed:
Recommendation 2: Ensure that examiners and supervisors are trained to: 1) consider the accuracy-related penalty for all applicable examination cases; 2) follow the proper procedures to document all actions taken during penalty consideration and development, whether proposing or not proposing the penalty; and 3) follow the requirements for supervisory involvement and timely, written approval of all penalty decisions.
Management’s Response: The IRS agreed with the recommendation. The IRS stated that the Penalty Practice Network will provide materials for all LB&I employees on procedures to document penalty considerations and development and the requirements for supervisory involvement and timely written approval of penalty decisions. The Penalty Practice Network will also consider revising the penalty lead sheet to address this recommendation.
Recommendation 3: Revise IRM 4.46 guidelines to: 1) clearly indicate which LB&I examiners are ultimately responsible for penalty development and documentation and 2) provide more specificity on the requirements of supervisory involvement in penalty development when proposing and not proposing penalties.
Management’s Response: The IRS agreed with the recommendation. The IRS stated that IRM 4.46 has recently been updated for some penalty-related matters. IRM 20.1.1, Penalty Handbook, Introduction and Penalty Relief, is in the process of being updated. The Penalty Practice Network will review and provide recommendations, if any, for potential additional updates.
Recommendation 4: Ensure that quality review systems are adequate and can accurately determine whether examiners are properly considering civil penalties, adequately supporting penalty decisions, consistently involving management, and obtaining required approvals.
Management’s Response: The IRS agreed with the recommendation. The Quality Review and Analysis function will review the IRM, including any updates or revisions, to determine if and how the quality review process should be modified to consider examiner and management responsibilities related to accuracy-related penalties.
TIGA also found a more general problem with closed examination paper files, finding such files were often missing or incomplete. This leads to the final TIGTA recommendation and response:
Recommendation 5: Using the IRS’s Lean Six Sigma team or other process improvement resources, evaluate the procedure for closing, shipping, and storing paper examination case files and take corrective action to improve the process.
Management’s Response: The IRS agreed with the recommendation. The IRS will review case closing and shipping procedures and the procedures to request closed case files from the Federal Records Center to determine whether additional clarity is needed and to ensure that employees are aware of the procedures.
The IRS further stated that it believes employees follow the rules relating to record retention policies. While TIGTA experienced problems in securing closed case files, the IRS believes that was due to many factors, including how the files were requested, the Document Locator Number used, the fact that the entire CIC case could not be provided due to its size, and that not all case information is initially closed to the Federal Records Center. Nonetheless, the IRS agreed that TIGTA’s report highlights the need for the IRS to evaluate improvements or adjustments to its current file retrieval process.
Office of Audit Comment: As discussed on page 15 of this report, IRM procedures require all IC examination workpapers with the closed paper case file to go to the IRS’s Centralized Case Processing function for closing actions and then to be sent to the Federal Records Center. TIGTA followed the IRM procedures to order the cases and provided the IRS with all the information used in the ordering process, including the Document Locator Numbers, to assist with locating the files. As of December 2018, we had only received partial closed files for 12 IC cases and received no files for four IC cases. Even if not all workpapers are initially sent to the Federal Records Center, as management states in their response, the fact remains the IRS was not able to provide the remaining workpapers.
Concerns have been expressed by those representing large businesses in exams that the report implies that LB&I’s penalty imposition rate on cases with assessments in excess of $10,000 should be the same SB/SE’s, or that SB/SE’s penalty imposition rate is the correct rate at which penalties should be imposed.
Certainly, since the substantial understatement penalty is tied to the percentage of tax understated, it’s likely that $10,000 is more than the trigger level in far more SB/SE exams than LB&I exams. The fact that the report focused on a single fixed amount of tax rather than a percent of tax ultimately determined to be due on exam certainly seems to introduce an issue with TIGTA’s methodology unless they controlled for this in a way not obvious from reading the report.
Specifically, IRC §6662(d)(1) provides the trigger levels for substantial understatement:
(d) Substantial understatement of income tax
(1) Substantial understatement
(A) In generalFor purposes of this section, there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the greater of—
(i) 10 percent of the tax required to be shown on the return for the taxable year, or
(B) Special rule for corporationsIn the case of a corporation other than an S corporation or a personal holding company (as defined in section 542), there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the lesser of—
(i) 10 percent of the tax required to be shown on the return for the taxable year (or, if greater, $10,000), or
(C) Special rule for taxpayers claiming section 199A deduction
In the case of any taxpayer who claims any deduction allowed under section 199A for the taxable year, subparagraph (A) shall be applied by substituting “5 percent” for “10 percent”.
Small Company, Inc., a C corporation, faces a proposed assessment of $11,000 on its 2017 income tax return. The final corrected tax determined for the year is $50,000, meaning the $11,000 is 22% of the tax required to be shown on the return. Small Company, Inc.’s proposed assessment represents a substantial understatement if sustained on exam, meaning that the §6662 20% accuracy-penalty generally applies unless the taxpayer can carry the burden to show why it should not.
Large Company, Inc., also a C corporation, also faces a proposed assessment of $11,000 on its 2017 income tax return. The assessment arises from disallowance of a specific deduction that is identical in amount and type as that of Small Company, Inc. The final corrected tax determined for the year is $200,000. The $11,000 proposed assessment represents 5.5% of the tax required to be shown on the return. In this case, the assessment is below the level that will be treated as a substantial understatement.
If the IRS wishes to pursue an accuracy related penalty against Large Company, Inc. it would bear the burden of proving that the underpayment was due to negligence or disregard of the rules under IRC §6662(b)(1), as defined in IRC §6662(c). The fact that the IRS has to show that negligence or disregard took place makes it much more difficult for the IRS to successfully impose the penalty.
 “Few Accuracy-Related Penalties Are Proposed in Large Business Examinations, and They Are Generally Not Sustained on Appeal,” Treasury Inspector General for Tax Administration, 2019-30-036, May 31, 2019 https://www.treasury.gov/tigta/auditreports/2019reports/201930036fr.pdf
 Ibid, p. 1-2
 Ibid, p. 7
 Ibid, p. 8
 Ibid, p. 8
 Ibid, p. 9
 Ibid, pp. 14-15
 Ibid, pp. 17-18
 Eric Yauch, “Practitioners Poke Holes in TIGTA Report’s Penalty Theories,” Tax Notes Today, 2019 TNT 109-5, June 6, 2019, https://www.taxnotes.com/tax-notes-today/audits/practitioners-poke-holes-tigta-reports-penalty-theories/2019/06/06/29l17 (subscription required)