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TAXPAYER ADVOCATE CRITICAL OF AUTOMATIC PENALTIES

June 25, 2024

By Joshua Ashman, CPA & Nathan Mintz, Esq.

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In a recent blog, the National Taxpayer Advocate (NTA) Erin Collins made several critical observations of the IRS’s penalty process, particularly with respect to foreign information penalties.

From our perspective, a number of our clients have in fact experienced the serious challenges outlined by the Taxpayer Advocate, so we hope that her honest critique is an effective first step towards improving the IRS’s approach to penalties, especially with respect to information reporting penalties imposed on U.S. citizens living abroad.

Aiming at the Wrong Target

NTA Collins begins her piece by combatting the myth that international information return penalties, such as IRS Form 5471 (ownership of foreign corporations) and Forms 3520 and 3520-A (ownership of and transactions with foreign trusts), only affect wealthy taxpayers and large corporations.

In fact, according to Collins, many average-income individuals and small businesses “face significant and potentially life-changing penalties, even when they voluntarily comply, for failing to meet obscure and complex foreign information reporting requirements.”

According to the Taxpayer Advocate, 71% of individual Code Sec. 6038 penalties are assessed against those making under $400,000, while 83% of business Code Sec. 6038 and Code Sec. 6038A penalties are assessed against “small and midsize businesses.”

To make matters worse, when information returns are filed late, an IRS system automatically applies penalties “without any review or action from IRS personnel,” Collins wrote.

In our experience, we have found that automatic penalties, in many cases, aren’t even justified, and yet it can take months, if not years, to properly resolve. This can be particularly frustrating for taxpayers living abroad, who struggle to be able to communicate with IRS agents, who are often difficult to reach by phone, or will only communicate regarding certain matters through the slow-moving mail system.

Discouraging Voluntary Compliance

Collins has previously noted in her writings that the practice of automatically assessing penalties punishes otherwise good-faith taxpayers, and perhaps, discourages voluntary compliance.

In her Annual Report to Congress, Collins said that instead of assessing automatic penalties, the IRS should instead focus more on education and outreach efforts.

“The IRS’s cavalier approach is unfair to taxpayers and inefficient for our tax system,” wrote Collins. “By systemically assessing penalties when taxpayers willingly come forward and file their late returns, the IRS discourages voluntary compliance. When taxpayers know that voluntarily filing is going to result in a crushing penalty that is going to be difficult and costly to challenge, how many taxpayers decide not to file and hope the IRS doesn’t find them?”

Curbing Avenues to Dispute Penalties

Currently, the IRS offers limited avenues for disputing penalties. If taxpayers are fortunate, an agent will abate a penalty directly on the phone after consulting a supervisor, if proper evidence of timely filing is provided.

We’ve also found that the IRS Independent Office of Appeals can sometimes be an effective avenue for appealing a penalty, but this assumes the office is willing to review and settle the abatement request.

NTA Collins has further recommended that Congress amend Code Sec. 6212 to let taxpayers dispute penalties in Tax Court through a streamlined process.

“Due to the tax expertise of its judges, Tax Court is often better equipped to consider tax controversies than other courts,” Collins added. “It is also more accessible to unrepresented taxpayers because it offers simplified, less formal procedures, particularly for disputes that do not exceed $50,000.”

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