Politicians love to brag about the voluntary nature of the U.S. tax system. Back in 1862, the first Commissioner of Internal Revenue, George Boutwell, reported glowingly that, “sustained by the patriotic sentiments of the people, it is a matter for congratulation that the taxes assessed have, with few unimportant exceptions, been paid with cheerfulness...” Those with boots on the ground had a different view: “Human nature must greatly change, before we shall find that patriotism is more universal than selfishness,” wrote the tax assessor Charles Emerson in 1867.
Good tax administration works with, rather than fights against, the selfishness of human nature. One way to do that is by creating structural mechanisms that put taxpayers into a default posture of compliance. Withholding is one of those. Another way is to give taxpayers incentives to accurately comply with their reporting and payment obligations, incentives such as avoiding penalties and interest.
Enhancing taxpayer compliance is a central purpose of both penalties and interest. See Policy Statement 20-1 in IRM 220.127.116.11 (08-01-2019). Last week’s case of Jon D. Adams v. Commissioner, T.C. Memo. 2019-99 (Aug. 12, 2019) (Judge Urda) is an object lesson in how penalties and interest do that. In particular the case illustrates how the difficulty in obtaining relief from interest, coupled with the very robust statutory interest rates, suggest that imposition of interest is more than just a mechanism to compensate the government for the lost time value of money; it is a compliance tool.
I confess I am no expert on the intricacies of penalties and interest rules. According to the IRM Penalty Handbook, there are over 140 penalty provisions now in the Code. So this intro will be very, very basic. If readers with better knowledge find I miss something, please use the comments to fill in.
Law: Penalty Basics
I think of penalties as coming in two flavors: mandatory and discretionary. Mandatory penalties are those like the §6651 penalties for failure to file and failure to pay. Yes, I know the Code labels those as “additions to tax” and not “penalties.” But everyone I know calls them penalties. So does the IRS in its guidance to taxpayers, both in Notice 746 (Rev. 6-2019) and on this webpage. However denominated, they are automatically added to tax liabilities. IRS employees exercise no discretion in their initial application.
Discretionary penalties are those like the §6662 accuracy-related penalties and the §6663 fraud penalty. Before these are applied, IRS employees must exercise discretion and judgment. Graev v. Commissioner, 149 T.C. 485 (2017). That said, in practice, the §6662 penalties appear to be almost as automatic as the §6651 penalties; the operational default seems to be to impose the penalties, making the discretion an exercise in restraint. The contrasting default for §6663 fraud penalties seems to be to not impose them, making the discretion a positive decision to affirmatively impose. It's the difference between "why" and "eh, why not?" Again, I welcome comments from practitioners on whether that distinction reflects their experience. If that distinction is true, it likely comes from the difference in who bears what burden in Tax Court. Taxpayers bear the burden to escape §6662 penalties while the IRS bears the burden to prove up the fraud penalty.
The compliance function of penalties is most evident from what it takes to get a penalty abated. Generally, abatement is authorized or required when the taxpayer has a good excuse. For example, §6664(c)(1) allows taxpayers to avoid the imposition of penalties if they show they had some reasonable cause for their non-compliance and they acted in good faith. Treas. Reg. 1.6664-4 gives some good guidance, including useful examples of reasonable cause. Similarly, §6404(f) requires the IRS to abate any penalties that are attributable to erroneous written advice from the IRS.
In addition to statutory relief for good excuses, the IRS has created administrative relief to reflect it’s policy that “[p]enalties best aid voluntary compliance if they support belief in the fairness and effectiveness of the tax system.” Penalty Handbook IRM 18.104.22.168.1(10). For example, the IRS will act administratively to abate certain penalties when incurred for the first time. See IRM 22.214.171.124.3.2.1. Similarly, if IRS actions put a substantial number of taxpayers at risk for certain mandatory penalties, the IRS will sometimes issue a blanket administrative waiver. See IRM 126.96.36.199.3.2.
This variety of statutory and administrative escape hatches from penalties helps us see how penalties serve as compliance tools, used as much to influence future behavior as to punish past misbehavior.
Law: Interest Basics
As to interest, §6601(a) provides that interest on an unpaid federal tax liability arises automatically as of the payment due date. §6601(e)(3) says interest runs on both taxes and penalties. Section 6621 provides that the rate of interest imposed for nonpayment by individual taxpayers is to be 3% more than the short-term federal rate. The IRS puts all that together in a quarterly Rev. Rul., the current one is Rev. Rul. 2019-15. Here’s a good website that charts the quarterly underpayment interest rates for the past 20 years. Right now the rate is 5%.
Unlike penalties, taxpayers have very little ability to obtain relief from the running of interest. Taxpayers get no relief from §6404(a)’s general authority to abate “any tax or any liability in respect thereof,” at least when the interest is associated with income taxes. That is because the Tax Court reads the §6404(b) prohibition against abatement claims “in respect of an assessment of any tax imposed under subtitle A or B” as including claims for abatement of interest on unpaid income taxes. Urbano v. Commissioner, 122 T.C. 304 (2000) (collecting cases).
That set up leaves §6404(e) as pretty much the only statutory relief for taxpayers seeking relief from the imposition of interest on unpaid income taxes (I talk about §6403 at the end). Taxpayers can request abatement from the IRS when they think that the interest was due to (1) an unreasonable error or delay by an IRS employee in (2) performing a ministerial or managerial act. Section 6404(h) then permits taxpayers to seek Tax Court of IRS denials.
In this case Mr. Adams asked the Tax Court to find that the IRS abused its discretion in refusing to abate interest that accrued on a 1999 liability. Since he had the burden to identify how IRS employees goofed, the procedural history of the case are here the relevant facts.
In 1999 Mr. Adams sold his nightclub “Secrets” in Jackson, Mississippi. Mr. Adams did not report the sale proceeds on his 1999 return but reported some of them when he amended his 1999 return in 2001. It was too little too late. In 2002 the IRS opened a criminal investigation and he was eventually convicted in 2007 of making false statements on both his 1999 and 2000 returns, a crime under §7602(1). He went to prison.
In 2011 Mr. Adams was released from prison only to face a civil examination of both years. The examination went back and forth. In 2012 the parties settled the 2000 year, and the IRS issued a 30-day letter proposing a deficiency of $111,082 and a civil fraud penalty of $83,311 for 1999.
In June 2012 Mr. Adams protested the 30-day letter. In September 2012 the case was assigned to an Appeals Officer (AO). I am sure many of you know what happened next: radio silence. Not until April 2013---7 months later---did the AO send a letter asking for more information. And, again, you know this drill: the AO gave a two-week deadline for response. Mr. Adams’ representative asked for and received, an extension but ultimately did not respond. In July 2013 the AO prepared Form 5402-C, sustaining the 30-day letter’s positions. In January 2014 an Appeals team manager approved the Form 5402-c and Appeals issued the NOD a week later.
In April 2014 Mr. Adams timely petitioned the Tax court to review the NOD. In June 2016 the Court entered a stipulated decision where the parties agreed to a deficiency of $91,762 and a fraud penalty of §68,822. That is not including interest.
In March 2017 Mr. Adams requested abatement of $207,044 in interest. It is not clear from the opinion whether this amount was the total accumulated interest or just the part attributable to the alleged delay. In February 2018 the IRS issued Mr. Adams a final determination denying the abatement request. Mr. Adams petitioned the Tax Court.
The Object Lesson: How Not to Avoid Interest
Mr. Adams’ case suggests to me that arguing “delay” to avoid interest is a losing proposition. That is because a taxpayer must not only show that some IRS employee failed to perform some ministerial or managerial task, but that such failure constituted an “unreasonable error or delay.” And what constitutes a “delay” at all is in the eye of the beholder.
Here, Mr. Adams alleged two “arbitrary delays by the Commissioner.” First, he said the IRS acted arbitrarily in holding off on the civil examination until 2011. Second, he said that during the civil examination itself IRS employees delayed ministerial or managerial acts.
Judge Urda gives short shrift to the first alleged delay. It flounders for lack of an identifiable managerial or ministerial act. The decision on when and whether to open a civil examination is inherently a discretionary act and not a ministerial act. What makes an exam timely or not is the applicable statute of limitations. That is why the flush language of §6404(e)(1) says that “an error or delay shall be taken into account only... after the Internal Revenue Service has contacted the taxpayer in writing with respect to such deficiency....” See Matthews v. Commissioner, T.C. Memo 2008-126 (giving legislative history of statutory language).
Mr. Adams' second contention---of unreasonable delays in the conduct of the civil examination--- also failed. The opinion is silent on Mr. Adams’ specific allegations (if there were indeed any). Maybe Mr. Adams thought that the two month period between his protest of the 30-day letter and the assignment of the case to an Appeals Officer was a managerial delay. Or perhaps he thought the 7 month radio silence was a delay. Or perhaps the 5 months that it took for the Appeals team manager to approve the AO’s recommendation was unreasonable. I see nothing else in the facts that could even come close. Readers are welcome to disagree, in the comments (please be polite!).
Treas. Reg. 301.6404-2(b)(2) defines a managerial act as “an act that occurs during the processing of a taxpayer's case involving...the exercise of judgment or discretion relating to management of personnel.” So an unreasonable delay in assigning a case would likely qualify as a managerial act.
But what is a “delay”? The best answer is likely to be that a “delay” is a period of time that deviates from the normal time. Sure, perhaps two months is a long time for a taxpayer eager to get to the merits. But it is hardly a “delay” when one considers the volume of appeals and the shortage of personnel. As this 2018 GAO Report noted, the staffing levels in Appeals “declined by nearly 40 percent from 2,172 in fiscal year 2010 to 1,345 in fiscal year 2017. Appeals anticipates a continued risk of losing subject matter expertise given that about one-third of its workforce was eligible for retirement at the end of last fiscal year.” This IRS website tells taxpayers to expect 120 days for the case to get assigned to an AO. The assignment here actually happened within about 60 days. So that’s pretty fast, depending on your point of view.
What about the 7 month period between the assignment of the case to an AO and the AO’s letter asking for information? And what about the 5-month time period between when the AO prepared the 5402-c and the time it was approved by a team manager? Overall, Mr. Adams’ appeal took 18 months from the time he filed in July 2012 until Appeals issued the NOD in January 2014. Again, we need a baseline to measure delay. The 2018 GAO report gives us one: it says that for FY14-FY17, “about 85% of all Appeals cases were resolved within one year of when the taxpayer requested an appeal.”
So, yes, it appears that Mr. Adams’ adventures in Appeals took longer than average. Heck, let’s call that delay! Let’s go further and call it unreasonable!
Mr. Adams still loses. He cannot show that any of the delay was because of a managerial or ministerial act. He must show that. He not only must show a delay, he must show it arose from some IRS employee’s failure to perform a ministerial or managerial task.
The AO’s job in reviewing a protest is inherently discretionary, not ministerial. Similarly, the Appeals team manager’s approval is not a ministerial act. And by discretionary, I do not mean simply discretionary as to the merits of the taxpayer’s protest, but I also mean discretionary in handling workload. Here, Judge Urda noted that “the Appeals officer did intermittent work on the case between September 2012 and April 2013.” Gosh, that “intermittent” sure sounds bad. It sounds like the AO was dilatory. Yep. But that’s part of the discretion. Being slower on one case may sometimes be necessary because of the press of other work. The AOs have discretion in managing their workload. Here, the AO apparently did enough during that period to decide more information was needed. That’s part of the back and forth when working with Appeals. And does not it always seems that Appeals takes a long time but wants responses in a short time? That’s the way the ball bounces, dear readers. And here, when the ball went back to the taxpayer’s court, there was no return at all back to Appeals. It seems Mr. Adams' representatives dropped the ball.
Comment: How to Avoid Interest
You will pay interest. Sure, you get what is effectively the prime rate, but that still adds up over time. And I think it is that certainty of accrual that makes it a compliance tool. Unlike other loans, taxpayers have a very difficult time seeing that they have taken a loan from the government, much less seeing any value from it. So it feels like a penalty to them. Worse, it’s a penalty that they cannot get out of, even if they have a good faith dispute that they eventually lose.
The only way to stop interest for sure without paying the asserted tax and penalties is to follow the deposit procedure under §6603. Section 6603 allows taxpayers to stop the running of interest by making a deposit. The IRS gives detailed instructions in Rev. Proc. 2005-18 but the basic concept is simple: if a taxpayer sends in money with a clear notice that it is intended to be a deposit and not a payment, then by gosh it will be a deposit.
The main difference between deposits and payments is interest: deposits do not accrue interest if the taxpayer eventually wins, but they do stop the running of interest. A second, and sometimes important difference, is that deposits are not subject to the limitation period in §6511(b)(2)(A). Taxpayer can get a deposit back or use it against a different tax liability in situations where the recovery of a payment would be barred by §6511(b)(2)(A). See e.g. Deaton v. Commissioner, 440 F.3d 223 (5th Cir. 2006).
Since I do not actively practice, I would be interested to know how many practitioners use the §6303 deposit procedure and under what circumstances. I understand the client must have the funds to pay, but how often do folks even have the conversation. It sure seems here that Mr. Adams could have saved himself a bunch of interest by making a deposit, if he had the funds to do so.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.