Last month, I wrote a blog post about the Canal Corporation v. Commissioner case. It's an interesting case and drew a lot of attention and commentary - mostly about: (a) whether the transaction worked as the taxpayer said, to delay the amount the taxpayer would have to pay in taxes; and (b) if not, whether the taxpayer should have to pay a penalty on top of the additional taxes due. There were a couple of other aspects of Canal Corporation, which didn't get a lot of attention, that I found more interesting. Last time I talked about what appears to have been a very costly strategic error: challenging the additional tax liability in Tax Court rather than through refund litigation in District Court or the Court of Federal Claims. This time I thought I'd talk about a problem with the way that Congress designed the penalty, which can be disproportionately harsh to some taxpayers.
The idea behind the "accuracy-related" penalty, section 6662 in the Internal Revenue Code, is fairly straight-forward. If the taxpayer files a tax return that shows less tax due that it should, the government will tack on an additional 20% of the additional tax owed as determined later by an audit. [*] It's a deterrent, encouraging taxpayers to prepare their returns carefully and discouraging taxpayers from taking questionable positions on their returns. Disputes between taxpayers and the IRS often include not only whether the additional tax is owed but also whether, even if the additional tax is owed, the taxpayer can at least avoid the penalty. [**]
But there are (in very over-simplified terms) two types of errors by taxpayers: permanent errors, when taxable income is omitted entirely, and timing errors, when taxable income is just deferred or delayed to a later year. (Theoretically taxpayers may overstate their taxable income or report it earlier than they should -- but the IRS is less concerned about that. :) ) If a taxpayer reports income in 2010 that should have been reported in 2008, or takes a deduction in 2008 that he should have taken in 2010, his tax liability is lower than it should be in 2008 and higher than it should be in 2010. Overall, the government may not be out any money, but still has to wait two years longer for the taxes. Taxpayers like putting off paying taxes as long as they can, but of course the government has a legitimate interest in receiving taxes on time.
The accuracy-related penalty is calculated on an underpayment of tax. That works well for a permanent error, but less so for a timing error. With a $100,000 permanent error, the government would have been out $100,000. But if the taxpayer underpaid its tax by $100,000 in 2008 but overpaid by $100,000 in 2010, the government still gets its $100,000, but two years later than it should. The government is really only losing the time value of money, not the entire $100,000. That's still important, but not as significant.
But since the penalty is calculated on an underpayment of tax for a particular year, that timing error can result in a penalty for 2008 of 20% of the underpayment or $20,000 -- the same amount that would be assessed on the permanent error that (if not detected) would have cost the government much more. The taxpayer gets no reduction in the penalty for the overpayment in 2010.
That's what happened in the Canal case. The taxpayer may have originally planned to defer the tax liability for much longer, but because of changing circumstances recognized the tax liability only two years after the year it should have according to the court.
Since the intent likely was for a much longer deferral, applying the penalty in this situation may not have been as draconian as it might appear. And in other circumstances, when the deferral was never intended to be more than a few years, the court can always take that into account informally. It can't arbitrarily reduce the penalty, but it can take the circumstances into account in deciding that the taxpayer had reasonable cause and shouldn't have to pay a penalty at all.
But the Canal case is a good reminder that you have to worry about more than merely omitting taxable income. Even deferring tax liability a year or two, if the IRS and a court determine that you were wrong to do so, can result in a penalty, and a heavier one than you might assume.
[*] The rules for penalties are very complex. Under some circumstances, the penalty may be 30% or 40% instead of 20%. Under certain circumstances, the taxpayer won't have to pay any penalty at all -- typically if he had a "reasonable cause" for understating the amount of tax and acted in good faith, or there was some degree of support for the position he took. Sometimes the law is very clear and the taxpayer was just wrong, but in a lot of cases, there is some legitimate dispute between taxpayers and the IRS concerning exactly what the law means. Even if the IRS or a court eventually decides that the taxpayer was wrong, he may have to pay the additional tax but avoid the extra penalty, depending on how much support there was for his position. How much support, in terms of cases or IRS rulings or various other precedents, is required to avoid the penalty depends on a lot of different factors such as what type of transaction was involved, whether the taxpayer provided enough information with the return that the IRS could tell there was a possible error, etc.
[**] That's also the reason that taxpayers often seek a written opinion from a CPA firm or law firm before engaging in a transaction. The written opinion hopefully can be used to demonstrate that the taxpayer took reasonable steps to ensure that the tax return was correct before filing it. It's insurance against having to pay a penalty if it turns out you were wrong. Of course, a written opinion -- even by a very reputable CPA firm or law firm -- is not absolute protection and courts often have upheld penalties if the CPA/lawyer didn't do a good job or had a conflict of interest. In fact, the taxpayer in Canal Corporation got a tax opinion . . . and still had to pay the penalty.