One of the greatest risks to the U.S. tax system today is the erosion of trust in the fairness and effectiveness of the system. As the IRS budget continues to fall in inflation-adjusted dollars and the demands on the agency increase, the IRS is increasingly being asked to do more with less (see National Taxpayer Advocate, Annual Report to Congress, 2020, p. vi, available at www.taxpayeradvocate.irs.gov: "Since FY 2010, Congress has reduced the IRS's budget by about 20 percent after adjusting for inflation."). Years of hiring freezes have allowed skilled employees to retire from the agency without the benefit of being able to pass along their knowledge to new, younger hires (id.). The media consistently reports on falling audit rates, decreasing levels of customer service, and the ability of the wealthy to avoid paying their fair share. In a system based largely on self-reporting, particularly with the "gig economy" on the rise, the threat of taxpayers choosing to simply play the audit lottery is not just theoretical.
The question of whether and how much to increase the IRS budget could not be more important at this juncture. The United States literally cannot afford a decrease in tax compliance rates. Taxes are not a mere inconvenience; they are, to quote Supreme Court Justice Oliver Wendell Holmes, the price "we pay for civilized society" (Compañía General de Tabacos de Filipinas, 275 U.S. 87, 100 (1927) (Holmes, J., dissenting)). The IRS collects 96% of that price, according to recent estimates (Publication 5382, IRS Progress Update, Fiscal Year 2020: Putting Taxpayers First, p. 2, available at www.irs.gov).
And yet the core theory of tax administration could not be simpler: Taxpayers who believe that the system is fair, efficient, and effective and who believe that they are being treated fairly and well comply at significantly higher rates than those who do not (see San Juan, "Who Pays the Price of Civilization?" 9 Columbia Journal of Tax Law 45 (January 2018); Hartner, Rechberger, Kirchler, and Schabmann, "Procedural Fairness and Tax Compliance," 38 Economic Analysis and Policy 137 (2008)). And taxpayers make these assessments with respect to a variety of touchpoints by them and their businesses with the IRS:
- Do I believe the tax rates that apply to me are fair, both in the abstract and as compared to other taxpayers?
- Do I believe I am being treated fairly by the IRS in connection with an examination or other enforcement activity?
- Do I believe the time frame for resolution of my tax issues is reasonable?
- Do I believe that I will be treated fairly if I voluntarily correct prior noncompliance?
Luckily for the IRS, the first issue lies at the feet of Congress, which sets tax rates and writes, rewrites, and rewrites again the Internal Revenue Code (file under: "Write Your Senator or Representative").
The answers to the following two questions depend largely on the level of funding provided to the IRS by Congress. For years, the IRS has watched its funding levels fall in terms of real dollars, resulting in decades of "deferred maintenance" with respect to the agency's aging computer systems and dwindling workforce. In the IRS's Taxpayer First Act Report to Congress (p. 7, available at www.irs.gov), submitted in January 2021, the agency estimated that it would take almost $2 billion in additional funding over five years to modernize its IT systems. Compare that to the current IRS annual budget for fiscal year 2021 of $11.9 billion (Congressional Research Service, Internal Revenue Service Appropriations, FY2021, p. 1 (Feb. 1, 2021), available at crsreports.congress.gov). The problem does not simply lie in the sheer amount of funding needed to bring the IRS up to date in terms of operations, however. The larger issue is the IRS's inability to predict its funding levels year over year, which would allow it to address its technology and human resource issues over the long term — issues that did not manifest themselves in a year and will not be solved with short-term funding.
How is the IRS different in this regard from any other government agency? First, more than any other federal agency or private organization, the IRS touches virtually every U.S. citizen (IRS 2020 Progress Update, p. 2), and that is even more true now, after three rounds of economic stimulus payments, than it was pre-pandemic. Second, appropriately funding the IRS is critical to the functioning of the nation's entire government system, as the agency collects the vast majority of the country's revenues (id.). Uncertain short-term funding of the IRS threatens the financial stability of the entire government, even before one factors in the effect of taxpayer views on compliance.
Which brings us to the last question: Will I be treated fairly if I come forward to report my own noncompliance? Here, the IRS holds virtually all of the power to affect taxpayer attitudes and beliefs. Experiments across the globe have shown that properly calibrated voluntary disclosure programs can be highly effective at raising awareness of issues of noncompliance and bringing taxpayers (and their tax dollars) back into the system (see generally OECD, Update on Voluntary Disclosure Programmes: A Pathway to Tax Compliance (August 2015), available at www.oecd.org). The IRS apparently agrees, as it currently offers several voluntary-disclosure-type programs, depending on a taxpayer's reason for noncompliance. For the most egregious cases — those involving willful noncompliance — IRS Criminal Investigation offers a Voluntary Disclosure Practice that may, under certain circumstances, result in protection from criminal prosecution (see www.irs.gov).
Two other popular programs address noncompliance issues specifically related to foreign financial assets, an area of the tax law that involves a complicated web of reporting requirements. The streamlined filing compliance procedures offer civil penalty protection to those whose noncompliance was "nonwillful," which can cover a multitude of sins including negligence, inadvertence, or simply misunderstanding the law (see www.irs.gov). For taxpayers with "reasonable cause" for a failure to file timely, complete, and accurate international information reporting forms, the delinquent international information return submission procedures (DIIRSP) may prevent penalties from being imposed in the first place (see www.irs.gov).
Foreign trust reporting: A case study
In November 2020, the IRS changed the DIIRSP website to clarify its current procedures regarding penalties assessed with respect to Forms 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, both of which, broadly speaking, are filed to report certain transactions with, or ownership of, foreign trusts. What is considered a "foreign trust" for U.S. tax purposes is far from intuitive to many taxpayers, including those who often get caught up in the "trust" reporting requirements for accounts such as overseas retirement savings or pension plans. For these taxpayers, the DIIRSP provided a strong incentive to come into compliance.
Upon discovering that a taxpayer had a Form 3520 or 3520-A reporting requirement, tax advisers routinely recommended that clients file the missing forms as quickly as possible with a reasonable-cause statement describing the reason for noncompliance. For many years following the 2014 introduction of the DIIRSP, this worked: The delinquent returns were submitted to the IRS, providing the government with the information it desired, and taxpayers were rewarded for their voluntary disclosure by the IRS's not asserting any penalties.
In May 2018, the IRS Large Business & International Division announced the rollout of an F3520/3520-A Non-Compliance and Campus Assessed Penalties campaign (see www.irs.gov) to "address noncompliance through a variety of treatment streams including . . . penalties assessed by the campus when the forms are received late or are incomplete" (see www.irs.gov, under the tab "Forms 3520/3520-A Non-Compliance and Campus Assessed Penalties"). Shortly thereafter, in November 2018, the IRS sent informational letters to taxpayers that it determined might have delinquent Form 3520 or 3520-A filing requirements (see www.irs.gov). At some point in 2019, taxpayers started to observe that late-filing Forms 3520 or 3520-A, even with a DIIRSP statement attached, was resulting in the automatic assessment of penalties, most often a flat $10,000 per form, or more if the assets reported rose above certain thresholds.
Following the receipt of a penalty assessment notice, the only administrative recourse for taxpayers with reasonable cause for their late filing is submitting a written abatement request to the service center that issued the notice. While the IRS has not confirmed this to be true, recent anecdotal evidence from tax practitioners confirms that these requests are routinely being denied. Following a denial from the service center, taxpayers may appeal the decision by submitting a written protest and engaging with an Appeals officer. Though many taxpayers have been able to successfully obtain penalty relief at this level, it can take well over a year from the submission of the initial abatement request until a resolution is reached with Appeals. Factoring in the professional fees necessary to navigate these various steps, the cost/benefit analysis of voluntarily complying has changed significantly.
Adding to the disincentive to voluntarily comply with these reporting requirements, the IRS has in recent months begun sending increasingly fear-inducing notices to taxpayers who are requesting penalty abatement, often starting just 30 days after the date of the initial penalty assessment. The notices inform the taxpayer that the IRS may file a notice of federal tax lien or levy assets to satisfy the penalty and, in some cases, result in a taxpayer's account being referred to IRS Collections before the IRS even responds to the taxpayer's abatement request.
To prevent these actions from escalating, taxpayers or their authorized representatives may call the IRS to request a collections hold, pending resolution of the abatement request. However, these holds are often not long enough to cover the time necessary for the IRS to respond to the abatement request, thus requiring multiple calls to the IRS to serially renew the requested holds. With wait times on the IRS Practitioner Priority Service frequently over an hour, the professional fees can continue to add up.
By the IRS's own admission, it continues to experience significant COVID-19—induced delays with respect to live phone support and answering mail from taxpayers (see www.irs.gov). Thus, there is no reasonable expectation that the process described above will become any less burdensome or time-consuming in the near future. The likely result is clear: Fewer taxpayers will decide that voluntary disclosure of delinquent Forms 3520 and 3520-A is worth the time, effort, or cost, as compared to the risk of enforcement. Stated otherwise, when compared to the actual noncompliance involved — the mere reporting of a foreign trust, unaccompanied by any actual tax due — taxpayers will judge the result of voluntary disclosure as being simply unfair.
|Melissa L. Wiley, J.D., is a senior manager in the Tax Controversy group in EY's National Tax Department in Washington, D.C. For more information about this column, please contact email@example.com.