In Come 2012 Taxes: Can anyone really trust the IRS anymore?

January 18, 2012

Tax law

(Editor’s note: With January comes the start of tax season.  Throughout the month, we’ll be looking at current and possible future developments in tax law.)

Click here for the first post on U.S. v. Home Concrete and Supply.

Click here for the second post on FACTA’s new reporting requirements.

Have you’ve ever heard the phrase, “never look a gift horse in the mouth?”

Although that may be good advice at times, it probably isn’t when it comes to gifts from the Internal Revenue Service.

Why?

According to the 2012 annual report of the Taxpayer Advocate Service, an independent office within the IRS, the IRS pulled a bait-and-switch with its 2009 Offshore Voluntary Disclosure Program (OVDP).

U.S. citizens are generally required to report foreign accounts and to report income from such accounts on their tax returns.

The IRS “strongly encouraged” taxpayers who failed to file these and other similar returns to participate in the 2009 OVDP.

If a taxpayer instead opted for discretely filing amended returns and paying the due taxes, the IRS warned that those taxpayers could be “criminally prosecuted.”

In return for participation in the OVDP, taxpayers would generally be subject to a 20% “offshore” penalty instead of various other penalties (which could have amounted to substantially more).

The IRS further stated that “under no circumstances will a taxpayer be required to pay a penalty greater than what he would otherwise be liable for under existing statutes.” 

It was widely understood by the public and tax lawyers that this comment meant that if a taxpayer argued that he had not intentionally violated the law, he would not have to pay even the reduced penalties of 20% (or later, 25%) but instead would pay a maximum of $10,000.

Unfortunately, things aren’t always what they seem.

On March 1, 2011, over a year after the 2009 OVDP filing deadline passed, the IRS issued a “clarification” on its earlier statement.

Specifically, the IRS stated that it would no longer consider whether taxpayers participating in the 2009 OVDP would pay less under existing statutes on the basis of non-willfulness or reasonable cause.

Instead, those taxpayers could either agree to pay more than they believed they owed, or withdraw from the OVDP.

Of course, the latter option opens the possibility of substantial civil and criminal sanctions, so neither  choice was particularly wonderful.

This clarification, by the way, applied retroactively, so taxpayers who believed they had already arranged a good deal with the IRS were in for an unpleasant surprise.

Does this “clarification” violate Fifth Amendment due process rights?

Almost certainly.

In fact, the TAS report explicitly mentions that the clarification could easily be subject to legal challenges.

Although such easily avoidable lawsuits are certainly a waste of agency time and resources, they aren’t the most potentially damaging fallout of this incident to the IRS.

Instead, that honor goes to the serious harm caused to the IRS’s credibility.

Even if the clarification was made in good faith to address an earlier oversight (i.e. it wasn’t an outright deception), the fact that the decision to issue the clarification was made with seemingly so little disregard for the impact on OVDP participants doesn’t seem much better.

For an agency such as the IRS that relies primarily on honest, voluntary reporting from taxpayers, this major credibility hit will very likely have some serious consequences.

Maybe next time the IRS decides to pull the rug out from under some unsuspecting taxpayers’ feet, it should consider the impact such a move will have on its future relations with the rest of America’s taxpayers.