Games, Lies, and Taxes

Abstract:     
Disputes over valuation are becoming increasingly common in reported estate and gift tax decisions. Although not nearly as common, such disputes are significant in income tax cases involving charitable contributions of all but listed securities as well as cases involving compensation paid in kind. Typically these disputes are resolved in lengthy administrative hearings that are occasionally followed by litigation over the value of the property involved. Recently there has been a modest attempt to employ game theory in such situations by providing for escalating penalties based on the degree of error in the value declared by the taxpayer. I propose that we extend game theory even further by allowing the Internal Revenue Service, on audit and at its election, to follow the established course of action for resolving valuation dispute or to choose from among two other alternative remedies. First, I propose that, subject to certain limitations, the value stated by the taxpayer on the return be treated as the granting of an option to the Internal Revenue Service to purchase the asset for the stated value. Second, I propose that the Internal Revenue Service be authorized to compel the taxpayer to enter into final offer arbitration with respect to the value of the asset. It is anticipated that adoption of these two steps will have a curative impact on the seemingly growing tendency of taxpayers to misstate values of assets on returns.

working papers series