Tax Politics and the New Substantial Understatement Penalty

Abstract

Concurrent with the IRS investigation of civil penalties in 1988 and 1989, Congress conducted its own inquiry into the penalty regime. Both the House and Senate held hearings on penalty reform in 1988 against the backdrop of tax reform. The congressional effort revealed widespread discontent with the penalty system among taxpayers and tax practitioners, legislators and administrators. Much of the ire was directed at the taxpayer substantial understatement penalty.

This article examines the Congressional penalty investigations as well as the pervasive confidence among tax policymakers that the decade-long battle against tax shelters was over with the government having emerged triumphant. A coherent penalty regime, elevated practice standards, sweeping tax reform legislation, reduced marginal tax rates, a broadened tax base, and alternative minimum taxes stoked the confidence of compliance reformers. At the same time, others warned of undiscovered methods of tax avoidance and the need to remain vigilant.

Despite notable advances against noncompliance during the 1980s, fundamental problems persisted, including: (i) the indefensible gulf between reporting standards for taxpayers and tax practitioners that allowed practitioners to advise overaggressive reporting positions without fear of sanction; (ii) the insidious litigation norms shared by taxpayers and tax practitioners and reflected in practice standards and penalty provisions; and (iii) the acquiescence of Treasury and Congress to minimal reporting standards, opportunistic levels of accuracy, and paltry audit coverage. Conflicting reporting obligations, litigation norms, and inadequate practice standards--all culprits in the first tax shelter wave - remained at large, and enabled the next wave of undiscovered tax avoidance.