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CHAPTER 10 - PENALTY/REFERRALS AND BACKUP WITHHOLDING
Background
With any audit, penalties must remain a valid concern if the facts and
circumstances justify application. Because of the nature of the
adjustments (substantial unreported income, false expenses, and failure to
file employment taxes), an examiner should be concerned with the planning
and documentation of penalties from the start of the contractor audit. The
following penalties should be considered and planned for at the beginning
of an audit:
Criminal Fraud Penalty - Evasion of Tax - IRC Section 7201
An examiner conducts a series of taxpayer interviews to determine the sources of income for a particular taxpayer. The examiner collects various source source documents to establish this income. The examiner may observe the taxpayer at his or her place of business and may interview third parties (wholesalers, contractors, accountants, etc.) to verify the income. If necessary, the examiner may use a summons for any additional records he or she deems necessary for the audit. Further, an examiner may make observations about the taxpayer's educational background and business sophistication to determine if the taxpayer is the person ultimately responsible for any filed tax returns.
If the examiner discovers during the performance of his or her duties firm indications of fraud, he or she is obligated to suspend activities at the earliest practicable opportunity without disclosing to the taxpayer, his or her representatives, or the taxpayer's employees the reason for such suspension. If the underreporting of income has proven to be substantial, recurred over 2 or more years, and the taxpayer has no valid explanation for the understatement, then the possibility of making a criminal fraud referral exists. See IRM 4565.
If the examiner is unsure about the indications of fraud, the examiner should seek guidance from the group manager or Examination Fraud Coordinator to determine if the indicators of fraud are sufficiently developed. However, the examiners should exercise care in seeking advice or direction from the Criminal Investigation Division for a specific case under examination.
Once the indications of fraud are confirmed, the examiner should prepare a Form 2797, Referral Report for Potential Fraud Cases, and refer the matter through channels to the Chief, CID. The purpose of the referral is to enable CID to evaluate the criminal potential of the case and to decide whether or not a joint investigation should be undertaken. It is very important that the Form 2797 contain detailed information to enable CID to make a proper evaluation. The report is to be prepared pursuant to IRM 4565.2.
Upon receipt of the Form 2797, the Chief, CID, will decide whether or not to accept the case. The criterion in making this decision is the evaluation of the criminal potential of the case. CID will select for joint investigation those cases in which it appears that sufficient evidence can be gathered to prove willful violation beyond a reasonable doubt as required in a criminal case. CID will also consider such factors as the amount of the tax loss, flagrancy of the violations, and the possible deterrent effect of criminal prosecution. The examiner must understand that the rejection of a referral does not mean that the civil fraud case cannot be developed successfully. See IRM 9322.
Civil Fraud Penalty: (IRC Sections 6653(b) and 6663)
IRC Section 6653(b)
For returns the due date for which (determined without regard to extensions) is on or before December 31, 1989
To establish a taxpayer's liability for the addition to tax for fraud, the Service must show by clear and convincing evidence that at least part of an underpayment is due to fraud. The Service must establish that there is both an underpayment and that there was fraudulent intent.
First, the initial interview must be thorough and must include the appropriate questions as to whether the taxpayer has reported all income from all sources. Questions must be clearly stated to the taxpayer and the taxpayer's responses should be documented as accurately as possible. Follow-up interviews may be needed as the audit progresses.
Evidence of unreported income must be clearly established. This means collection of any source documentation such as cancelled checks received by the contractor, Forms 1099 provided by the manufacturers and copies of any disbursement journals showing payments to contractors.
The taxpayer must be proven to be the party ultimately responsible for the tax return. Although this responsibility is usually proven by the taxpayer's signature on the return, this is sometimes not enough. In rare instances, the return preparer may indicate that when the tax return was prepared, the preparer adjusted the income to reflect what the preparer felt was an accurate figure. Although this would probably occur with the consent of the taxpayer, it would raise some doubt as to the ultimate accountability of the taxpayer.
If possible, try to observe and document all of the taxpayer's dealings in the day-to-day operation of the business. In many cases, the taxpayers are immigrants who may have problems dealing in English. Education levels may also serve to limit the taxpayer's business sophistication. In these cases, an examiner must prove that the taxpayer is sophisticated enough to understand his or her actions when a substantial amount of income is unreported. Knowing that a taxpayer is sufficiently competent to understand his or her actions and proving it are two different things. If a third party contact is made to collect evidence in the form of cancelled checks, it may prove helpful to inquire as to whether the manufacturers remembered their dealings with the taxpayer. In some instances, manufacturers have had to deal with the contractor's children because of an English difficulty. This makes it difficult to establish fraudulent intent because a defense of lack of comprehension could be raised. Again, it is emphasized that a thorough initial interview should include information about the taxpayer's educational background.
For returns due after December 31, 1988, but on or before December 31, 1989, the penalty is 75 percent of the underpayment attributable to fraud. For returns due after December 31, 1986, but on or before December 31, 1988, the penalty is 75 percent of the underpayment attributable to fraud plus 50 percent of the interest payable on such portion. For returns due on or before December 31, 1986, the penalty is 50 percent of the underpayment attributable to fraud plus 50 percent of the interest payable on such portion. For returns due after December 31, 1986, but on or before December 31, 1988, the 75 percent/50 percent penalty applies only to the amount of the underpayment attributable to fraud. However, it is the burden of the taxpayer to prove that an amount is not attributable to fraud once the Service has established that any part of the underpayment is due to fraud.
IRC Section 6663
For returns the due date for which (determined without regard to extensions) is after December 31, 1989
OBRA 1989 substantially revised and reorganized the penalty provisions.
One of the changes made was to remove the fraud penalty from IRC section
6653(b) and include it in a new IRC section 6663. The penalty is still 75
percent of the underpayment attributable to fraud. These changes apply to
returns due after December 31, 1989. Also, it should be noted that the
fraud penalty cannot be imposed unless a return has been filed. See IRC
section 6664(b).
Negligence Penalty: (IRC Sections 6653(a) and 6662(b)(1)
This penalty should be considered on a case by case basis whenever a taxpayer makes substantial errors in reporting income, claiming unreasonable deductions which cannot be substantiated by facts, or claiming personal deductions.
IRC Section 6653(a)
For returns the due date for which (determined without regard to extensions) is on or before December 31, 1989.
For returns due on or before December 31, 1988, if any part of the
underpayment is due to negligence or disregard of rules or regulations,
IRC section 6653(a) imposes a penalty equal to 5 percent of the entire
underpayment plus an amount equal to 50 percent of the interest payable on
the portion attributable to negligence. For returns due after December 31,
1988, but on or before December 31, 1989, the penalty is 5 percent of the
underpayment.
IRC Section 6662(b)(1)
For returns the due date for which (determined without regard to extensions) is after December 31, 1989
OBRA 1989 removed the negligence penalty from IRC section 6653(a) and
made it part of the new accuracy-related penalties under IRC section 6662.
The penalty is now 20 percent of the underpayment attributable to
negligence or disregard of rules or regulations. There is no stacking of
components of the accuracy-related penalty. Thus, if the underpayment is
attributable to both negligence and substantial understatement of income
tax, the maximum penalty that can be imposed on that underpayment is 20
percent (not 40 percent). Also, an accuracy-related penalty cannot be
imposed unless a return has been filed. See IRC section 6664(b). For
reasonable cause exception, see IRC section 6664(C).
Substantial Understatement Penalty: (IRC Sections 6661 and
6662(b)(2))
IRC Section 6661
For returns the due date for which (determined without regard to extensions) is on or before December 31, 1989
The criteria for application of this penalty is an understatement of taxes over $5,000 ($10,000 for corporations other than S-Corporations and personal holding companies) or 10 percent of the corrected tax, whichever is greater. In determining whether the $5,000/10 percent understatement threshold has been met, do not take into account the portion of the understatement for which there was substantial authority. In the case of a tax shelter item, do not reduce the understatement unless there was substantial authority for the tax treatment taken and the taxpayer reasonably believed that the tax treatment was more likely than not the proper treatment. Other exceptions may also apply; consult the Code and regulations.
IRC Section 6662(b)(2)
For returns the due date for which (determined without regard to extensions) is after December 31, 1989
As already mentioned above, OBRA 1989 created a new IRC section 6662
which contains the accuracy-related penalties. The penalty for substantial
understatement of income taxes is now part of the accuracy-related
penalties. The penalty amount is 20 percent of the underpinning
attributable to any substantial under- statement of income taxes. As with
all accuracy-related penalties, this penalty does not apply if no return
has been filed and there can be no stacking of the accuracy-related
penalties (discussed above). Also, the reasonable cause exception may
apply. See IRC section 6664(c).
Information Return Penalties: IRC Sections 6652, 6676, 6678, and 6721 -
6724
In cases where contractors need to subcontract work which they cannot handle, they may be required to file and furnish Form 1099 if the income criteria has been met. This penalty should also be considered if Form W-2 is not issued to employees.
IRC Sections 6652, 6676 and 6678
For returns and statements the due date for which (determined without regard to extensions) is on or before December 31, 1986.
IRC section 6652 imposes a penalty for failure to file certain information returns and other statements. The penalty under IRC section 6652 is increased if the failure is due to intentional disregard of the information reporting requirement. IRC section 6676 imposes a penalty for failure to supply taxpayer identification numbers. The IRC section 6676 penalty applies to situations where the contractor fails to include his or her taxpayer identification number on Forms W-2 or 1099, or the payee's taxpayer identification number on Forms W-2 or 1099. IRC section 6678 imposes a penalty for failure to furnish certain payee statements (for example, for failure to furnish a Form W-2 to the employee).
IRC Section 6721 - 6724 and IRC Section 6676
For returns and statements due date for which (determined without regard to extensions) is after December 31, 1986, but on or before December 31, 1989
IRC section 6721 imposes a penalty for failure to file certain information returns. IRC section 6722 imposes a penalty for failure to furnish certain payee statements. IRC section 6723 imposes a penalty for not including all of the required information (or for inclusion of incorrect information on an information return or on a payee statement). IRC section 6724 sets forth the definitions and special rules with respect to the information return penalties. The penalties under IRC sections 6721 and 6723 are increased if the failure is due to intentional disregard of the information reporting requirement. IRC section 6676 imposes a penalty for failure to supply taxpayer identification numbers. If a penalty is imposed under IRC section 6676, a penalty cannot be imposed under
IRC section 6723(a) or (b).
IRC Sections 6721 - 6724
For returns and statements the due date for which (determined without regard to extensions) is after December 31, 1989
OBRA 1989 revised IRC sections 6721 through 6724. As revised, IRC section 6721 imposes a penalty for failure to file an information return and for failure to include all required information on the information return (or for inclusion of incorrect information). IRC section 6722 imposes a penalty for failure to furnish a payee statement and for failure to include all required information on the payee statement (or for inclusion of incorrect information). IRC section 6723 imposes a penalty for failure to comply with a specified information reporting requirement (for example, failure to include or furnish a taxpayer identification number). IRC section 6724 sets forth the definitions and special rules with respect to the information return penalties. The penalties under IRC sections 6721 and 6722 are increased if the failure is due to intentional disregard of the information reporting requirement.
The penalty for failure to provide all the required information (or for inclusion of incorrect information) should be considered when the examiner finds numerous occurrences which would suggest intentional disregard, such as the following:
1. No payee identification number
2. Incomplete payee name or address
3. No payor identification number
4. Incomplete payor identification name or address
5. Wage payments only partially included on Form W-2, because a portion was paid in cash or general account check, and thus not reported for Form W-2 purposes.
Backup Withholding: (IRC Section 3406)
Under the backup withholding rules of IRC section 3406, a payor is required to deduct and withhold a certain percentage of the payment if, for example, the recipient of the payment fails to furnish his or her taxpayer identification number to the payor. For amounts paid after December 31, 1983, but on or before December 31, 1992, the amount required to be deducted and withheld is 20 percent of the payment. For amounts paid after December 31, 1992, the amount required to be deducted and withheld is 31 percent of the payment (see Announcement 92-162). Although backup withholding is not a "penalty," it should be considered in connection with payments reported to non-employees, that is, subcontractors or homeworkers. If payments to non-employees are accepted in audit, and there is no income tax issue, there could still be a backup withholding issue -- for example, if the contractor should have backup funds withheld because the subcontractor or homeworker did not provide a taxpayer identification number to the contractor. If payments to non-employees are not accepted in audit because of a lack of documentation, the primary issue would probably be a disallowance on the income tax return. Backup withholding of 20 percent would likely be an alternative issue in such a situation.
As already mentioned, one of the key "triggering events" is that the contractor made a reportable payment and the payee did not furnish his or her taxpayer identification number to the contractor. This simple event will open up the possibility of backup withholding.
Once it has been determined, that the taxpayer (that is, the contractor) does not have the taxpayer identification number, the following questions may be instructive in determining whether the taxpayer ever had obtained the number, thus precluding an explanation by the taxpayer that the taxpayer had the number at one time and lost it:
1. How much is being claimed for the payments in question?
2. Does the taxpayer have verification of the amounts claimed?
3. Is the documentation being accepted?
4. To whom are these payments being made?
5. What is the address of these persons?
6. What is the telephone number of these persons?
7. Does the taxpayer have any other identifying information about these persons, such as a driver's license number?
8. What are the taxpayer identification numbers of these persons?
Note: Regarding The Assertion of Penalties and Backup Withholding
The penalties under IRC sections 6653(a), 6653(b), 6661, 6662, and 6663 are included with the income tax RAR. The penalties under IRC sections 6652, 6676, 6678, and 6721 - 6723 are asserted in a separate penalty file. For a more complete discussion of penalties, reference to the Penalty Handbooks, IRM (20), is suggested. The liability for deducting and withholding under IRC section 3406 is asserted in the same manner as additional employment taxes.