Tax Penalties as Health Reform:

James Peaslee uncovers another goody buried in the House health care reform bill: Strict liability for accidental underpayment of income taxes.

Under current law, taxpayers who lose an argument with the IRS can generally avoid penalties by showing they tried in good faith to comply with the tax law. In a broad range of circumstances, the health-care bill would change the law to impose strict liability penalties for income-tax underpayments, meaning that taxpayers will no longer have the luxury of making an honest mistake. The ability of even the IRS to waive penalties in sympathetic cases would be sharply curtailed.

The proposed changes in penalty rules have largely escaped notice because they are buried in a part of the bill that purports to deal with abusive tax shelters. They are barely mentioned in the Ways and Means Committee summary. Their inclusion in the bill underscores the need to read it closely. If anyone had doubts about the value of loading the text of the bill into a wheelbarrow and bringing it to the beach this August, the proposed changes to tax penalties should dispel them.

Of course, it would be silly to expect legislators to actually read the whole bill before they vote for it (that would prevent them from blaming the IRS for enforcing the law as Congress enacted it).

UPDATE: I asked Mr. Peaslee if he would like to respond to the comment thread below. He wrote back:

I am glad to see so many people are interested in this on an end of summer day.

Just to be clear, there are three circumstances in which automatic penalties are applied (which I think are accurately described as broad categories). One relates to tax underpayments arising from the economic substance proposal (or the application of any other similar rule of law). Another relates to large businesses (yes the kind the WSJ readers care about) and a third relates to something called a "tax shelter" which is defined to include any transaction having a significant purpose of tax avoidance (note, not evasion).

The fact that it took so long for a number of your bloggers to find anything other than the economic substance related change does show it was shall we say not apparent on the face of the bill, which was one of my points.

The change relating to "tax shelters" applies to all categories of taxpayers. The "tax shelter" label is highly misleading because of the way the term is defined. The IRS is some settings has taken the view that any transaction that produces a tax advantage involves tax avoidance. A "significant" purpose is a very low threshold. Further, a step that is part of an overall commercial transaction can be undertaken to achieve a tax advantage and hence be a tax shelter as defined. This change could be a very sweeping one given the vagueness of the language. The Government has deliberately avoiding defining the language in other settings because they don't know how to distinguish good from bad and want to preserve their options.

The economic substance change also seems to be tax shelter oriented but because it applies to "similar rules of law" who knows what it covers. Any setting in which a transaction is taxed according to its substance not its form? Also, the core economic substance rule that triggers penalties is extremely vague. They couldn't figure out how to draft it so they set out some statutory rules and then left it to a court to decide if they are relevant without offering any guidance (the rules apply only if a court finds them to be relevant). What grade would you give a student who came up with that?

If you were devising a penalty system that relied on terms as vague as the ones employed here, wouldn't you really worry that those affected could end up being treated unfairly? Are there any crim. law professors on this blog? You are guilty if you commit murder or any "similar" crime.

The larger points I would hope more of you (as law professors) would agree with are: Don't do things by stealth but in the open. Don't make ad hoc changes but think it through. And don't impose penalties without requiring fault, at least big penalties. This latest bit of proposed legislation is sadly part of a trend as the examples I gave (which applied to broad categories as well) showed.