A Tax Morass Only a Lawyer Could Love
Monday, December 10, 2012
The IRS is beginning to implement a tax penalty that poses some very real economic and constitutional dangers, including the harassment of taxpayers for political ends.
Here’s another concern for beleaguered taxpayers: the next time you file a tax return that requests a refund, you could be slapped with a 20 percent penalty (not a tax) if the IRS thinks you’ve made an “excessive claim” and thereby denies the refund — even if your filing was objectively reasonable and made in good faith! The IRS is beginning to implement the regulations now.
The villain here is a 2007 amendment to the Internal Revenue Code, 26 U.S.C. § 6676, which poses some very real economic and constitutional dangers. It gives the government countless opportunities for abuse of power, including the harassment of taxpayers for political ends. As it chills the process whereby individuals and businesses seek to recover unduly taxed personal property, Section 6676 can cause cascading economic disruptions affecting the entire economy.
Two particular features of this monstrosity present ample opportunity for government mischief. First, what is an “excessive claim”? It’s not just a frivolous or capricious claim filed by rogue tax cheats in order to rob the public fisc, but merely any amount by which the taxpayer’s actual claim exceeds “the claim allowable.” Claim one penny more than the IRS deems allowable, and you’re on the hook unless you have a “reasonable basis” for that claim.
Second, this “reasonable basis,” rather than being a commonsense safe harbor, has no set standard other than perhaps the definition that the Treasury Department uses for other parts of the tax code: some basis “that is significantly higher than not frivolous or not patently improper,” whatever that means.
Imagine how ordinary citizens get stuck in the tax bog, struggling with their returns and all of a sudden having to puzzle through these arcane standardless terms in the midnight hours of the filing deadline, wondering whether they have anticipated the IRS’s every move and hoping they’ll somehow escape the arbitrary 20 percent penalty if they’re wrong.
But wait, there’s more! When Congress used the “reconciliation” process to pass Obamacare, it added a subsection (c) to Section 6676, which was meant to give guidance on all this morass but, inevitably, made it worse. The Obamacare amendment provides that an “excessive claim” resulting from a “noneconomic substance transaction” is to be treated as lacking the requisite reasonable basis.
Claim one penny more than the IRS deems allowable, and you’re on the hook unless you have a ‘reasonable basis’ for that claim.
That is, to avoid the strict liability rule that automatically penalizes “excessive” claims, the taxpayer will have to show that the underlying transaction giving rise to the claim objectively changed his “economic position” in a meaningful way and that he had a “substantial purpose” for entering the transaction.
If you think that’s a test only a lawyer could love, you’re right: this extraordinarily problematic language invites an endless litigation mire. The government is telling us not to struggle against the tax code or we’ll only sink deeper.
Not all hope is lost, however. Taxpayers might yet find refuge in an unlikely place: the First Amendment’s petition clause. Though the petition clause might seem like a confused hermit lost in the tax law mists, its explicit protection of our right to “petition the government for a redress of grievances” provides wisdom here. When a taxpayer files a claim for refund or credit, or litigates a tax claim, he is fundamentally petitioning a government agency to take action and redress his legal grievance. To penalize him for a reasonable, good-faith exercise of his right is unconstitutional.
Just last year a near-unanimous Supreme Court (Justice Scalia partially dissented), speaking through Justice Kennedy in Borough of Duryea, Pa. v. Guarnieri, reiterated that the petition clause “protects the right of individuals to appeal to courts and other forums established by the government for resolution of legal disputes.” And federal courts of appeal across the country have coalesced around a standard for cabining penalties that threaten to curtail the right of individuals to appeal to government forums for resolution of their legal claims: the First Amendment prohibits penalties on an individual’s exercise of his petition right unless the underlying claim is a “sham.”
For example, a case from the Eighth Circuit defined a sham as any claim that was “1) objectively baseless in that no reasonable litigant could expect success on the merits and 2) subjectively motivated by bad faith.” And several recent cases in the D.C. and Seventh Circuits reaffirmed the so-called Noerr-Pennington doctrine, which was developed by the Supreme Court in the 1960s to narrowly construe antitrust law so as not to conflict with the petition clause.
If you think that’s a test only a lawyer could love, you’re right: this extraordinarily problematic language invites an endless litigation mire.
These cases affirm the principle “that when a person petitions the government for redress, the First Amendment prohibits any sanction on that action,” and that Noerr-Pennington was “crafted to protect the freedom to petition guaranteed under the First Amendment” and even today is “understood as an application of the First Amendment’s speech and petitioning clauses.”
Applied to Section 6676, the First Amendment can thus safeguard taxpayers from government abuse by limiting the “reasonable basis” requirement so that the IRS can wield it no more oppressively than the “sham” exception to the petition clause. Tax returns containing non-sham claims simply can’t constitutionally be penalized.
Of course, the IRS could very easily extend a lifeline and rescue taxpayers by promulgating regulations to alleviate the threats to economic and political freedom. As suggested by Derek Ho, a Washington lawyer and former clerk to Justice Souter, in a letter to the IRS commissioner, the IRS could implement regulations narrowly construing Section 6676 to avoid potential conflicts with the petition clause. Indeed, a long line of Supreme Court precedent requires the IRS to avoid applying the tax code in a way that invites constitutional challenge.
While we readily concede that the IRS doesn’t often play the role of hero — and that waiting for the Obama administration to rescue taxpayers is a dubious strategy — the courts and the political process remain open avenues for escape. Taxpayers and voters must be prepared to protect their hard-earned incomes and assert their constitutional right to redress of grievances without fear of government reprisal.
Ilya Shapiro is a senior fellow in constitutional studies at the Cato Institute and editor-in-chief of the Cato Supreme Court Review. Matt Gilliam is a legal associate at Cato.
FURTHER READING: Shapiro also writes “Why Citizens United Has Nothing to Do with What Ails American Politics” and “Solar Power’s Time to Shine?” Alan D. Viard and Robert Carroll contribute “Happy Birthday, America! Time to Totally Overhaul Your Tax Code.” Bryan Dowd asks “Why Is the Obamacare Tax/Penalty Needed at All?” Lee Harris says “Stop Apologizing for Our Liberties.”
Image by Darren Wamboldt / Bergman Group