The Improved Frivolous Return Penalty

The Tax Relief and Health Care Act of 2006 has brought significant changes to the frivolous income tax return penalty under Section 6702.

Until now, the low penalty amount and limited reach of this penalty meant that taxpayers did not have to worry about the consequences of filing frivolous tax returns. However, with the changes in the law, this is no longer the case.

In this article, we will discuss the modifications made to the frivolous return penalty and what taxpayers need to know to avoid the penalties associated with it.

The Sec. 6702 Frivolous Return Penalty

Prior to the recent change, Section 6702 provided for a $500 penalty for filing a frivolous “tax return.”  It was a very short tax code section.

The new Section 6702 is much longer. Section 6702 now provides a $5,000 penalty for filing a frivolous “tax return” and a $5,000 penalty for filing a frivolous “tax submission.” The tax submission language is broader than a tax return.

New Section 6702(b)(2)(A) defines a “frivolous submission” as any request for a collection due process hearing or application for an installment agreement, offer in compromise, or taxpayer assistance order that the IRS deems to be frivolous and that the IRS sets out in a published list (the new Section 6702 does not take effect until the IRS publishes this list). Thus, the IRS gets to decide what documents count and when the document is frivolous.

This power is not unchecked, however. The new Section 6702 also provides that the “frivolous submission” penalty will not apply to taxpayers if they withdraw their submission within 30 days after the IRS notifies the taxpayer that their submission was frivolous.

There may be instances where the IRS deems a collection due process hearing request, installment agreement, or offer in compromise frivolous — even though submitted by the taxpayer in good faith. The question is how taxpayers are going to be able to convince the IRS of their good faith intent. This is particularly problematic since there is a wide range of many “submissions” that could easily be acceptable. We will have to wait for the IRS’ frivolous list to see how the IRS addresses this issue.

Reducing the Penalty Amount

The new Section 6702 gives the IRS the authority to reduce the amount of the penalty if the IRS determines that such a reduction would “promote compliance with and administration of the Federal tax laws.”

This is a much different and pro-IRS standard than the “ordinary care” standard (for reasonable cause) that is employed with other IRS tax penalties. It should also be noted that the Code does not include the hardship provisions that are associated with other penalties.

The Takeaway

The IRS now has the ability to declare just about any document as “frivolous” and impose a penalty. Clearly, this may help with tax protestor submissions, but it may also be applied to more innocent documents. Time will tell how the IRS implements and uses this penalty.