Substantial Compliance: Finding Acceptance With the IRS

A professor can increase overall class scores for extra credit. A police officer is authorized to issue warnings for minor traffic infractions. A judge can allow a defendant to plead guilty to a lesser charge when justice warrants it.

These situations involve individuals who have a certain level of authority or power in a particular context and are able to use that power to affect outcomes in a positive way.

What about IRS auditors? Do IRS revenue agents have this type of authority or discretion when conducting IRS audits? When it comes to tax issues, this concept is embodied in the doctrine of “substantial compliance.”

The Doctrine of Substantial Compliance

The doctrine of substantial compliance is a legal principle that allows a party who has not fully complied with a legal requirement to still receive some of the benefits or protections of the law if they have made a good faith effort to comply. This principle is often invoked as an argument by parties who have failed to comply with all of the technicalities of a legal requirement.

It essentially says that one party should not forfeit his or her rights if he or she attempts to comply with the law, but he or she does not fully comply with all of the technicalities of the law.

For example, in bankruptcy cases, a debtor who has made a good faith effort to comply with bankruptcy law but has not fully complied with all of the requirements may still be able to have their debts discharged. The bankruptcy code has a specific provision, Section 523(a)(3)(B), that allows for the application of the doctrine of substantial compliance in certain circumstances.

In employee benefits cases, the doctrine of substantial compliance may come into play when an employer has made a good-faith effort to provide benefits to employees but has failed to comply with all of the technical requirements of the benefit plan. If the employer can show that they have substantially complied with the plan requirements, they may be able to avoid penalties or lawsuits.

In real estate construction defect cases, the doctrine of substantial compliance may be used to determine whether a defect in construction is significant enough to warrant legal action. If a defect does not affect the safety or functionality of the building, but is a minor technical violation, the doctrine of substantial compliance may be invoked to avoid legal action.

But what about tax cases? Can IRS auditors apply this principle?

Substantial Compliance in Tax Cases

The courts have addressed substantial compliance for tax cases. Suffice it to say that they have been hesitant to apply the doctrine.

One of the most cited cases is the critique of the doctrine by Judge Posner:

Reading the Tax Court’s decisions on the subject of substantial compliance is enough to make one’s head swim. Tax lawyers can have no confidence concerning the circumstances in which non-compliance with regulations governing the election of favorable tax treatment will or will not work a forfeiture. The result has been a surge of unnecessary litigation well illustrated by the present suit. We think the doctrine should be interpreted narrowly, and point out that the courts of appeals owe no special deference to the Tax Court’s legal views. . . . The common law doctrine of substantial compliance should not be allowed to spread beyond cases in which the taxpayer had a good excuse (though not a legal justification) for failing to comply with either an unimportant requirement or one unclearly or confusingly stated in the regulations or the statute.

This quote is from Prussner v. United States, 896 F.2d 218 (7th Cir. 1990). This criticism has been echoed by other courts. Here is an example:

[s]ubstantive regulatory requirements must be complied with fully,” and that a regulation providing that favorable tax treatment may only be elected when certain payments are made within sixty days of the end of a taxable year is a substantive rule not subject to substantial compliance.

This one is from Thomas Int’l, Ltd. v. United States, 773 F.2d 300 (Fed. Cir. 1985).

You can see the theme here. The courts are willing to apply substantial compliance, but they are not willing to do so when the law in question is not clear.

Substantial Compliance and the IRS

This is the perspective of the court. Luckily, not all cases make their way to the court. Most cases are either handled administratively or never end up being cases at all.

The IRS is often willing to apply the doctrine of substantial compliance. It does so without actually citing the doctrine. It does so by simply exercising discretion in how it administers our tax laws.

You may see this applied in your case if the IRS sets a materiality threshold for your IRS audit, for example. It may show up in the IRS agent simply agreeing not to make certain adjustments even when they are warranted.

The IRS’s discretion is not pure benevolence. It is usually attributable to its resource limitations and the inability to work the high volume of tax cases that deserve its attention. For every case the IRS challenges, hundreds, if not hundreds of thousands of tax returns simply pass by with no review by the IRS whatsoever. This is why the IRS focuses on “touching as many tax returns” as it can. It is lite review is thought to encourage more taxpayers to voluntarily comply with our tax laws. It’s better for you to hear that your neighbor was audited and had to pay a few dollars, rather than to hear that the audit rate is less than one or two percent.

Forgiveness of IRS Penalties

The IRS’s substantial compliance also has a basis in our penalty laws. The accuracy penalty rules allow taxpayers to have up to a twenty percent understatement of tax before penalties apply. This applies to the underlying tax, so the tax adjustment can be much larger than this. Imagine if you had $100,000 of taxable income. Your tax might be $30,000. Simplifying it, you might be able to have a $10,000 deduction that is disallowed by the IRS and still not have an understatement in excess of 20 percent.

The IRS first-time abate policy is similar. The IRS applies this policy to remove certain penalties for those who have no similar penalties in the prior three years. The IRS often applies this policy to remove failure to file penalties, for example.

The IRS’s offer in compromise based on effective tax administration is similar. This program allows the IRS to entirely erase tax liabilities when doing so is basically the right thing to do.

The Takeaway

What does this mean for you? The takeaway is that you can and should expect the IRS to apply the doctrine of substantial compliance. It will not do so by citing the doctrine. Instead, it may do so in how it handles your case.

Many IRS agents apply this doctrine. Some do so liberally. There are also other agents who take just the opposite tact and, unfortunately, expect every penny to be accounted for. Luckily there is an administrative appeals process and a tax court process for these cases.

As your advocate, it is often up to you to push the IRS auditor to apply this doctrine. Persistence and fair dealing can go a long way in encouraging the IRS auditor to do so. If you enlist a tax attorney to help with your case, this is one of the skills an experienced tax attorney brings to the table.