What Peeing in the Pool Can Teach Us About Tax Compliance (A Reprise)

Today we are at the ABA Tax Section May Meeting soaking up some insights that we hope to share with readers. In the meantime, rather than go dark, we are reposting a piece from February 2014.  The post highlights how individual  tax returns tend to be incorrect when there is an opportunity for either the taxpayer or the preparer to turn away from the facts. Recent tax gap data confirms that compliance follows information reporting, so when individuals know that payers report income not surprisingly they tend to file more accurate returns. Not all tax returns are accompanied by third party information, with small business taxpayers earning much income not subject to reporting and some family status benefit provisions like the EITC and CTC dependent in part on variables like residence of kids which are outside the information reporting regime.  

While sweeping in Caddyshack, Groundhog Day, the brilliant Dan Ariely and my wife, the post discusses how it is easy psychologically to avoid reality. It suggests that the tax system should perhaps force preparers to face the facts in the form of expanded due diligence when issues are not easily backstopped by information reporting. The piece perhaps has more relevance today, as in late 2015 Congress expanded the due diligence rules to cover CTC and the American Opportunity Tax Credit.  The expansion raises questions as to what role preparers play in the tax system, with some suggesting that the proposals push the preparer toward auditing their client. Moreover, there has been a steady decline in use of paid preparers for the EITC, suggesting perhaps that the added costs that preparers pass on to their clients have contributed either to a shift to DIY returns or ghost returns that preparers fail to sign to avoid possible liability.  Les

The tax-filing season is here. All across the great land, people are logging in to Turbo Tax, asking their accountant Uncle Fred to do their return for free, or visiting the enrolled agent who like NFL coaches tells their families that during the season they will not be around much til the season ends.

The start of tax season also coincides with Groundhog Day. Phil popped out this past weekend, and while he forecasts six more weeks of winter, I am today thinking about pools and their unlikely connection to tax compliance and tax return preparers. Consider the story from a couple of years ago involving Ryan Lochte and Michael Phelps. Former Olympic teammates and sometime rivals Lochte (who made news last year and possible tax exams everywhere with a TMZ report of a $600 tip at a steakhouse in Vegas) and Phelps made quite a stir when they admitted that they occasionally urinate in the swimming pool while waiting around before races.  What does the reaction to this story tell us about tax compliance? Well, it connects to the concept of willful blindness and tax return preparers and one of my favorite academics, Dan Ariely, who has written extensively on rationality and why people lie and cheat.


The major health risk associated with pools is drowning. I know a bit about this because my lovely wife Valinda chaired our local club’s pool committee.  CDC stats on drowning are startling:

  1. From 2005-2009, there were an average of 3,533 fatal unintentional drownings (non-boating related) annually in the United States — about ten deaths per day. An additional 347 people died each year from drowning in boating-related incidents:
  2. Children ages 1 to 4 have the highest drowning rates. In 2009, among children 1 to 4 years old who died from an unintentional injury, more than 30% died from drowning.
  3. Drowning is responsible for more deaths among children 1-4 than any other cause except congenital anomalies (birth defects).
  4. About one in five people who die from drowning are children 14 and younger.
  5. For every child who dies from drowning, another five receive emergency department care for nonfatal submersion injuries.

Ok, back to tax compliance. While not nearly as serious a problem as drowning, people using the pool as a public urinal is a problem, or at least a perceived problem. While scientists confirm that generally the presence of urine in the pool poses little health danger, the science does not alter our revulsion at the prospect of someone pulling down their trunks and whizzing in the deep end.

Professor Ariely offers more on the topic (for his blog post on this see here; my title to this post is a direct borrow from his post which was about willful blindness and the public’s view of Jamie Dimon and JP Morgan Chase):

Many of us have spent time beside a pool. And you have probably wondered: what are the odds that no children (or adults, for that matter) have peed in the water? When pressed, we’d have to admit that the odds that the pool is pee-free are close to zero, but the lack of absolute certainty allows us to relax and swim anyway. We may comfort ourselves with some fuzzy thought about chlorine, or the immense volume of the pool relative to a few bladders, and our concerns slip away.

Now, compare this with watching a kid stand by the pool and pee into it. Throw in some swimming trunks around his knees and a frantic, embarrassed parent scooping him up, alas, too late. Now you’re no longer able to hold on to the slight possibility that the pool is free of urine. The relative volume of the water in the pool is now little comfort when you just saw a kid pee in it. Could you still take a quick dip?

Well, for readers still with me, this squeamish guy would act just as Spaulding did when the Baby Ruth floated by in Bushwick Country Club’s swimming pool in Caddyshack: “Doodie!!!!” (for that classic scene click here—that never gets old).

So how does this connect to tax compliance? I think that some return preparers put their blinders on when it comes to information that their clients tell them. Generally, in our tax system current rules emphasize that preparers have duties of further inquiry only in relation to specific information about a particular taxpayer. If, for example, the preparer has reason to believe the information is false, the preparer must ask further questions. For some preparers, if forced to see reality (e.g., that a client in fact is not sharing information on cash receipts), the psychological costs of preparing that return and turning a blind eye to the taxpayer’s gaming of the system will increase. Moreover, by being asked direct questions, the taxpayer’s own psychological costs for cheating will also increase.

To be sure, there will always be dishonest taxpayers and preparers who will disregard those costs and do the wrong thing, but as Ariely and others point out these psychological costs make a difference for the vast majority of people who decide in certain situations whether to be truthful.

There is one major exception to the rule that preparers do not have targeted due diligence obligations. As I have previously written in a post, the only specific preparer due diligence rules in the Code relate to EITC. The recent discussion draft on tax administration reform that Senator Baucus floated (summarized briefly here) would expand the due diligence rules to the child tax credit. What about other areas of systemic noncompliance, like the underreporting of income by self-employed taxpayers, which is responsible for the major part of the underreporting tax gap, well in excess of the gap from every refundable credit combined?

Back in 2008, when I wrote a research report for TAS on tax return preparers, I specifically proposed that IRS and Congress tighten up the EITC due diligence rules but also consider expanding those rules to other areas:

[t]he current rules [on due diligence] emphasize that preparers have duties of further inquiry only in relation to specific information about a particular taxpayer. If, for example, the preparer has reason to believe the information is false, the preparer must ask further questions. I propose that Congress and the IRS heighten the preparer’s responsibilities in response to research that suggests there is systemic noncompliance with specific issues. Their doing so will reflect a more nimble approach to tax compliance, allow for tailored responsibilities that tie to specific systemic issues, and increase taxpayer and practitioner visibility and responsibility for presenting correct factual information on tax returns.

Congress and IRS have tightened up the EITC due diligence rules. Why not due diligence for other issues? The asking of direct questions by preparers would likely increase the psychological costs for individuals who might  cheat on the returns but might have been inclined to tell incomplete or inaccurate information to the preparer. It is the same type of idea that animated a recent proposal by Joe Bankman of Stanford and others when they proposed creating a smart return that would use technology and adaptive questioning to increase the psychological costs of taxpayers themselves lying on a tax return.

Parting Thoughts

For those serious about tax administration, and not just those whose focus on EITC overclaims masks a hidden agenda that reflects an undue bias on one aspect of the tax compliance problem, it is time to raise the psychological costs of cheating in other parts of the tax system. Targeted due diligence rules that direct preparer attention to specific issues that tend to have high error rates (like unreported small business income) will foster increased accountability and visibility and likely reduce the underreporting tax gap.







Extenders Bill Gives IRS Additional Powers to Impose Penalties on Preparers and Disallow Refundable Credits

Most readers at this point are probably aware of the passage of the Protecting Americans from Tax Hikes Act of 2015 (PATH). It has been getting mainstream attention for its (mostly) permanent extension on all sorts of benefits and expenditures embedded in the tax code.

In addition to PATH’s goodies, it has major procedural and administrative implications. Late-enacting legislation presents an administrative headache for IRS as it will be scrambling to get its tax season forms and instructions to line up with the law. Beyond the filing season implications and of particular significance for readers of Procedurally Taxing, the law has many procedural provisions. In this brief post, I will highlight some of the provisions that are directed at reducing errors generally associated with returns claiming refundable credits, as well as offer some brief commentary and suggest posts where we have discussed some of the issues implicated in the provisions. In a future post we will address the other procedural aspects of the legislation, which include provisions addressing venue of appeals of innocent spouse and CDP cases, a provision in response to the Kuretski Where is the Tax Court Located issue and a handful of others.

For those who want more than the summary here, note that the Joint Committee has published a technical explanation of the entire bill; Ways and Means has published a section by section summary as well. The actual language of the bill can be found here. Anthony Nitti over at Forbes has a nice summary of the substantive goodies in the bill, including a breakout of what is permanent and what has an expiration date.


Procedural Quid Pro Quo (Or the Pound of Flesh For the Extensions)

There are a bunch of provisions that can best be thought of as part of the quid pro quo associated with extensions and sweeteners to refundable credits that largely benefit lower-income and more moderate-income taxpayers. I will describe the main ones below.

Due Diligence

Effective for the 2016 tax year, Section 207 of PATH expands the due diligence rules that apply to EITC returns to returns with the Child Tax Credit and the American Opportunity Tax Credit to help pay for education expenses. I have written extensively on the due diligence penalty as applied to EITC over the past two years, including posts addressing challenges that IRS has in administering the rules and difficulties preparers face in due diligence audits. See for example Preparers and Due Diligence. The legislation requires Treasury to produce two reports relating to the due diligence rules (one for EITC and the other for CTC and AOTC), including studies on effectiveness and comparing due diligence rules to other measures to address noncompliance. Interestingly the law also requires the study to address whether “due diligence of this type should apply to other methods of tax filing….”, a nod to the issue we discussed in a few posts considering appropriations bill language that directed IRS to require self-prepared returns to have additional questions and schedules for EITC returns (more on that see Legislative Language Directs IRS to Make Self-Prepared EITC Returns More Burdensome).

Extension of Ban and Expansion of Math Error

Section 208 of Path (pages 114-119 of the bill itself) is perhaps the most controversial and onerous of the pound of flesh provisions. It does three main things:

  1. It extends the two and ten-year ban that applies to EITC taxpayers to also include returns claiming the CTC and AOTC. The ban will bar individuals from claiming the CTC and AOTC for ten years if there is a determination that the claim was due to fraud and for two years if they are found to have recklessly or intentionally disregarded the rules;
  2. It allows IRS to use math error procedures if a taxpayer claims one of the credits in a year in which the ban is in place; and
  3. It allows IRS to impose special certification requirements (already in place for EITC) for taxpayers who have had a CTC or AOTC denied through deficiency procedures prior to claiming one of those credits in a future year. Absent certification, IRS can use math error procedures to deny the claimed credits in a year after the credit has been reversed through deficiency procedures (interesting issues lurk here on the intersection of math error and deficiency procedures when the return generating a reversal in that later year also may generate a proposed deficiency).

On numerous occasions I and others have expressed deep reservations about the IRS’s administration of the EITC ban and its use of existing math error powers. See for example a post from last year on possible math error expansion, and a post discussing a case illustrating the difficulties IRS has in administering the ban. I will come back and discuss in a standalone post the reason why this penalty is bad tax administration (and potentially subject to challenge) but at a minimum its expansion requires a major commitment on the IRS’s part in providing detailed standards in imposing the ban and procedures for taxpayers potentially subject to the ban. To that end,  I point readers to the study from the National Taxpayer Advocate 2013 annual report, where there is a detailed discussion of IRS often failing to follow procedures in imposing the ban. In that report the NTA notes how “the IRS applies the two-year ban on the basis of unexamined assumptions about the taxpayer’s state of mind or even presupposes reckless or intentional disregard of the rules and regulations, potentially causing significant harm to taxpayers who may be entitled to EITC in a subsequent year.”

Reversal of Rand

Note that Section 209 of the legislation also includes a reversal of Rand so that the definition of underpayment now matches the definition of deficiency. Under the new law,  the accuracy-related penalty can be applied to any part of a reduced refundable credit subject to deficiency procedures.

More Focus on Preparers

While the legislation does not give IRS authority to regulate unlicensed preparers, it does in Section 210 increase the penalty applicable to paid tax preparers who engage in willful or reckless conduct. The provision expands the penalty for tax preparers who engage in willful or reckless conduct to the greater of $5,000 or 75 percent of the preparer’s income with respect to the return (it was 50% under prior law). The provision applies to returns prepared for tax years ending after the date of enactment.


On the positive side of the ledger Section 401 requires that IRS employees are familiar with and act in accordance with the taxpayer bill of rights. Those rights include the following:

The Right to Be Informed

The Right to Quality Service

The Right to Pay No More than the Correct Amount of Tax

The Right to Challenge the IRS’s Position and Be Heard

The Right to Appeal an IRS Decision in an Independent Forum

The Right to Finality

The Right to Privacy

The Right to Confidentiality

The Right to Retain Representation

The Right to a Fair and Just Tax System

It remains to be seen whether the IRS’s additional powers to penalize preparers and taxpayers as set forth in PATH can or more accurately will be reconciled with taxpayer rights. The commitment to taxpayer rights requires not just that IRS employees are familiar with those rights, but training and a commitment to procedures that protect those rights. While PATH has opened the door to expanded credits, that door can be easily shut for eligible taxpayers if IRS fails to respect (and Congress does not recognize) the challenges associated with administering those programs.