Section 6676 – the Problem Penalty

Today we welcome first-time guest poster Professor Del Wright from the Valparaiso University School of Law. In this post Professor Wright describes some of the many problems with the civil penalty imposed on excessive refund claims, an issue he tackled head-on in an excellent forthcoming article in the Akron Law Journal. Professor Wright’s article and post illustrate the increasing need for civil penalty reform, including a more thoughtful approach to the means of challenging IRS imposition of penalties, an issue we have discussed before and likely will again, and one that Professor Wright has also discussed in a draft article that we hope he will also describe in a future PT post. Les

In a number of posts, Procedurally Taxing has identified problems with the IRS enforcement of penalties, particularly penalties assessed against refundable tax credits. In my article, Bogus Refunds & Bad Penalties: The Feckless and Fixable Refund Penalty System, I address the largely unutilized section 6676 penalty, offer reasons why the IRS has been reluctant to impose the penalty, and explore the Pandora’s box of issues that will be opened if the IRS seeks to impose it more aggressively.


Section 6676 provides generally that an erroneous claim for refund on an income tax return is subject to a 20% penalty, based on the “excessive amount” of the penalty, i.e., the amount by which a taxpayer’s claim for refund exceeds the allowable claim. Lastly, the law excuses taxpayers whose claims have a “reasonable basis,” a term undefined in the statute.

Section 6676 was enacted in 2007, based on concerns by both TIGTA and the Joint Committee on Taxation that erroneous refund claims were straining IRS resources and impeding effective tax administration.Congress later amended section 6676 in 2010, creating section 6676(c), which uselessly extended the section 6676 refund penalty to refund claims based on transactions lacking economic substance. No reported evidence indicates that the economic substance erroneous refund penalty has ever been applied (a search of “economic substance” and section 6676(c) yields no results).

My article highlights problems with the law since enactment and portends future problems. I make the point that erroneous claims for refunds are made primarily by three groups:

  1. Fraudsters – individuals filing fraudulent tax returns to claim an undeserved refund;
  2. Gamers – mostly high net worth individuals seeking to game the tax system, through aggressive tax avoidance maneuvers, to generate refunds; and
  3. Strivers – low income individuals seeking refunds based on mistakes of law or fact. I chose the sobriquet “Strivers” because many of the problems with Section 6676 arise in connection with the means-tested refundable tax credits, such as the First Time Homebuyers Credit or the Additional Child Tax Credit (“refundable credits”), largely created to help the working poor.

While section 6676 was drafted to combat all three, the Strivers will bear the brunt of the poorly-drafted section 6676 regime. My reasoning is as follows:

  • The overwhelming majority of Fraudster refund claims are based on identity theft or other fraudulent and/or criminal activity. An idiosyncratic tax penalty like section 6676 for every instance of fraud will have little deterrent effect on those individuals. Moreover, the IRS has far more powerful weapons in its arsenal to attack fraud than section 6676.
  • As a preliminary matter, Gamers are rarely eligible to receive refundable tax credits, as many refundable credits phase out at higher levels of income. Thus, Gamers would only make an erroneous claim for refund on a tax return after they had already paid tax. However, broadly speaking, Gamers enter into tax avoidance maneuvers not to generate false refunds, but to avoid paying taxes in the first place. Because the U.S. tax system allows most non-wage income to be reported after the fact, Gamers have a greater opportunity to structure transaction to avoid tax, and if they request a refund, it is usually after the IRS has challenged a particular set of transactions. At that point, the section 6676 is inapplicable, because the law covers only erroneous refund claims made on a return. Moreover, as I point out in the article, to the extent a tax avoidance maneuver could generate a section 6676 penalty, Gamers are able to avoid the penalty entirely through strategic tax planning.

That leaves the Strivers, and section 6676 does a poor job in creating a fair penalty for them.

Problems with Section 6676

There are myriad problems with section 6676, and others have identified and discussed those problems in this blog and elsewhere. I will address two largely unaddressed problems highlighted in my article. The first problem relates to the circumstances in which the penalty will apply.

Prior to the Tax Court’s decision in Rand v. Commissioner, 1141 T.C. 376 (2013), the IRS asserted section 6662 or 6663 penalties on disallowed refundable credits, whether the disallowed credits would have caused a reduction in tax (i.e., an underpayment) or generated a refund. Taxpayers faced with such penalties could contest those penalties through deficiency procedures, and could rely on section 6664(c)’s reasonable cause defense. That changed after Rand, and changed again after the IRS issued PMTA 2014-015 (the “PMTA”)

As noted in this blog, “In Rand, a majority of Tax Court judges held that, for purposes of section 6662′s accuracy-related penalty, the “underpayment” at section 6664(a) on which the penalty could be imposed did not include disallowed refundable tax credits — except to the extent that such credits reduced the tax down to zero, but not below zero. “ The IRS ultimately conceded the Rand issue and issued the PMTA to address some of the open questions with the law.

According to the PMTA (and consistent with Rand), if the excessive claim is part of an underpayment, the appropriate penalty is the section 6662 negligence penalty (or, if applicable, the section 6663 fraud penalty). Therefore, for a non-fraudulent erroneous refund claim, if the section 6662 or 6663 penalty applied, the taxpayer could rely on the section 6664(c) reasonable cause defense. However, if the excessive claim is not part of an underpayment, then the appropriate penalty is section 6676, and a taxpayer’s only defense is the reasonable basis. Nothing in the law or regulations for section 6676 defines “reasonable basis,” but in the PMTA, the IRS asserted that reasonable basis in section 6676 has the same meaning as in Treas. Reg. § 1.6662-3(b)(3).

Although the PMTA was likely correct in using Treas. Reg. § 1.6662-3(b)(3) to define reasonable basis in section 6676, in my article, I argue that the reasonable basis standard neither makes sense in the context of the taxpayers claiming refundable credits, nor is what Congress intended. As explained below, this is one of the few times what my professors (U. of Chicago) jokingly called in law school the “Yale” method of statutory construction should have been employed: when the legislative history is unclear, look to the statute.

As part of the 2007 Joint Committee Report that discussed what was to become section 6676, the Joint Committee contemplated a reasonable cause exception to the then-proposed section 6676 penalty. Specifically, the JCT Report noted that the penalty would apply absent a reasonable basis or if “the taxpayer did not have reasonable cause.” However, the reasonable cause defense was excluded from the final bill, leaving only the “reasonable basis” exception. Nothing in the record suggests that this was a conscious choice by Congress. A possible explanation is that in actually drafting the provision, the drafters may have concluded incorrectly that “reasonable basis” and “reasonable cause,” both undefined in the JCT Report, were one in the same, and truncated the latter as redundant. However, that small change has large implications for taxpayers, particularly the Strivers.

That reasonable basis definition eliminates penalties only for transactions with one or more valid legal, as opposed to factual, justifications. Thus, unlike the reasonable cause defenses, taxpayers cannot rely on good faith legal or factual errors to escape section 6676 penalties. Moreover, as the Taxpayer Advocate noted in her 2014 Annual Report, the reasonable basis standard excludes “IRS forms or accompanying instructions, IRS publications, or IRS answers to Frequently Asked Questions,” i.e., precisely the types of guidance Strivers claiming means-tested refundable credits are likely to rely upon. This problem is exacerbated by the fact that if the excessive claim is included in an understatement and section 6662 applies, the taxpayer can use the reasonable cause defense. There is no good policy reason that the availability of the reasonable cause defense should turn on the vagaries of whether the erroneous claim generates an understatement.

The second problem with section 6676 relates to the lack of an explicit right to a pre-assessment challenge. Before discussing the pre-assessment issues, it is important to first understand how taxpayers may challenge a section 6676 penalty. According to the PMTA, that right depends on whether the erroneous claim generates (1) an understatement or (2) a claim for refund. Those situations are discussed below:

Situation 1 – Understatement

If the disallowance generates an understatement, the IRS can issue a deficiency notice and the taxpayer can challenge the disallowance through deficiency procedures. However, as noted in an earlier post [here], it is not entirely clear that the Tax Court has jurisdiction, in a deficiency proceeding, to adjudicate section 6676 penalties. According to the PMTA, the IRS believes such penalties are within the purview of the Tax Court, based on Smith v. Commissioner, 133 T.C. 424, 429 (2009). The IRS reasoning is curious. In the PMTA, the IRS relies on the following statement in Smith:

“If a penalty is not dependent on the determination of a deficiency, then the penalty is not subject to deficiency procedures.”

Based on that statement, the IRS uses the counterfactual to conclude that if a penalty is dependent on the determination of a deficiency (here, an underpayment based on the reduction in tax), then the penalty is subject to deficiency procedures. The IRS argument is an informal fallacy (and No True Scotsman), because nothing in the Tax Court’s language explicitly supports its proposed conclusion. Whether the Tax Court will extend its jurisdiction to section 6676 remains to be seen, but as Les has noted in the Saltzman Book treatise the penalty “should not be subject to the deficiency procedures” and as Carl Smith has noted in a post in Procedurally Taxing, in such a situation, “the Tax Court will likely dismiss the section 6676 penalty…for lack of jurisdiction.”

Situation 2 – Claim For Refund

If the disallowance generates a claim for refund, the IRS can immediately assess a penalty. To challenge the penalty, the taxpayer could either pay the penalty and sue for refund, or wait until the IRS sought to collect, and use the collection due process procedures. In either case, if the refund claim was factually erroneous, the taxpayer’s only defense would be to demonstrate that there was a “reasonable basis” for the error, pursuant to Treas. Reg. § 1.6662–3(b)(3).

In my article, I argue that the failure to provide a pre-assessment challenge to the section 6676 penalty may not pass constitutional muster. The crux of that argument is that filing a claim for refund is a long-recognized form of First Amendment petitioning activity that deserves especially broad protection under the Noerr-Pennington doctrine. That doctrine generally holds that absent proof the petitioning activity is a sham or “objectively baseless,” any infringement upon that petitioning activity, such as section 6676’s immediately assessable penalty, may not pass constitutional muster. That “objectively baseless” standard was set forth in in Professional Real Estate Investors, Inc. v. Columbia Pictures Industries, Inc., 508 U.S. 49 (1993) (“PRE”), and requires a court to find that that “no reasonable litigant could realistically expect success on the merits.” Id. at 60-61. That issue was recently the subject of an article [link free for ABA members] in The Tax Lawyer, Derek Ho & Christopher Klimmek, Penalizing Tax Petitions: Why the Erroneous Refund Penalty in Section 6676 Violates Taxpayers’ First Amendment Rights, 68 Tax Law. 463 (2015).

The “reasonable basis” standard for penalty relief is significantly higher than the “objectively baseless,” standard set forth in PRE. Thus, the penalty is akin to a strict liability penalty, and subject to challenge on constitutional grounds absent some mechanism to protect taxpayers. Possibly recognizing that risk, the IRS asserted in the PMTA that “it has been [it]’s practice to provide administrative appeal rights prior to assessment of the section 6676 penalty.” However, nothing in the law or regulations requires the IRS to do so, and if it fails to offer those rights, a taxpayer (and, most likely, a law school tax clinic), will have an interesting constitutional question to litigate.