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IRS ‘Harsh’ Penalty Power Grows, Shutting Taxpayers Out of Court

May 10, 2022, 8:45 AM

The government’s once-niche power to levy tax penalties that courts say they can’t review until fully paid has exploded, prompting calls for Congress to address a growing barrier-to-justice issue.

All taxpayers “should generally have an opportunity to take their cases to court,” IRS National Taxpayer Advocate Erin Collins wrote in her 2022 legislative recommendations to Congress. “Taxpayers who cannot afford to pay what the IRS says they owe should have the same opportunities to choose a judicial forum as wealthier taxpayers who can afford to pay.”

Collins is among those calling for the repeal of the so-called “Flora rule,” named after a 1960 Supreme Court decision that required a taxpayer to fully pay his tax bill before suing for a refund. Several courts have interpreted the rule to apply to IRS “assessable” penalties, which can only be challenged in court through refund suits.

That wouldn’t have been a big issue in 1960: Only four such penalties existed at the time, and two of them were “divisible,” meaning paying the penalty for one transaction or event would allow for a suit impacting a broader penalty. But over the years, Congress enacted several dozen new assessable penalties, and many of them aren’t divisible. That has greatly increased the number of Americans shut out of court unless they can afford to preemptively pay a fine.

While other tax bills can generally be challenged at the U.S. Tax Court without first paying, the only avenue to seek relief on unpaid assessable penalties is the IRS Independent Office of Appeals. Government watchdogs and tax practitioners say the Flora rule creates an equity issue, where people who can afford to pay have more options than those who can’t.

“I don’t think, when you think about our justice system, that we should associate pay-to-play with the justice system,” Collins said in an interview with Bloomberg Tax. “It should be available for everyone across the board.”

Enforcement Priorities

The Flora rule creates unequal judicial access across an array of enforcement actions. Taxpayers can face penalties of up to $200,000 under Section 6707A, for example, for failing to report transactions similar to those listed as tax avoidance vehicles. They can also face penalties under tax code Section 6677(a) totaling 35% of amounts they failed to report in foreign trusts.

Victor Jaramillo, a member at Caplin & Drysdale, said he has seen clients dealing with assessable penalty determinations tied to foreign trust and gift reporting requirements ranging from $2 million to $90 million.

The Flora rule also will add a barrier to challenging penalties for noncompliance with new cryptocurrency reporting requirements for the 2023 tax year. The bipartisan infrastructure law enacted last fall requires those designated as crypto “brokers” to send information to the IRS, a reporting mandate backed by an assessable penalty under tax code Section 6721.

“I assume that all lawyers see this as an access-to-justice issue,” said former IRS attorney Jonathan Black, now an associate at Caplin & Drysdale. “In the private practice, we generally represent people who can afford our representation, and even for them, the way the IRS is asserting some of these penalties—essentially without ever reviewing them—is really harsh.”

The IRS declined to comment on the way the agency is asserting penalties.

Hard to Pay

Even relatively small assessable penalties can prove insurmountable for some, according to T. Keith Fogg, who runs Harvard Law School’s federal tax clinic, which represents low-income taxpayers. He pointed to a $5,000 penalty under tax code Section 6702 for filing frivolous tax returns.

“The people that I represented who have this frequently have been misled by somebody, by a preparer or by something they read online,” and then got confused during the IRS’s assessment process and didn’t communicate properly, Fogg said.

The Flora rule also impacts taxpayers who simply need time to pay because it intersects with a two-year time limit that often applies for claiming refunds after paying taxes. That means a taxpayer on an installment agreement can only get a court to consider a refund of the portion of the tax bill paid within the two years before their claim was filed.

“That’s an issue for anyone who doesn’t have the ability to pay, and it could be low-income, middle-income, even high-income, that doesn’t have liquid assets,” said Nina Olson, who was the IRS National Taxpayer Advocate from 2001 to 2019.

Olson, now executive director of the Center for Taxpayer Rights, has also urged lawmakers to repeal the Flora rule.

Calls for Congressional Fix

Even some judges have raised concern about the restriction on challenging unpaid penalties.

The U.S. Court of Appeals for the Second Circuit, for example, seemed to call on legislators to step in when it upheld in 2018 the dismissal of a case brought by John Larson over penalties totaling more than $61 million.

“The notion that a taxpayer can be assessed a penalty of $61 million or more without any judicial review unless he first pays the penalty in full seems troubling, particularly where, as Larson alleges here, the taxpayer is unable to do so,” wrote Judge Richard C. Wesley, who was joined by Judges Barrington D. Parker and Denny Chin.

“But, '[w]hile the Flora rule may result in economic hardship in some cases, it is Congress’ responsibility to amend the law,’” Wesley added.

Fogg in 2018 sent a letter on behalf of the Harvard Federal Tax Clinic to House tax-writers, urging them to consider legislative changes that would broaden access to the courts by “reconceptualizing” assessable penalties as administrative penalties subject to Tax Court review.

The clinic’s Flora proposal was part of a broader set of comments on a wide-ranging IRS overhaul law enacted late in 2018. That law, known as the Taxpayer First Act, included mandates aimed at strengthening taxpayer rights, but didn’t address assessable penalties.

Value of Courts

The IRS Independent Office of Appeals—the lone avenue to challenge unpaid assessable penalties—can offer significant relief to taxpayers. But that relief can still fall far short of what taxpayers believe they are entitled to.

In the Larson case, the appeals office reduced the penalties by more than $90 million based on the liability of others. But Larson argued that he couldn’t pay the more than $61 million he still faced by the time the Second Circuit heard his case, which meant he couldn’t get a ruling on his argument that he should only be ordered to pay about $7 million.

Kostelanetz & Fink attorney Megan Brackney, who worked on Larson’s Second Circuit case but didn’t represent him at the appeals office, said in her experience the office seems constrained when it comes to IRS enforcement priorities such as tax shelter promotion or foreign information return penalties.

“I don’t know why because I’m on the outside, not on the in, but I do know it’s a whole lot easier to settle a straight income tax case than it is to settle ones that involve these types of penalties,” she said.

IRS spokesperson Bruce Friedland said appeals officers don’t seek IRS approval to resolve cases and don’t coordinate potential settlements with the agency’s examination and collection workers. While the appeals office may reach out for advice to the IRS Office of Chief Counsel, it “will independently review that advice as part of our analysis of the hazards of litigation to both the government and the taxpayer,” he said.

Fogg, who has represented clients before the appeals office, said the process “is not always that helpful.” He suggested that giving taxpayers the right to challenge unpaid assessable penalties in court could lead to more favorable treatment at appeals.

“Then they know they’ve got to be a little more thoughtful about what they do, because otherwise they can look bad in court,” Fogg said.

To contact the reporter on this story: Aysha Bagchi in Washington at

To contact the editors responsible for this story: Patrick Ambrosio at; Gregory Henderson at