Artificial Intelligence continues to impact all industries as companies and individuals try and find the perfect balance between automation and sufficient oversight and monitoring. Tax reporting would appear, on its face, to be a prime candidate for the promises of efficiency achieved through AI’s streamlined review of large amounts of data and identification of potential errors or inconsistencies. The Internal Revenue Service already uses AI to select individuals and partnerships for audit, identify fraud, and other compliance and enforcement functions. I’ve previously written about the IRS’ historical struggle with auditing partnerships and the future of partnership enforcement, which may include the use of AI. A Government Accountability Office study on government use of AI has indicated that its own studies require high-quality data and a skilled workforce to truly recognize the benefits of the technology. It has been reported that the IRS pausing current modernization efforts to evaluate the use of AI going forward. However, a recent U.S. Tax Court ruling signals that the increased use of software for compliance may not spare taxpayers from errors made by the new technology. In fact, the immediate future may be less forgiving for errors by software than traditional human error.
Artificial Intelligence Could Reduce Reporting Burden
The IRS receives millions of third-party informational returns used for analysis and enforcement against non-compliance with reporting and tax payment obligations. Information reporting can come from employers (e.g. Form W-2), non-employee compensation (e.g. Form 1099-NEC), or intermediaries to the sale of goods or services (e.g. Form 1099-K), and an entirely new set of informational reporting was sought and imposed for digital assets. Congress and President Donald Trump recently removed informational reporting requirements for certain DeFi transactions indicating the burden on small businesses and the digital asset community. However, informational reporting is still required for certain “brokers” involved in digital assets transactions on the new IRS Form 1099-DA.
Businesses, especially small businesses, the added costs of creating, implementing, and overseeing compliance with informational reporting can be quite burdensome. Many such businesses choose to purchase software programs to assist in those compliance efforts. As the availability of software programs implementing AI promise savings of both time and cost adoption is certainly expected to increase. Companies must comply with tax reporting obligations or face potentially large penalties by the IRS for non-compliance. Therefore, an AI solution would be an attractive option. However, based on a recent Tax Court case the use of an AI tax reporting software solution may not save you from large tax penalties if the software makes a mistake.
One of the many informational reporting penalties the IRS can assess is for failure to file a Form 8300 when a business receives more than $10,000 in cash in one or more related transactions. In a recent U.S. Tax Court case, Dealers Auto Auction of Southwest LLC v. Commissioner, an Arizona company purchased specialized software intended to assist with compliance in preparing IRS Form 8300 after a noncompliance incident in a previous year. Despite having the software in place, the IRS determined that the company failed to file all of the required Forms 8300 and assessed $118,140 in penalties. Failure to file an informational return like the Form 8300 results in a $250 penalty for each return not filed not to exceed $3 million in any calendar year.
This penalty can, in some situations, be enhanced if the IRS deems the failure to be “intentional disregard” of the statute. In general, intentional disregard exists where a taxpayer knows or should know of the obligation and chooses to ignore it. Actual knowledge is one thing, but “should know” may be construed differently by the IRS and the impacted taxpayer. This is especially true in the context of a taxpayer’s responsibility over software, using artificial intelligence or not, it has purchased to handle compliance.
Tax Reporting Penalty Relief
Information return penalties, usually assessed under Section 6721 of the Internal Revenue Code, can be particularly high because of their per failure application and potential enhancement for alleged “intentional disregard.” Thousands of mistakes at a $250 per mistake charge adds up quickly and a $3 million ceiling on penalties is little comfort. There is, thankfully, a defense against imposing the penalties if it can be shown that the failure is due to reasonable cause and not willful neglect.
A taxpayer meets the “reasonable cause” exception to information reporting penalties if they can show significant mitigating factors for the failure or the failure arose from events beyond the filer’s control. The statement outlining the facts showing reasonable cause is usually signed under penalties of perjury, which comes with its own risks for misstatements. In Dealers Auto Action of Southwest LLC, the company involved argued that it relied on the software it purchased but the software did not perform as intended. However, the Tax Court noted that the company’s own brief indicating “there may have been a failure with the computer system” and that the record was not clear on what specific failures involved the software and whether the failures might be connected to input errors. The company claimed that the failure was due to software malfunctions beyond its control and the IRS countered with the argument that reliance on software does not establish reasonable cause.
Several individual taxpayers have tried, unsuccessfully, to defeat penalties using reasonable cause defenses claiming that tax preparation software like Turbo Tax generated the errors resulting in accuracy penalties. The Tax Court, in Bunney v. Commissioner, held that TurboTax is only as good as the information entered. However, IRS regulations still indicate that circumstances indicating reasonable cause against accuracy penalties include “honest misunderstanding of fact or law” and “isolated computational or transcriptional” errors. Also, the regulations still provide for reasonable cause against accuracy penalties if the taxpayer relied on qualified professional tax advisor (e.g. CPA) when taking a position later determined to be incorrect. Perhaps a future case will decide whether reliance on a CPA using AI still meets the reasonable cause exception or not.
The Tax Court, in Dealers Auto Auction of Southwest LLC, did rejected the IRS’ “blanket assertion” that software malfunctions cannot qualify for reasonable cause. Although this gives hope for future taxpayers, it did not provide penalty relief in Dealers Auto Auction’s claim of software errors. Why not? It appears that company was unable to show sufficient facts to convince the Tax Court that the software was really to blame. The Tax Court found that the record did not adequately show as software failure and that the company itself had failed to show adequate controls to identify the noncompliance. The Tax Court also pointed to the lack of proof that the company acted reasonably before or after the failure. For example, the Tax Court noted that there was no evidence regarding the installation, training or use of the software. Also, the number of Forms 8300 decreased from 212 in 2014 to 116 in 2016 and no explanation was given as to why the reduction appeared reasonable. Regardless, the Tax Court appears to be indicating there needed to be more affirmative actions by the taxpayer in implementing and overseeing the software and its operation. As AI attempts to take more and more human interaction out of the process, how will future AI misfunctions be judged when “reasonableness” is required for penalty relief.
Conclusion
The government recognizes the burden on businesses, especially small businesses, to comply with informational reporting requirements but maintains the expense is required to enforce the tax laws and maintains penalties for failures in reporting. Both the IRS and companies under reporting obligations are looking to software innovation, including artificial intelligence, to ease burdens on analysis of large amounts of data. As the IRS attempts to reduce both costs and people through increased use of AI will it expect tolerance of its own software malfunctions. If the IRS’ AI system results in errors there are few remedies for taxpayers recover the cost of disputing those errors. The IRS has penalties and other enforcement mechanisms to punish private use of software that doesn’t produce expected results. According to this current Tax Court decision, it appears that taxpayers will need to maintain evidence of proper operation and oversight of any software because the benefit of the doubt isn’t going to the taxpayer in software situations.
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