Playing the Audit Lottery: The Role of Penalties in the US Tax Law in the Aftermath of Long Term Capital Holding v. United States


Tax motivated transactions have become a serious consideration for Congress in recent years. The concerns include the extent of loss of tax revenues, harm to the integrity of the tax system, and equity. Although these concerns are understandable, Judge Learned Hand stated many years ago that: “[A]nyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s tax.” It is necessary, as this article will argue, to balance between the taxpayer’s right to plan its moves within the tax law and the tax authorities’ right to prohibit such transactions. To date, most legislative attacks on corporate tax shelters have targeted specific transactions and have taken place on an “ad-hoc,” after-the-fact basis through legislation, administrative guidelines, and litigation. In recent years, legislation has become more comprehensive, the important elements of which include enhancement of new penalties, stronger disclosure requirements, and changes in substantive law. It would seem that these recent attempts to introduce more comprehensive legislation signal legislative dissatisfaction with the existing piecemeal rules.

Penalties have played a key role in those attempts to crack down tax-motivated transactions. Under the “bad man theory, a rational person decides whether or not to comply with the law by calculating his or her own benefits and costs, including the risk of punishment, and breaks the law whenever his or her potential gain from disobeying the law exceeds his risk of punishment. The same equation applies to obeying tax law. The probability of detection and audit combined with the magnitude of the penalties are the major expected costs of underpayment of taxes. Accordingly, the cost-benefit behavior is frequently referred to as “playing the audit lottery.” Penalties are, therefore, an additional “price” on engaging in an activity that might be viewed as tax-motivated.

It is unquestionable that the primary purpose behind the enactment of the various accuracy-related penalty provisions in the Code was to deter taxpayer from “playing the audit lottery.” As of today, however, the various penalty provisions have only partially achieved their stated goals.

This article discusses the various measures taken by Congress and Treasury in recent years. Specifically, using a cost-benefit equation, I will show that in order to reduce the taxpayer’s incentive to play the audit lottery, Congress must focus on increasing the likelihood that the taxpayer will pay the penalty rather than the rate of penalty.


Tax Law

Date of this Version

November 2005