(MONEY Magazine) – A MONEY reporter recently asked a top federal tax official to explain why tax penalty collections -- for such infractions as filing late, missing estimated payments and making mistakes on returns -- have risen a startling 38% since 1989. How could that happen despite a law enacted that year banning excessive penalties? Despite the kinder and gentler approach ordered by Congress and President Bush? And despite the Internal Revenue Service's own avowed intention to emphasize education over enforcement? ''I don't know,'' responded Marshall Washburn, the IRS' deputy assistant commissioner for examinations since 1989. Well, we know. After four months of research, including interviews with 35 tax experts in and out of government, study of 850 pages of IRS and congressional records and our review of reports by the watchdog General Accounting Office, here's what we found: -- Contrary to the letter and spirit of the '89 law, the IRS still blatantly uses penalties to raise revenue. Congress itself is partly at fault. Says David Berenson, national director of tax policy at Ernst & Young in Washington, D.C. and a seasoned IRS watcher: ''As Congress tries to squeeze more out of the tax law, it holds the IRS' feet to the fire to increase penalty revenues.'' The result: Taxpayers are getting burned too. Last March, incoming IRS Commissioner Shirley D. Peterson told Congress that stepped-up enforcement alone will bring in an additional $11.4 billion from businesses and individuals by 1995. Between 1989 and 1991, the number of returns filed rose only 2.5%. Yet the number of delinquency penalties soared 77% to 3.2 million, and negligence penalties climbed nearly 30% to 2.5 million. In addition, the '89 law specifically outlawed a practice called stacking -- assessing multiple penalties for a single offense. This ban alone should have slowed the penalty juggernaut -- but it didn't. All together, the IRS collected $1.5 billion in delinquency and negligence penalties in 1991, a 52% increase in two years. (The remaining $2 billion came from estimated-tax, failure-to-pay and other penalties.) -- The middle class is being pounded the hardest. For the 40% of taxpayers with little income besides salary and bank interest, the IRS computer matching program amounts to a top-to-bottom audit that can catch every discrepancy, however innocent. Begun in 1966, the program routinely compares information on taxpayers' 1040 forms with some 99% of the more than 1 billion W-2s, 1099s and other documents sent to the IRS each year by employers, banks, brokers and other income-paying institutions. However, the IRS hasn't yet figured out how to extend its matching program to nonsalary income such as capital gains, pensions and partnership payouts. Therefore, the typically higher-income taxpayers who collect such income are getting a relatively free ride. No wonder that, according to the most recent IRS estimate available, underreporting of capital gains ballooned from $5 billion in 1985 to $12 billion in 1988. -- Penalty notices contain errors so routinely that no taxpayer should pay up automatically. An earlier MONEY investigation (published in April 1990) revealed that fully half the letters the IRS sends to taxpayers demanding taxes, penalties and interest are in error. Interviews with tax experts who deal regularly with the agency indicate that little has changed since then. ''These notices still have an enormously high rate of errors,'' says David J. Silverman, an enrolled agent and author of Battling the IRS (David J. Silverman & Co., $16.95; 800-395-6983). An April 1990 GAO study of so-called penalty abatements -- withdrawals or reductions of fines after taxpayer appeals -- found that 29% were made to correct IRS errors in assessing penalties for failure to file and to pay tax. An estimated $26.1 billion of the $110.7 billion the agency has assessed since 1986 resulted from mistakes ''caused by taxpayer and IRS error,'' says Commissioner Peterson. -- Many penalty assessments are so unjust that they constitute a denial of citizens' fundamental right to due process. In fiscal 1991, IRS computers spat out 9 million of the agency's 21 million penalties. That means that roughly four out of 10 taxpayers get bills for suspected tax violations without first being asked to explain a seeming gap. Furthermore, once you are fingered, even by a mindless computer, the IRS assumes you are guilty. You must prove your innocence. A July 1991 report by the GAO found that in 76% of the cases, the IRS didn't adequately explain its reasons for assessing two of the most common penalties, those for negligence and for substantially understating taxes owed. Sen. David Pryor (D-Ark.), chairman of the Senate subcommittee that oversees the IRS, told MONEY: ''Penalties are still used as a weapon, as a whip over the innocent and the guilty taxpayer's head, and as a point of leverage.'' It isn't supposed to be like this, of course. The Improved Penalty Administration Compliance Tax Act (known as Impact), which President Bush signed on Dec. 19, 1989, was intended to reform the penalty system and outlaw stacking. The President and Congress also stated that penalties would henceforth be used only to encourage compliance. No longer could the IRS use them to boost revenues, no matter how much the politicians pressured the agency to close the $127 billion gap between the taxes Americans pay and what the IRS says they owe. Indeed, only last February, IRS assistant commissioner Washburn told MONEY flatly: ''Penalties today are used to enhance voluntary compliance. They are absolutely not used as revenue raisers.'' That, however, isn't what the IRS record indicates. From 1979 to 1989, the heyday of stacking, IRS penalty collections from individual taxpayers rose about fivefold, from $488 million to $2.6 billion, partly as a result of the IRS' praiseworthy war against abusive tax shelters. The number of penalties roughly doubled during that decade, from 9.5 million to 16.6 million, while the volume of tax returns rose by only 24%, to 113 million. Yet after Impact became law, IRS penalty assessments actually accelerated. In fiscal 1991, which ended Sept. 30, the agency hit individual taxpayers with 21 million penalties, a 26% rise from 1989; the $3.5 billion in penalty collections leaped 38% in the same period. That's equal to 60% of the entire IRS budget for 1991, up from 49% two years ago. IRS Commissioner Peterson's explanation for the continuing penalty explosion: Impact hasn't had enough time to show results. Ernst & Young's Berenson disagrees. ''Penalties will increase as Congress keeps pounding on the IRS for more revenue,'' he says. ''It's like red meat to a lion.'' Even so, in an interview with MONEY, Peterson stopped short of endorsing penalties. ''Basically, penalties were designed to encourage compliance,'' she says. ''But there are better ways'' -- namely, education and the $8 billion in new computers the IRS began installing in 1988. Yet the great accomplishment of computers may have already been made: Since '88, the tide of matchable documents has risen only 4.7% because most were already being matched. At the same time, the IRS has cut back on audits, from 4.7% of total returns in 1965 to less than 1% today, and increasingly turned to much more cost- effective document matching as its principal enforcement tool. Audits generate only $8 in revenue for every dollar the IRS spends on them, while the rate of return on computerized matching is $32 to $1. Audits still produce more than $5 billion of tax and penalties from individuals, however. And IRS revenue agents and auditors are now under intense pressure from their bosses to boost revenues. ''If there's a suspicion that more money can be squeezed from a return, even if the taxpayer has consulted with a tax professional about the items in question, the agent is supposed to assess penalties, close out the case and move on,'' says Mark Gray, an official with the National Treasury Employees Union. Thus IRS employees have less incentive than ever to give taxpayers the benefit of the doubt, even if errors are unintentional. Worse yet, the agents' haste and overzealousness often lead to mistakes on their part. The 1991 GAO study discovered that fines for negligence and substantial understatement of taxes were assessed erroneously one-third of the time. Inexplicably, fully 85% of the mistakes benefited the taxpayers. Overall, only 5.7% of penalties were canceled or reduced in fiscal 1991 (average individual penalty in 1991: $178). While that's discouraging, it also suggests that too few taxpayers choose to fight. No one should unknowingly pay an unfair tax -- or forget that unjust demands for extra taxes and penalties can be overturned if you know how to make your case. Here are the fines the IRS dishes out, in order of frequency, and how you can successfully appeal them: -- Failure to pay. The IRS most commonly makes this accusation when items on your tax return don't match information provided to the agency by anyone who pays you income. The IRS annually sends out about 5 million of these notices, known as CP-2000s, roughly a third of them in May. The forms demand an explanation of the discrepancy -- or payment of additional tax within 10 days. If you fail to respond, you'll face a penalty of 0.5% a month (1% if a subsequent notice is sent), up to a maximum of 25% of the tax due plus 8% a year interest compounded daily. The average penalty in 1991 was $80. CP-2000s are the most error-prone notices of all, according to the GAO -- in 1988, it discovered that two-thirds of taxpayers charged with underreporting their income actually did nothing wrong. Typical reasons for the flub-filled CP-2000s: The IRS received incorrect information about income paid to you, or a data entry transcriber punched a wrong figure into the IRS computer system. On receiving a CP-2000, review your records. If you made the error, send the IRS a check for the overdue tax plus interest immediately to avoid a penalty. But challenge the penalty if you can show that your oversight was an honest mistake -- for instance, your bank miscalculated interest income. If your employer, bank or broker is responsible for the CP-2000 mistake, ask for a corrected W-2 or 1099 form. The same day, send a copy of your request -- and a letter explaining the underpayment -- to the IRS by certified mail. Similarly, when the IRS has made the mistake, send a clearly worded rebuttal like the one on page 167 and copies of supporting records to the agency via certified mail. -- Failure to pay estimated tax. Taxpayers with investment or other income not subject to withholding must make quarterly tax payments to the IRS to avoid this penalty, currently an annual 8% of the tax due. The IRS levied 5.7 million such penalties in 1991; they averaged $166 each. This penalty is often easy to get rescinded. If you receive a notice assessing a penalty that you believe is wrong, send the agency copies of your canceled checks (front and back to prove they've been cashed) for the taxes along with a letter explaining when the checks were mailed; enclose copies of any supporting documents. -- Delinquent tax returns. Taxes that are overdue because people don't file on time are subject to a stiff penalty of 5% a month of the tax due, up to a maximum of 25%. (Taxpayers who file late but are due refunds are not penalized; fines are calculated only against a balance due.) Some 3.2 million delinquency penalties pulled in an average of $363 each last year. When taxpayers don't file returns, the IRS acts as their tax preparers. Using the information sent to the agency by employers, banks, brokers and the like, IRS employees construct substitute tax returns for nonfilers and estimate the amount of tax owed. Then the IRS sends out bills. About 400,000 substitute returns are issued each year. The IRS' take from them: $2 billion, or $5,200 per return. Ralph Rogers of Bremerton, Wash. got ensnared in the IRS machinery when he informed the agency in December 1990 that because of slow sales at his silk- screening business, he couldn't file payroll taxes of $6,100. Four months later, when Rogers discovered that he couldn't meet his next tax bill either, he asked the IRS to let him pay by installments. He received no response, but seven months after that, the IRS seized his $3,800 checking account. By then, interest and penalties had upped his tab to $8,322. Rogers eventually paid off the debt with a loan from a friend. Aggrieved by what he regarded as unfair treatment (''I had paid all my taxes up until that point''), he wrote a three-page protest, arguing that he did not deserve the $4,710 penalty. Two months later, the agency sent him two checks totaling $1,700. One was for overpayment of taxes; the other was a partial refund of penalties. If you have an excellent excuse for missing the deadline, such as a death in your immediate family, explain it in a letter attached to your return. (For the 10 excuses the IRS is most apt to accept, see page 163.) -- Negligence. This highly subjective penalty is exacted after an audit. The fine is 20% of any underpayment that an IRS revenue examiner attributes to negligence. In 1991, the IRS assessed 2.4 million negligence penalties, averaging $284 each. The Internal Revenue Manual says an examiner will assess a negligence penalty if a taxpayer tries to take a deduction or a credit that ''would seem to a reasonable or prudent person too good to be true.'' That broad definition can translate all too easily into a presumption of negligence, according to Ed Karl, director of the American Institute of Certified Public Accountants in Washington, D.C. Maintaining improper or inadequate records counts as negligence, but a difference of opinion about an unclear tax rule should not. In addition, taxpayers who show what the manual calls substantial authority for interpreting a tax rule in their favor are not considered negligent. Sources of substantial authority include court opinions, Treasury Department regulations and IRS revenue rulings. Because a tax lawyer or accountant has much greater access to such sources than you do, it pays to hire one if you are accused of negligence. One couple who beat a negligence rap with the help of a tax lawyer: Roy and Sybille Koberstein of Tempe, Ariz. In 1991, the Kobersteins were hit with a $10,000 negligence penalty because of a disputed tax-shelter write-off they took in 1984 and 1985. After several months of investigation into the tax shelter's history, their lawyer, Yale Goldberg, dug up citations buried in tax law that helped establish reasonable cause for canceling the penalty. However, Goldberg notes that ''the sworn affidavits attesting that the Kobersteins relied on professional advice were probably most persuasive of all for the IRS.'' The agency confirmed this to MONEY.

If an examiner closes out an audit without waiving a negligence penalty that you believe to be unjustified, appeal first to the examiner's manager. If you and the manager can't reach an agreement, you have 30 days to request an administrative hearing with the IRS appeals office. If you lose at that level, you have 90 days to appeal the examiner's finding in Tax Court. If you lose again, you can file suit against the agency in U.S. District Court or Claims Court, but that can be expensive. Lawyer's fees alone often run to $250 an hour or more. -- Substantial understatement. This fine, assessed primarily in audits, applies when a taxpayer underpays his or her taxes by the greater of $5,000 or 10% of the correct amount. The penalty is 20% of the underpayment. The IRS assessed 35,000 of these penalties in 1991, averaging $4,361 each. The unyielding arithmetic of the substantial-understatement fine puts pressure on accused tax cheats to make a deal even if they don't think they are guilty. For example, the agency has claimed since 1987 that Jo Ann Pearcy of Springfield, Mo. owes more than $175,000 in back taxes, interest and penalties. It charges that she embezzled money from an appliance store, now bankrupt, where she worked as a bookkeeper. She has unwaveringly denied the allegations and in 1989 won a criminal case brought against her by the IRS. Undeterred, the agency is now threatening to sue her for back taxes in Tax Court. Argues IRS spokesman Ellen Murphy: ''Acquittal on a criminal charge of tax evasion does not relieve liability for taxes owed or interest and applicable civil penalty.'' So far, Pearcy has spent more than $100,000 in attorney's and accountant's fees and can expect to spend $50,000 more before her case is resolved. ''I keep on fighting because I am innocent,'' she says. ''I know I'll win, even if it takes years.''