[House Hearing, 106 Congress]
[From the U.S. Government Publishing Office]
PENALTY AND INTEREST PROVISIONS IN THE INTERNAL REVENUE CODE
=======================================================================
HEARING
before the
SUBCOMMITTEE ON OVERSIGHT
of the
COMMITTEE ON WAYS AND MEANS
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
__________
JANUARY 27, 2000
__________
Serial 106-110
__________
Printed for the use of the Committee on Ways and Means
U.S. GOVERNMENT PRINTING OFFICE
67-952 WASHINGTON : 2001
_______________________________________________________________________
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC
20402
COMMITTEE ON WAYS AND MEANS
BILL ARCHER, Texas, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
BILL THOMAS, California FORTNEY PETE STARK, California
E. CLAY SHAW, Jr., Florida ROBERT T. MATSUI, California
NANCY L. JOHNSON, Connecticut WILLIAM J. COYNE, Pennsylvania
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM McCRERY, Louisiana JIM McDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. McNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHILIP S. ENGLISH, Pennsylvania KAREN L. THURMAN, Florida
WES WATKINS, Oklahoma LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona
JERRY WELLER, Illinois
KENNY HULSHOF, Missouri
SCOTT McINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
A.L. Singleton, Chief of Staff
Janice Mays, Minority Chief Counsel
______
Subcommittee on Oversight
AMO HOUGHTON, New York, Chairman
ROB PORTMAN, Ohio WILLIAM J. COYNE, Pennsylvania
JENNIFER DUNN, Washington MICHAEL R. McNULTY, New York
WES WATKINS, Oklahoma JIM McDERMOTT, Washington
JERRY WELLER, Illinois JOHN LEWIS, Georgia
KENNY HULSHOF, Missouri RICHARD E. NEAL, Massachusetts
J.D. HAYWORTH, Arizona
SCOTT McINNIS, Colorado
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
hearing records of the Committee on Ways and Means are also published
in electronic form. The printed hearing record remains the official
version. Because electronic submissions are used to prepare both
printed and electronic versions of the hearing record, the process of
converting between various electronic formats may introduce
unintentional errors or omissions. Such occurrences are inherent in the
current publication process and should diminish as the process is
further refined.
C O N T E N T S
__________
Page
Advisories announcing the hearing................................ 2
WITNESSES
U.S. Department of the Treasury, Joseph Mikrut, Tax Legislative
Counsel........................................................ 10
Joint Committee on Taxation, Lindy Paull......................... 18
Internal Revenue Service, W. Val Oveson, National Taxpayer
Advocate....................................................... 27
______
American Bar Association, Section of Taxation, Ronald A. Pearlman 59
American Institute of Certified Public Accountants, Mark H. Ely.. 66
National Association of Enrolled Agents, and JAA Enterprise,
L.L.C., Judith Aiken........................................... 52
Tax Executives Institute, Inc., and BellSouth Corporation,
Charles W. Shewbridge, III..................................... 80
SUBMISSIONS FOR THE RECORD
American Council of Life Insurers, Mark A. Canter, letter and
attachments.................................................... 93
Ceridian Corporation, Minneapolis, MN, James R. Burkle, statement 101
Coalition for the Fair Taxation of Business Transactions,
statement...................................................... 104
KPMG Interest Netting Coalition, Mark H. Ely; Harry L. Gutman;
David L. Veeder, Dallas, TX; and R. David Miller, Tampa, FL,
statement...................................................... 106
Profit Sharing/401(K) Council of America, statement.............. 108
PENALTY AND INTEREST PROVISIONS IN THE INTERNAL REVENUE CODE
----------
THURSDAY, JANUARY 27, 2000
House of Representatives,
Committee on Ways and Means,
Subcommittee on Oversight,
Washington, DC.
The Subcommittee met, pursuant to notice, at 10 a.m., in
room 1100, Longworth House Office Building, Hon. Amo Houghton
(Chairman of the Subcommittee) presiding.
[The advisories announcing the hearing follow:]
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
October 26, 1999
No. OV-12
Houghton Announces Hearing on
Penalty and Interest Provisions in the
Internal Revenue Code
Congressman Amo Houghton (R-NY), Chairman, Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee will hold a hearing on the penalty and interest provisions
in the Internal Revenue Code, including recent studies by the U.S.
Department of the Treasury and the Joint Committee on Taxation that
were mandated by the Internal Revenue Service (IRS) Restructuring and
Reform Act of 1998 (P.L. 105-206). The hearing will take place on
Tuesday, November 9, 1999, in the main Committee hearing room, 1100
Longworth House Office Building, beginning at 10:00 a.m.
Oral testimony at this hearing will be from invited witnesses only.
Invited witnesses include Jon Talisman, Deputy Assistant Secretary for
Tax Policy, U.S. Department of the Treasury; Lindy L. Paull, Chief of
Staff, Joint Committee on Taxation; W. Val Oveson, National Taxpayer
Advocate; and representatives from the National Association of Enrolled
Agents, the American Bar Association, the American Institute of
Certified Public Accountants, and the Tax Executives Institute. Any
individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing.
BACKGROUND:
In 1988 and 1989, the Subcommittee held a series of hearings on the
penalty and interest provisions in the tax code. The hearings
culminated in an overhaul of the penalty and interest regimes with the
enactment of the Improved Penalty Administration and Compliance Tax
Act, included in the Omnibus Budget Reconciliation Act of 1989 (P.L.
101-239).
In the IRS Restructuring and Reform Act of 1998, Congress directed
the Treasury and the Joint Committee on Taxation to conduct studies to
examine whether the current penalty and interest provisions: (1)
encourage voluntary compliance, (2) operate fairly, (3) are effective
deterrents to undesired behavior, and (4) are designed in a manner that
promotes efficient and effective administration of the provisions by
the IRS.
The Joint Committee on Taxation completed and released its study,
Study of Present-Law Penalty and Interest Provisions as Required by
Section 3801 of the Internal Revenue Service Restructuring and Reform
Act of 1998 (Including Provisions Relating to Corporate Tax Shelters),
on July 22, 1999. The Treasury completed its report, Penalty and
Interest Provisions of the Internal Revenue Code, on October 25, 1999.
In announcing the hearing, Chairman Houghton stated: ``It has been
10 years since Congress last took a comprehensive look at the interest
and penalty regimes in the Code. The Subcommittee led the way then, and
now the Subcommittee will review the provisions that were passed 10
years ago to determine whether these provisions are effective and
promote fair treatment of taxpayers without undue complexity. We will
also consider recommendations to improve upon these provisions.''
FOCUS OF THE HEARING:
The focus of the hearing is to review the current penalty and
interest provisions in the Code and to consider recommendations to
simplify penalty administration and to reduce taxpayer burden. On
October 26, 1999, Chairman Archer announced that the full Committee
will hold a hearing on corporate tax shelters on November 10, 1999 (See
Full Committee press release No. FC-14).
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch
diskette in WordPerfect 5.1 format, with their name, address, and
hearing date noted on a label, by the close of business, Tuesday,
November 23, 1999, to A.L. Singleton, Chief of Staff, Committee on Ways
and Means, U.S. House of Representatives, 1102 Longworth House Office
Building, Washington, D.C. 20515. If those filing written statements
wish to have their statements distributed to the press and interested
public at the hearing, they may deliver 200 additional copies for this
purpose to the Subcommittee on Oversight office, room 1136 Longworth
House Office Building, by close of business the day before the hearing.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a
witness, any written statement or exhibit submitted for the printed
record or any written comments in response to a request for written
comments must conform to the guidelines listed below. Any statement or
exhibit not in compliance with these guidelines will not be printed,
but will be maintained in the Committee files for review and use by the
Committee.
1. All statements and any accompanying exhibits for printing must
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1
format, typed in single space and may not exceed a total of 10 pages
including attachments. Witnesses are advised that the Committee will
rely on electronic submissions for printing the official hearing
record.
2. Copies of whole documents submitted as exhibit material will not
be accepted for printing. Instead, exhibit material should be
referenced and quoted or paraphrased. All exhibit material not meeting
these specifications will be maintained in the Committee files for
review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a
statement for the record of a public hearing, or submitting written
comments in response to a published request for comments by the
Committee, must include on his statement or submission a list of all
clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the
name, company, address, telephone and fax numbers where the witness or
the designated representative may be reached. This supplemental sheet
will not be included in the printed record.
The above restrictions and limitations apply only to material being
submitted for printing. Statements and exhibits or supplementary
material submitted solely for distribution to the Members, the press,
and the public during the course of a public hearing may be submitted
in other forms.
Note: All Committee advisories and news releases are available on
the World Wide Web at ``http://waysandmeans.house.gov''.
The Committee seeks to make its facilities accessible to persons
with disabilities. If you are in need of special accommodations, please
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
business days notice is requested). Questions with regard to special
accommodation needs in general (including availability of Committee
materials in alternative formats) may be directed to the Committee as
noted above.
NOTICE--CHANGE IN TIME AND LOCATION
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
November 2, 1999
No. OV-12 Revised
Change in Time and Location for Subcommittee
Hearing on the Penalty and Interest Provisions
in the Internal Revenue Code
Tuesday, November 9, 1999
Congressman Amo Houghton (R-NY), Chairman of the Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee hearing on the penalty and interest provisions in the
Internal Revenue Code scheduled for Tuesday, November 9, 1999, at 10:00
a.m., in the main Committee hearing room, will now be held in room B-
318 of the Rayburn House Office Building beginning at 3:00 p.m.
All other details for the hearing remain the same. (See
Subcommittee press release No. OV-12, dated October 26, 1999.)
NOTICE--HEARING POSTPONEMENT
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
November 9, 1999
No. OV-12 Revised
Postponement of Subcommittee Hearing on
the Penalty and Interest Provisions
in the Internal Revenue Code
Tuesday, November 9, 1999
Congressman Amo Houghton (R-NY), Chairman of the Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee hearing on the penalty and interest provisions in the
Internal Revenue Code scheduled for Tuesday, November 9, 1999, at 10:00
a.m., in the main Committee hearing room, will now be held in room B-
318 of the Rayburn House Office Building beginning at 3:00 p.m.
All other details for the hearing remain the same. (See
Subcommittee press release No. OV-12, dated October 26, 1999.)
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
January 18, 2000
No. OV-14
Houghton Announces Hearing on
Penalty and Interest Provisions in the
Internal Revenue Code
Congressman Amo Houghton (R-NY), Chairman, Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee will hold a hearing on the penalty and interest provisions
in the Internal Revenue Code, including recent studies by the U.S.
Department of the Treasury and the Joint Committee on Taxation that
were mandated by the Internal Revenue Service (IRS) Restructuring and
Reform Act of 1998 (P.L. 105-206). The hearing will take place on
Thursday, January 27, 2000, in the main Committee hearing room, 1100
Longworth House Office Building, beginning at 10:00 a.m.
Oral testimony at this hearing will be from invited witnesses only.
Invited witnesses include Jon Talisman, Deputy Assistant Secretary for
Tax Policy, U.S. Department of the Treasury; Lindy L. Paull, Chief of
Staff, Joint Committee on Taxation; W. Val Oveson, National Taxpayer
Advocate; and representatives from the National Association of Enrolled
Agents, the American Bar Association, the American Institute of
Certified Public Accountants, and the Tax Executives Institute. Any
individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing.
BACKGROUND:
In 1988 and 1989, the Subcommittee held a series of hearings on the
penalty and interest provisions in the tax code. The hearings
culminated in an overhaul of the penalty and interest regimes with the
enactment of the Improved Penalty Administration and Compliance Tax
Act, included in the Omnibus Budget Reconciliation Act of 1989 (P.L.
101-239).
In the IRS Restructuring and Reform Act of 1998, Congress directed
the Treasury and the Joint Committee on Taxation to conduct studies to
examine whether the current penalty and interest provisions: (1)
encourage voluntary compliance, (2) operate fairly, (3) are effective
deterrents to undesired behavior, and (4) are designed in a manner that
promotes efficient and effective administration of the provisions by
the IRS.
The Joint Committee on Taxation completed and released its study,
Study of Present-Law Penalty and Interest Provisions as Required by
Section 3801 of the Internal Revenue Service Restructuring and Reform
Act of 1998 (Including Provisions Relating to Corporate Tax Shelters),
on July 22, 1999. The Treasury completed its report, Penalty and
Interest Provisions of the Internal Revenue Code, on October 25, 1999.
On November 10, 1999, the full Ways and Means Committee held a hearing
on the corporate tax shelter issue
In announcing the hearing, Chairman Houghton stated: ``It has been
10 years since Congress last took a comprehensive look at the interest
and penalty regimes in the Code. The Subcommittee led the way then, and
now the Subcommittee will review the provisions that were passed 10
years ago to determine whether these provisions are effective and
promote fair treatment of taxpayers without undue complexity. We will
also consider recommendations to improve upon these provisions.''
FOCUS OF THE HEARING:
The focus of the hearing is to review the current penalty and
interest provisions in the Code and to consider recommendations to
simplify penalty administration and to reduce taxpayer burden.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Any person or organization wishing to submit a written statement
for the printed record of the hearing should submit six (6) single-
spaced copies of their statement, along with an IBM compatible 3.5-inch
diskette in WordPerfect 5.1 format, with their name, address, and
hearing date noted on a label, by the close of business, Thursday,
February 10, 2000, to A.L. Singleton, Chief of Staff, Committee on Ways
and Means, U.S. House of Representatives, 1102 Longworth House Office
Building, Washington, D.C. 20515. If those filing written statements
wish to have their statements distributed to the press and interested
public at the hearing, they may deliver 200 additional copies for this
purpose to the Subcommittee on Oversight office, room 1136 Longworth
House Office Building, by close of business the day before the hearing.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a
witness, any written statement or exhibit submitted for the printed
record or any written comments in response to a request for written
comments must conform to the guidelines listed below. Any statement or
exhibit not in compliance with these guidelines will not be printed,
but will be maintained in the Committee files for review and use by the
Committee.
1. All statements and any accompanying exhibits for printing must
be submitted on an IBM compatible 3.5-inch diskette in WordPerfect 5.1
format, typed in single space and may not exceed a total of 10 pages
including attachments. Witnesses are advised that the Committee will
rely on electronic submissions for printing the official hearing
record.
2. Copies of whole documents submitted as exhibit material will not
be accepted for printing. Instead, exhibit material should be
referenced and quoted or paraphrased. All exhibit material not meeting
these specifications will be maintained in the Committee files for
review and use by the Committee.
3. A witness appearing at a public hearing, or submitting a
statement for the record of a public hearing, or submitting written
comments in response to a published request for comments by the
Committee, must include on his statement or submission a list of all
clients, persons, or organizations on whose behalf the witness appears.
4. A supplemental sheet must accompany each statement listing the
name, company, address, telephone and fax numbers where the witness or
the designated representative may be reached. This supplemental sheet
will not be included in the printed record.
The above restrictions and limitations apply only to material being
submitted for printing. Statements and exhibits or supplementary
material submitted solely for distribution to the Members, the press,
and the public during the course of a public hearing may be submitted
in other forms.
Note: All Committee advisories and news releases are available on
the World Wide Web at ``http://waysandmeans.house.gov''.
The Committee seeks to make its facilities accessible to persons
with disabilities. If you are in need of special accommodations, please
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
business days notice is requested). Questions with regard to special
accommodation needs in general (including availability of Committee
materials in alternative formats) may be directed to the Committee as
noted above.
Chairman Houghton. On behalf of Mr. Coyne, if I can
associate myself with you, and Mr. Hayworth, we are delighted
that you are here today, and thanks very much. The hearing will
begin.
I doubt that there is anyone on this panel who has not
heard more than one heart-breaking story from constituents who
find themselves facing crushing back taxes and penalties and
interest payments because they simply were unable to comply
with a Tax Code they have no hope of understanding. Albert
Einstein once said that compounded interest is the most
powerful force in the universe, and taxpayers whose interest
payments far exceed their underlying taxes certainly can
appreciate the truth of those words of his.
Just yesterday the staff here met with representatives of a
group of investors who were defrauded by an enrolled agent. His
promotional materials targeted working people, promising them
``quality investments for folks that dream about owning a piece
of the country.'' Pretty appealing.
So according to the Willamette Week, before an investor
gave him any money, he would assign the investor a portion of
his cattle-breeding operation's expenses. The investor then
claimed those expenses as a tax deduction. The agent prepared
nearly all of his investors' tax returns, which enabled him to
assign them enough deductions to claim a refund for all of the
taxes they paid in the previous three years. When investors got
their refund checks, they paid him 75 percent and kept the
remaining 25 percent.
Today, nearly all of the investors face back taxes, and
penalties and interest going back in some cases into the 1970s,
because their deductions were disallowed. One of these
investors, a fellow called Ed Van Scoten, says the IRS is
trying to collect about a half million dollars from him and, in
quotes, ``who are they trying to kid,'' he asks? ``they could
never get $500,000 from me if I worked 5 lifetimes,'' end
quote.
In some cases, individual investors first receive notice
from the IRS of their 1981 to 1986 tax liability beginning in
early 1998, and the interest clock of course was running all
this time. The unscrupulous will always prey on the
unsuspecting, but something is seriously wrong with a penalties
and interest regime that adds to the problems faced by the
victims of this sort of scam.
Furthermore, as you know, we have to do more to make our
tax laws and the penalties and interest regime easier to
understand.
In 1988 and 1989, this subcommittee, under our friend,
Chairman J.J. Pickle, held a series of hearings on penalty and
interest reforms. The result was a major overhaul of the
penalty and interest system. None of the Members on the dais
today were on the subcommittee at that time. That is true,
isn't it? You weren't on here. However, counsel for both the
subcommittee majority and minority, Mike Superata and Beth
Vance, were instrumental in seeing those changes become law.
In 1998, this subcommittee shepherded through Congress the
IRS Restructuring and Reform Act. In that legislation, Congress
directed the Joint Committee on Taxation and the Department of
the Treasury to study the Tax Code and to examine whether the
penalty and interest provisions encouraged voluntary
compliance, operated fairly, deterred undesired behavior, and
whether they are designed to promote effective administration
by the IRS.
So we are here today to review the reports by the Joint
Committee and the Treasury. I am also looking forward to
hearing from the National Taxpayer Advocate Val Oveson, who is
literally on the front line every day dealing with taxpayer
problems with these provisions.
As we all know, we rely on voluntary compliance with our
tax laws. The Federal Government depends on tax receipts to
fund Social Security, Medicare, education, defense, highways
and of course other critical functions. Each year, the
government collects more than a trillion and a half dollars in
tax receipts. But each year, billions of dollars are lost
because individuals and businesses avoid paying their share.
The Treasury estimates that the government lost more than $127
billion in 1998, and that is $127 billion that the rest of us
must make up in higher taxes.
So the penalty system does serve a critical purpose and it
deters noncompliance by imposing costs on noncompliance, and it
penalizes those who try to skirt the system.
However, the penalties and interest can be quite severe,
even debilitating. Therefore, we must work to ensure that the
penalty and interest system is understandable. Taxpayers cannot
avoid what they do not understand. More importantly, we must
minimize the number of taxpayers who are caught in the penalty
system not because they were cheating, but because they were
mistaken. We as representatives of the people must take pains
to ensure that innocent taxpayers' lives are not ruined by a
cascading imposition of penalties and interest due to honest
mistakes.
So what I hope to accomplish is simple. I hope we can
develop a consensus built upon the recommendations we receive
today to achieve the objectives we outlined when we asked for
these reports. To repeat: To encourage voluntary compliance, to
enable the IRS to operate fairly, to deter undesired behavior,
and to promote effective administration by the IRS.
Now I am pleased to yield to our ranking Democrat, Mr.
Coyne.
Mr. Coyne. Thank you, Mr. Chairman. In 1989, the Ways and
Means Oversight Subcommittee developed comprehensive proposals
to reform the Tax Code's interest and penalty provisions. These
provisions, known as the Improved Penalty Administration and
Compliance Tax Act, or IMPACT, were enacted into law with the
strong support of taxpayers and the professional tax community
across the country. Now, more than 10 years later, it is
appropriate that the subcommittee review the IRS's
administration of tax penalties and interest.
I want to commend Chairman Houghton for providing the
subcommittee with an opportunity to discuss the experts'
suggestions for further legislative reforms. Also, I want to
welcome representatives from the Department of the Treasury,
the Joint Committee on Taxation, and the National IRS Taxpayer
Advocate concerning their recent studies of the particular
issue that we are addressing today.
In our continuing oversight of our tax system, it is
critical that we understand how interest and penalty
assessments are affecting taxpayers and how the system can be
improved. The Taxpayer Bill of Rights legislation enacted over
the past decade addressed some of the more compelling tax
problems that taxpayers face. The Taxpayers' Bill of Rights 2
authorized the IRS to abate interest and penalties in certain
situations and expanded the interest-free period for tax
payment. Taxpayer Bill of Right number 3 required the IRS to
provide taxpayers with detailed interest and penalty
computations and delinquency notices, suspended interest, and
certain penalties for audit delays, and reduced penalties for
installment payment arrangements.
Even with these changes, however, more can be done. Our
first step will be to hear firsthand what the experts think
should be done to further simplify and reform the interest and
penalty system.
I thank the witnesses for their testimony that they are
about to give. Thank you.
Chairman Houghton. Thanks very much. Mr. Hayworth, do you
have a statement you would like to make?
Mr. Hayworth. Mr. Chairman, just to say to you and the
ranking member, I am honored to be here with you this morning
and happy that even the snow did not deter this important
oversight hearing. We welcome those who are here to testify.
Thank you, Mr. Chairman.
Chairman Houghton. Thank you very much.
I guess the snow did not hurt anybody in Oklahoma, either.
Would the distinguished gentleman like to make a statement?
Mr. Watkins. I would, Mr. Chairman. First, a little
informal, we did have a big snow in Oklahoma, but I just could
not resist trying to get back here for this committee meeting,
you know. It is a very important one. But we did have about a
foot of snow to work through.
Mr. Chairman, I would like to ask you for your help. I
think this is a very important hearing, and I commend you for
having it. The Internal Revenue Service civil tax penalty and
interest provisions are something that has been very much a
part of my concern, and this subcommittee successfully led the
effort 10 years ago to rationalize the civil tax penalties, and
it is only appropriate that today we undertake to review those
important reforms.
As you know, I have a particular concern about the present
law, the interest rate situation. For far too long the IRS has
been using interest rate differentials to extract excessive
interest charges from the American taxpayer. Last year, we were
victorious in having global interest netting enacted to
equalize interest rates during those times when both the
government owes the taxpayers some refunds and the taxpayer
owes some additional taxes. Unfortunately for taxpayers,
though, Mr. Chairman, the IRS has taken a very narrow view of
the new statute and are denying taxpayers the full measure of
the relief that this subcommittee intended to provide. I think
it was our intention to make sure we leveled that playing
field.
I look forward to working with you, Mr. Chairman, just as I
would say in a kind of sidebar, you and I have a keen interest
in international trade, the global opportunities that we have
around the world. We are in a global competitive society. We
need to be making it easier and there should be incentives to
try to get out there and do more in the global arena, but by
making such a narrow eye in that needle, it is very difficult
for us to get things done.
So I look forward to working with you, and I ask for your
help to correct this problem so that we can guarantee our
taxpayers that they will not be charged interest rates by the
IRS when they do not truly owe a debt to the government.
I would like to submit for the record a letter that many
Members of this subcommittee signed last year supporting the
need for this change. Mr. Chairman, thank you for being on that
letter with me and working with us on this. I look forward to
hearing the witnesses today on this. So I am delighted to be
back with you today on the sunshiney face of this committee,
ready to go.
Chairman Houghton. Thank you, Mr. Watkins.
Well, we have our first panel. Mr. Joseph Mikrut, the Tax
Legislative Counsel of the Department of the Treasury, is going
to kick off here. Then Ms. Paull, who is head of the Joint
Committee on Taxation; and Mr. Oveson of the Internal Revenue
Service, the National Taxpayer Advocate, will talk, in that
order.
So Mr. Mikrut, I understand that you need a few more
minutes than the usual five. Please go ahead and take it, and
you are on.
STATEMENT OF JOSEPH MIKRUT, TAX LEGISLATIVE COUNSEL, U.S.
DEPARTMENT OF THE TREASURY
Mr. Mikrut. Thank you, Mr. Chairman. Mr. Chairman, Mr.
Coyne and distinguished members of the subcommittee, good
morning. Thank you for the opportunity to discuss with you
today the Treasury Department's study and recommendations with
respect to the penalty and interest provisions of the Internal
Revenue Code. It has been 11 years since the Congress has
undertaken a comprehensive look at these important and
fundamental pieces of our tax law and we commend the
subcommittee for reopening this dialogue.
The study conducted by the Treasury and its report issued
on October 25, 1999, copies of which have been made available
to the members of the subcommittee, was mandated by the IRS
Restructuring Reform Act of 1998. The study was to review the
administration and implementation of the penalty and interest
provisions and make appropriate legislative and administrative
recommendations. In developing our report, we solicited,
received and studied comments from the general public and
consulted closely with the IRS.
In July 1999, we issued a white paper that made a number of
recommendations, including those with respect to penalties on
the issue of corporate tax shelters. Those recommendations were
incorporated by reference into our October study and were the
subject of a full committee hearing in November. I will not
discuss these issues further today.
The staff of the Joint Committee and the National Taxpayer
Advocate in his annual report to Congress also have conducted
similar studies and have similarly made recommendations
regarding the penalty and interest provisions of the code.
Although there are differences amongst these recommendations,
these differences are a matter of degree and there is general
agreement on the importance of the role of penalties and
interest in our system.
For the sake of brevity, I will not repeat all of the
materials in the Treasury study. Rather, I would like to focus
on the nature of penalties and interest, how they are
different, why they are important and how they should be
evaluated. I would like to sum up by pointing to some of the
more important recommendations we make in our study.
With respect to penalties, in general, our income tax
system is one of self-assessment that imposes three principal
requirements on taxpayers: Timely-filed returns, to report the
correct amount of tax owed, and to timely pay the amount due
and owing. The penalty regime acts as an inducement for
compliance with these requirements by providing sanctions for
noncompliance.
There are over 100 civil and criminal penalty internal
revenue codes. Our study focuses on certain principle penalties
which account for the majority of assessments and abatements
for which we receive the most comments and which affect the
largest number of taxpayers. These penalties are the failure to
file, the failure to pay the estimated tax penalties, the
accuracy-related penalties, and the deposit penalties. In
evaluating these and other penalties, we are mindful that
achieving a fair and effective tax system of compliance
requires striking a balance that fosters and maintains the
current high degree of voluntary compliance amongst the vast
majority of taxpayers, encourages taxpayers who are not
compliant to quickly resolve their noncompliance problems with
the IRS, and imposes an adequate system of sanctions that are
fair to taxpayers whose noncompliance may be due to diverse
causes that involve different degrees of culpability, but do
not impose substantial additional burdens or complexities upon
either taxpayers or the IRS.
Achieving such a balance is difficult because a system of
sanctions that accounts for these differences may be complex,
while a system that does not adequately make distinctions may
be viewed as unfair. At the same time, compliant taxpayers, who
make up the great majority of all taxpayers, deserve a tax
system that recognizes their compliance. There is no perfect
system for sanctions, and striking the appropriate balance
involves trade-offs amongst competing concerns. We believe our
study and the recommendations therein strike the proper balance
among these competing concerns.
With respect to interest, we have examined the respective
roles of interest and penalties in our tax system with a view
toward manipulating an appropriate distinction between the two:
Penalties or sanctions for noncompliant behavior, while
interest is a charge for the use or forbearance of money.
Treasury recognizes that taxpayers sometimes view interest as a
penalty, and the Internal Revenue Code in certain sections
blurs the distinction between the two. However, recognizing the
difference between interest and penalties is an important
element in crafting legislation and regulations that impose and
abate interest and penalty charges.
Penalty provisions should be designed to influence
compliant behavior. Interest provisions should be designed to
make parties, both taxpayers and the government, whole with
respect to overpayments and underpayments of tax. Penalties
generally can be abated for reasonable cause and other
statutorily-prescribed reasons that reflect their function as a
sanction. By contrast, the grounds for abatement of interest
are more properly narrowly drawn.
Even though one can easily distinguish between interest and
penalties, determining the proper rate of interest is sometimes
difficult. Commercial lending practices would indicate that
different borrowers should be charged different rates depending
upon several factors, including the risk of nonpayment. In
addition, lenders typically lend at higher rates than they
borrow. With respect to taxes, the Federal Government is maybe
viewed as an involuntary lender and often a lender of last
resort. The uniqueness of this role and the need for interest
provisions that are administerial may lead one to craft
interest provisions that deviate from the normal commercial
lending practices.
With respect to our specific recommendations, I would like
to highlight just a few. Under current law, the penalties for
failure to file and failure to pay are coordinated and applied
at a combined 5 percent per month charge for unpaid taxes over
the first five months. Treasury recommends uncoupling these two
provisions and restructuring them. The current front-loading of
the failure-to-pay penalty under current law and the first five
months delinquency does not provide a continuing incentive to
correct filing failures and imposes additional financial
hardships upon taxpayers. The failure-to-pay penalties should
provide appropriate incentives for taxpayers to correct the
payment delinquency and, if necessary, make arrangements for
payments under various programs such as the installment program
that the IRS makes available.
We believe that the estimated tax penalties should remain a
penalty, but there are three principal simplification matters
that we would propose. First, individuals should not be subject
to estimated tax penalties if the balance due on the returns is
less than $1,000; a reasonable cause waiver from penalties
should be applied to first-time offenders; and penalty waivers
should be provided automatically for certain de minimis
amounts.
The backbone of our Federal income tax payment system has
been the employer withholding and the deposit of FICA and
income taxes from wages and salaries of employees. Penalties
ranging from 2 to 10 percent apply to deposits made anywhere
from one to 16 days late. Treasury recommends no immediate
changes to these provisions. However, we do believe that the 10
percent penalty for failure to use the correct deposit method
should be reduced. This type of error certainly does not
deserve a 10 percent penalty.
We also recommend that in cases where depositors miss a
deposit deadline by only one banking day, an interest charge
rather than a 2 percent penalty be applied.
Finally, with respect to the interest provisions, we
continue to believe that the underpayment interest rate should
be a uniform rate determined by the appropriate market's rates
of interest. The existing differentials applicable to
corporations we believe have policy undertakings and should be
retained.
Mr. Chairman, there are a lot of provisions contained in
our report, many of which I have not gone through. But in
conclusion, we strongly support a penalty and interest regime
that fosters and maintains the current high level of
compliance, provides appropriate costs and sanctions for
noncompliance, and provides a reasonable and administrable
degree of latitude for individual taxpayer circumstances and
errors. We believe that the proposals made in our report strike
this appropriate balance. We look forward to working with you,
Mr. Chairman, and members of the subcommittee and full
committee in further developing these and any other legislative
proposals in this area.
I would be pleased to respond to any questions you may
later have.
[The prepared statement follows:]
[An attachment is being retained in the Committee files:]
STATEMENT OF JOSEPH MIKRUT, TAX LEGISLATIVE COUNSEL,
U.S. DEPARTMENT OF THE TREASURY
Mr. Chairman, Ranking Member Coyne, and distinguished Members
of the Subcommittee:
I appreciate the opportunity to discuss with you today the
Department of Treasury's study and recommendations with respect
to the penalty and interest provisions of the Internal Revenue
Code of 1986.
The study conducted by Treasury and its report issued on
October 25, 1999 were mandated by the Section 3801 of the
Internal Revenue Service Restructuring and Reform Act of 1998
(RRA98). The study was to review the administration and
implementation of those provisions and make appropriate
legislative and administrative recommendations. On July 1,
1999, the Treasury Department issued The Problem of Corporate
Tax Shelters: Discussion, Analysis, and Legislative Proposals,
a white paper that made a number of recommendations, including
with respect to certain penalties, to address the problem of
corporate tax shelters. Those recommendations were incorporated
by reference into the October penalty and interest report, and
were the subject of a hearing in November in the full
Committee.
In General
As stated in its report, Treasury focused its penalty and
interest study on the principal civil penalty provisions that
affect large numbers of taxpayers and account for the majority
of penalty assessments and abatements. In evaluating these
penalties, Treasury was mindful that achieving a fair and
effective system of compliance involves striking a balance that
(i) fosters and maintains the high degree of voluntary
compliance among the vast majority of taxpayers, (ii)
encourages taxpayers who are not compliant to expeditiously
resolve noncompliance problems with the IRS, and (iii) imposes
an adequate system of sanctions that are fair to taxpayers
whose noncompliance may be due to diverse causes that involve
different degrees of culpability, but do not impose substantial
additional complexity or burden. Achieving such a balance is
inherently difficult because a system of sanctions that is
calibrated to account for these differences may be complex, but
a system that does not make adequate distinctions may be
unfair. There is no perfect system of sanctions and striking
the appropriate balance inherently involves tradeoffs among
competing concerns. The issue of penalties is one that often
strikes an emotional chord, particularly with respect to
penalties with their attendant normative overtones. At the same
time, compliant taxpayers -the vast majority of taxpayers--
deserve a tax system that recognizes their compliance. Although
a penalty regime should not be overly harsh to noncompliant
taxpayers whose noncompliance may not reflect deliberate
flouting of the tax laws, it is equally true that the currently
high compliance level should not be discouraged. Treasury's
study and recommendations reflect an effort to strike a
reasonable balance, understanding that there is no single
solution and different approaches can be formulated to achieve
the same goals.
Treasury also examined the respective roles of penalties
and interest in our tax system, with a view toward maintaining
an appropriate distinction between penalties as sanctions for
noncompliant conduct and interest as a charge for the use or
forbearance of money. Treasury recognizes that current law does
not always make a clear or consistent distinction between
interest and penalties, but believes that this distinction is
important both with respect to taxpayer perception of the
amounts they are required to pay and the underlying reasons for
the imposition, the desired deterrent effects, and the
corollary consequences of the characterization of the payment.
The distinction between penalties and interest has particular
consequence for the statutory provisions that permit abatement
of those impositions. Penalties generally can be abated for
reasonable cause and other statutorily-prescribed reasons that
reflect their function as a sanction, that is, as a deterrent
to noncompliant conduct. By contrast, the grounds for abatement
of interest traditionally have been more narrowly drawn because
interest is a charge for the use or forbearance of money. To
the extent that current-law penalties are converted to interest
charges or interest becomes a more dominant mechanism for
dealing with arrears in payment, important corollary
consequences, such as interest deductibility or interest
abatement provisions, must be considered. In general,
Treasury's position is that interest should remain principally
a charge for the use or forbearance of money and should be set
at a rate that approximates market rates. Although there are
penalties in the Code that have attributes of an interest
charge and whose legislative origins support that
characterization, these penalties also function as sanctions.
Treasury is particularly concerned that conversion of certain
penalties to interest, even if supportable on analytical
grounds, may involve a correlative blurring of the distinctions
that have been drawn in the Code between penalty and interest
abatement provisions. If that distinction is blurred, it may
cause further confusion among taxpayers regarding the
distinction between penalties and interest.
Treasury also is mindful of the ongoing IRS reorganization
and implementation aspects of the new taxpayer right provisions
of RRA 1998. Considerable guidance has been issued by Treasury
in the past year relating to a number of these new provisions
and the IRS is engaged in a major overhaul of its structure and
systems as directed by Congress. Time is required for the
impact of these new provisions to be evaluated and certain of
the new provisions affect IRS programs, such as the offer-in-
compromise program, that provide avenues other than abatement
for relief from monetary impositions.
Specific Recommendations
In its report, Treasury made a number of specific
legislative recommendations, which are described below.
Penalties for Failure to File and Failure to Pay
Treasury recommends that the failure to file and failure to
pay penalties be restructured to eliminate the frontloading of
the failure to file penalty and to impose a higher failure to
pay penalty than under current law. The frontloading of the
failure to file penalty under current law in the first five
months of a filing delinquency does not provide a continuing
incentive to correct filing failures and imposes additional
financial burden on taxpayers whose filing lapse may be coupled
with payment difficulties so as to impede compliance. The
filing obligation is of paramount importance to the tax system,
but imposition of a severe penalty in the first five months of
a filing delinquency appears incongruent with the availability
of automatic extensions of time to file. Treasury proposes,
accordingly, that the failure to file penalty be restructured
to impose a lower penalty rate over a longer period of time, up
to the current-law maximum amount. The current-law higher
penalty for fraudulent failures to file, however, would be
maintained. This proposal would maintain a failure to file
penalty to encourage timely filing, but not impose as
significant a financial burden as under current law for a
filing lapse of short duration, while providing a continuing
incentive for delinquent filers to correct a filing lapse of
longer duration.
The failure to pay penalty should provide appropriate
incentives to taxpayers to correct a payment delinquency and,
if necessary, arrange for payment under various payment
programs that the IRS makes available. A taxpayer who fails to
make such arrangements in a timely manner should be subject to
a higher penalty rate than that provided under current law.
Treasury proposes, accordingly, that the failure to pay penalty
be restructured to accomplish these purposes by imposing a
penalty at the current rate of 0.5 percent per month for the
first six months of a payment delinquency. The penalty rate
would be raised to one percent per month for continuing payment
delinquencies after the sixth month to provide an additional
incentive to pay an outstanding tax liability. As under current
law, the maximum penalty would be 25 percent. These penalty
rates would be reduced if taxpayers make, and adhere to,
arrangements with the IRS for payment. The failure to pay
penalty would not be coordinated, as under current law, with
the failure to file penalty to recognize that each form of
delinquency is a separate act of noncompliance. More
specifically, these recommendations would:
(1) Restructure the failure to file penalty to impose a
penalty of 0.5 percent per month of the net amount due for the
first six months of a delinquency in filing tax returns, which
penalty rate will be increased to one percent per month
thereafter, up to a maximum 25 percent. This restructured
penalty would eliminate the current-law frontloading of the
penalty into the first five months of a filing delinquency,
providing a continuing incentive for delinquent filers to
correct their filing delinquency over longer periods of time.
The maximum penalty of 25 percent is the same as under current
law. As under current law, fraudulent failures to file would be
penalized at a higher penalty rate of 15 percent per month, up
to a maximum of 75 percent.
(2) Restructure the failure to pay penalty to impose a
penalty of 0.5 percent per month of the net amount due for the
first six months of a payment delinquency, which rate would be
increased to one percent per month thereafter, up to a maximum
25 percent. The penalty rate would be decreased from 0.5
percent to 0.25 percent per month if the taxpayer, within six
months, enters into a payment arrangement with the IRS to which
the taxpayer adheres. Likewise, the one-percent penalty rate
would be reduced to 0.5 percent if the taxpayer, after the
lapse of six months, enters into a payment arrangement with the
IRS to which the taxpayer adheres.
Treasury also recommends that consideration be given to
charging a fee, in the nature of a service charge, for late
filing of ``refund due'' or ``zero balance'' returns.
Presently, the failure to file penalty is imposed if a balance
is due with the return but is not imposed if tax is not owed as
a result, for example, of overwithholding. The importance of
the filing obligation and the IRS administrative costs
associated with nonfiling may warrant imposition of a fee for
late-filed returns to encourage timely filing even if no
balance is due with the return, at least after the IRS has
contacted the nonfiling taxpayer.
Consideration also can be given to permitting the IRS to
utilize a fixed interest rate for installment agreements to
avoid the incurrence by a taxpayer who has made the required
installment payments of a balloon payment at the end of the
agreement.
Penalties for Failure to Pay Estimated Tax
Treasury recommends that the current-law addition to tax
for failure to pay estimated tax remain treated as a penalty.
Treasury recognizes that the current sanction has attributes of
interest and of a penalty. The ancillary effects, however, of
converting the sanction to an interest charge do not warrant
such a change. Conversion to an interest charge may mean that
existing statutory waiver provisions are inappropriate.
Conversion to interest also would permit corporations to deduct
the payment of such sanction.
In recognition, however, of the potentially cumbersome
nature of complying with the estimated tax payment
requirements, the following simplifying changes are recommended
for consideration:
(1) Individuals should not be subject to estimated tax
penalties if the balance due with their returns is less than
$1,000. Thus, estimated tax payments should be included in the
calculation of the $1,000 threshold, but Treasury recommends
this change under a simplified averaging method that would
preclude taxpayers from satisfying the threshold by
concentrating estimated tax payments in later installments.
(2) A reasonable cause waiver from penalty should be
permitted for individuals who are first-time estimated
taxpayers, provided the balance due on the tax return is below
a threshold amount and is paid with a timely filed return.
(3) Penalty waiver should be provided for individual
estimated tax penalties below a de minimis amount, in the range
of $10 to $20.
Penalty for Failure to Deposit
Treasury recommends that few immediate changes be made to
the deposit rules or penalties at this time to provide a
sufficient period of time for changes to the deposit rules
enacted by RRA 1998 to take effect. However, the penalty for
failure to use the correct deposit method should be reduced..
The current-law 10-percent penalty is too severe for this type
of error.
Treasury also recommends that, in cases where depositors
miss a deposit deadline by only one banking day, consideration
be given to a reduction in the current penalty rate of two
percent to a lower amount, but above an interest charge for a
one-day delay.
Accuracy-Related and Preparer Penalties
The minimum accuracy standards, for disclosed and
nondisclosed tax return positions, should be modified to impose
the same standards on taxpayers and tax return preparers. A
significant proportion of taxpayers rely on paid preparers.
Such professionals have dual responsibilities to their client/
taxpayers and to the integrity of the tax system and should be
expected to be knowledgeable and diligent in applying the
Federal tax laws.
The minimum accuracy standards should be raised to require
a ``realistic possibility of success on the merits'' for a
disclosed tax return position and ``substantial authority'' for
an undisclosed return position. The standards for tax shelter
items of noncorporate taxpayers should be higher. In the case
of disclosed positions, substantial authority and a reasonable
and good faith belief that the position had a ``more likely
than not'' chance of success should be required. For
undisclosed positions, substantial authority should be
accompanied by a reasonable and good faith belief based upon a
higher standard of accuracy than the ``more likely than not''
chance of success standard. The proposed changes in the
accuracy standards would reduce the number of accuracy
standards, impose minimum standards that are higher than
current law litigating standards to discourage aggressive tax
reporting, and eliminate divergence between the standards
applicable to taxpayers and tax preparers.
Treasury further recommends consideration of better
harmonization of the substantial understatement and negligence
penalties. In many cases, the standards applicable to the
substantial understatement penalty may subsume the negligence
standards. It may be appropriate to consider whether the
negligence penalty should relate only to understatements that
do not satisfy the ``substantiality'' requirement.
In determining the amount of the preparer penalty,
consideration should be given to a fee-based or other approach
to more closely correlate the preparer penalty to the amount of
the underlying understatement of tax, rather than the current-
law flat dollar penalty amount.
Finally, Treasury also recommends enactment of the
Administration's Budget proposals that would address penalties
applicable to corporate tax shelters and the determination of
``substantiality'' for large corporate underpayments.
Penalty for Filing a Frivolous Return
The current-law penalty for filing a frivolous tax return
should be raised from $500 to $1,500, but the IRS should abate
the penalty for a first-time occurrence if a nonfrivolous
return is filed within a reasonable period of time. This
penalty amount was last raised in 1982 and significant numbers
of such penalties are assessed. This approach will help bring
taxpayers who file frivolous returns into better compliance.
Failures to File Certain Information Returns With Respect to
Employee Benefit Plans
Several penalties currently apply to a qualified retirement
plan's failure to file IRS Form 5500. These penalties should be
consolidated into a single penalty not in excess of a monetary
amount per day and not to exceed a monetary cap per return.
This penalty would be waived upon a showing of reasonable
cause. Welfare and fringe benefit plans should be subject to a
similar single penalty.
Penalty and Interest Abatement
Interest Abatement
Abatement of interest in situations where taxpayers have
reasonably relied on erroneous written advice of IRS personnel
should be available. Treasury does not recommend further
legislative expansion of the provisions permitting abatement of
interest. A distinction exists between the imposition of
interest as a charge for the use of money and penalties as
sanctions for noncompliance. Because of this distinction,
abatement of interest should be allowed in more limited
circumstances than for penalties and generally restricted to
circumstances where the IRS may be at fault or where serious
circumstances outside the taxpayer's control result in payment
delays. Current law provisions permitting abatement in
circumstances of unreasonable IRS error or delay and in certain
other prescribed circumstances provide sufficient scope for
interest abatement at this time. In addition, taxpayers have
recourse to other mechanisms for mitigation of interest and
penalties, such as the offer-in-compromise program, which are
in the early stages of implementing changes after enactment by
RRA 1998.
Consideration of any modification of the current law
monetary limitation on mandatory interest abatement in cases of
erroneous refunds should be coupled with consideration of
whether the IRS has adequate means under current law to recover
erroneous refunds. Procedural impediments exist with regard to
the recovery of erroneous refunds by assessment in all cases
and litigation is required in some circumstances.
Penalty Abatement
Other than as described above, Treasury recommends that the
IRS implement administrative improvements to ensure greater
consistency in the application of penalty abatement criteria
and enhanced quality review of penalty abatement decisions.
Interest Provisions
The underpayment interest rate (other than the ``hot
interest'' rate) should be a uniform rate determined by
appropriate market rates of interest. Treasury recognizes that
no single rate is the appropriate market rate for all taxpayers
but concludes that, for reasons of fairness and
administrability, a single rate generally should apply to
underpayments of tax. The appropriate rate should be in the
range of the Applicable Federal Rate (AFR) plus two to five
percentage points to reflect an average market rate for
unsecured loans.
The existing rate differentials between the underpayment
and overpayment rates for corporate underpayments and
overpayments, including the ``hot interest'' rate on large
corporate underpayments, should be retained. Because of the
recent enactment of global interest netting rules, it is
premature to eliminate existing rate differentials.
Treasury does not support an exclusion from income for
overpayment interest paid to individuals. The legislative
policy precluding deductions of consumer interest does not
warrant such a change.
Conclusion
Treasury strongly supports a penalty and interest regime
that fosters and maintains the current high level of
compliance, provides appropriate costs and sanctions for
noncompliance, and provides a reasonable and administrable
degree of latitude for individual taxpayer circumstances and
errors.
The proposals made in Treasury's report strike an
appropriate balance among these objectives. The failure to file
and failure to pay penalty would be restructured to provide
appropriate sanctions without undue burden on taxpayers and
with incentives for taxpayers to address payment difficulties
with the IRS expeditiously. The proposals made with regard to
estimated tax and deposit penalties are intended to address
complexity and mitigate unintentional errors while recognizing
the importance of the estimated tax and deposit rules to our
``pay-as-you-go'' tax system. The recommendations with respect
to the accuracy and preparer penalties recognize the importance
of our self-assessment system, the damage to taxpayer
perceptions of fairness as a result of overly aggressive tax
reporting by some taxpayers, and the importance of preparers
and other practitioners in protecting the integrity of the tax
system. Treasury's recommendations regarding penalty and
interest abatement preserve the distinction between penalties
and interest while providing latitude for mitigation in
appropriate circumstances. Treasury's recommendation that
current interest differentials be maintained with respect to
corporate underpayments and overpayments is grounded in
marketplace differences between borrowing and lending rates and
reducing incentives for delayed payment of large corporate
underpayments or incurrence of large corporate overpayments.
The new global interest netting rules also are in the process
of implementation and time is required to evaluate their
efficacy.
Finally, consideration of any legislative change in the
current penalty and interest regime must take into account: 1)
behavioral impact of significant change cannot be predicted
with precision; and 2) the ability of the IRS to administer the
new rules in a timely and equitable manner.
This concludes my prepared remarks. We look forward to
working with you, Mr. Chairman, and members of the Subcommittee
and full Committee in further developing these and any other
legislative proposals in this area. I would be pleased to
respond to your questions.
[The attached report: ``Report to the Congress on Penalty
and Interest provisions of the Internal Revenue Code,'' Dated
October 1999, is being retained in the Committee files. The
Report can also be viewed electronically from the Treasury's
website at ``http: www.treas.gov/taxpolicy/library/
intpenal.pdf''.]
Chairman Houghton. All right. Thank you very much, Mr.
Mikrut.
Before we have the questions, I think we ought to hear
everyone here.
Ms. Paull, would you like to testify?
STATEMENT OF LINDY PAULL, CHIEF OF STAFF, JOINT COMMITTEE ON
TAXATION
Ms. Paull. Thank you, Mr. Chairman and Mr. Coyne and
members of the committee. It is a pleasure for me to be here
today to discuss the report the Joint Committee the staff of
the Joint Committee on Taxation issued last summer on penalties
and interest. I have a statement, a written statement for the
record, and I would just simply like to briefly summarize the
major recommendations in our reports relating to penalties and
interests that don't relate to corporate tax shelters. The
committee held a corporate tax shelter hearing at the end of
last session at which we presented those recommendations.
With respect to interest, we have an assortment of
recommendations. The first recommendation that we would make is
to have a single interest rate for underpayments, overpayments,
for all taxpayers, and our recommendation, based on a balancing
of a variety of factors, would be to set that interest rate at
a short term applicable Federal rate, plus 5 percent.
We also recommended that interest paid by the Federal
Government to individual taxpayers in the interest of fairness
should not be includable in income. Under the present law,
individual taxpayers do not get a tax deduction for interest
paid to the Federal Government with respect to their tax
liabilities.
In addition, we recommend that the IRS be given expanded
authority to abate interest. Right now the authority to abate
interest is very, very narrow. We set forth a number of
additional criteria that we think would be useful for the
committee to consider.
We would recommend that the authority to abate interest be
expanded to cover any unreasonable error or delay caused by the
IRS, not just administerial or managerial acts. We also would
recommend that the authority to abate interest be expanded to
cover any erroneous refund, so long as the taxpayer did not
cause that erroneous refund to be issued, not just those
refunds that are under $50,000 or less, as under current law.
We would also recommend that authority to abate interest be
expanded when the taxpayer has reasonably relied on written IRS
court statements, and those written IRS statements cause the
underpayment of tax. We also have a recommendation with respect
to somewhat of a catchall. Itis very difficult to foresee every
circumstance that occurs, but there could be circumstances
where the imposition of interest would cause a gross injustice.
In addition, we recommended that the estimated tax penalty
be converted into an interest charge instead of a penalty, and
also we made some specific recommendations on how to simplify
the computation of the estimated tax payments, the interest
charge on the estimated taxes that are underpaid.
We recommend the complete elimination of the failure to pay
penalty for a number of reasons. If you were to get the
interest charge correct or closer to maybe some prevailing
rates would be, you would not need this penalty. It is somewhat
of a duplication of interest. In addition, the penalty in the
instance of when taxpayers have come forward and indicated how
much they owe, but are unable to pay it and want to enter into
an installment agreement, we would recommend some changes to
encourage more quickly getting into those installment
agreements. Therefore, in lieu of the failure-to-pay penalty,
we recommend that a 50 percent annual late charge be put in
place at the appropriate time. Our recommendation was four
months from the filing of a return, or the assessment of a tax.
That recommendation was based on the normal extensions for the
automatic extensions for filing tax returns, but we are
flexible on that period.
The final recommendation we have on the interest side is to
recommend that the IRS establish some new dispute reserve
account whereby a taxpayer can deposit money while in dispute
with the IRS. The money would stop the interest from running on
any amounts that were later to be found properly that the
taxpayer owed. If the taxpayer was correct and did not, in
fact,--the taxpayer's position was correct and did not, in
fact, owe the interest--I mean the taxes, the taxpayer would
receive the money back, with interest, which is a change from
the provision under current law.
With respect to penalties, we did not make any
recommendations to change the failure-to-file penalty because
we believe it is really important to get tax returns filed as
quickly as possible; the tax returns or the starting point for
you to be able to figure your correct tax liability and all of
the administrative procedures that go with that.
With respect to the accuracy-related penalties, our
recommendation was to conform the standards for filing tax
returns, conform the standards used to report items on the tax
return for taxpayers and return preparers and, in some
instances, we would recommend those standards be increased.
With respect to the failure to deposit payroll taxes,
because the IRS Reform Act recently changed the rules, our
recommendation was to not propose a new change this quickly
after the IRS Reform Act, but to recommend monitoring of those
rules. In particular, I think we pointed out that when a
taxpayer moves from one time period to another, whether it is
moving from quarterly deposits to monthly deposits to twice a
week to the next business day, when you trip through those time
frames or you go back and forth through those time frames, that
can cause some difficulties. Certainly there is a--you know,
the taxpayer can come forward with a reasonable cause to try to
get out of the penalty, but that is the area that we thought
needed to be monitored and some additional time being focused
on over the next few years.
Finally, we have a few smaller proposals with respect to
the returns that are filed by pension plans and tax-exempt
organizations. With that, I will just end and say that we would
be willing to work with the subcommittee to come up with
whatever recommendations you feel is appropriate, and we
welcome the opportunity to appear before you today.
[The prepared statement follows:]
STATEMENT OF LINDY PAULL, CHIEF OF STAFF,
JOINT COMMITTEE ON TAXATION
My name is Lindy Paull. As Chief of Staff of the Joint
Committee on Taxation, it is my pleasure to present the written
testimony of the staff of the Joint Committee on Taxation (the
``Joint Committee staff'') at this hearing concerning tax
penalties and interest before the Subcommittee on Oversight of
the House Committee on Ways and Means.\1\
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\1\ This testimony may be cited as follows: Joint Committee on
Taxation, Testimony of the Staff of the Joint Committee on Taxation
Before the Subcommittee on Oversight of the House Committee on Ways and
Means, January 27, 2000 (JCX-2-00), January 26, 2000.
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A. Background
Section 3801 of the Internal Revenue Service Restructuring
and Reform Act of 1998 (the ``IRS Reform Act'') directed the
Joint Committee on Taxation and the Secretary of the Treasury
to conduct separate studies of the present-law interest and
penalty provisions of the Internal Revenue Code (the ``Code'')
and to make any legislative or administrative recommendations
they deem appropriate to simplify penalty and interest
administration or reduce taxpayer burden. The studies were
required to be submitted to the House Committee on Ways and
Means and the Senate Committee on Finance by July 22, 1999.
In responding to this legislative mandate, the Joint
Committee staff undertook an extensive study of the present-law
system of penalties and interest. The Joint Committee staff
reviewed each of the penalty and interest provisions in the
Code. The Joint Committee staff economists analyzed the
economic considerations that affect taxpayers' decisions with
respect to compliance and the Federal government's decisions in
setting enforcement parameters, including penalties. The Joint
Committee staff met with representatives of the Department of
the Treasury (the ``Treasury'') and the Internal Revenue
Service (the ``IRS''), requested the General Accounting Office
to investigate IRS practices regarding penalties and interest
and, with the assistance of the Library of Congress, reviewed
penalty and interest regimes in other countries. The Joint
Committee staff solicited comments from taxpayers, tax
practitioners, tax clinics serving low-income individuals, and
other interested parties, and met with representatives of major
taxpayer groups and professional organizations to discuss their
comments.
The Joint Committee staff study \2\ includes a variety of
recommendations to modify the present-law system of penalties
and interest. These recommendations are designed to improve the
overall administration of penalties and interest and to provide
consistency in application with respect to similarly situated
taxpayers.
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\2\ Joint Committee on Taxation, Study of Present-Law Penalty and
Interest Provisions as Required by Section 3801 of the Internal Revenue
Service Restructuring and Reform Act of 1998 (including Provisions
Relating to Corporate Tax Shelters) (JCS-3-99), July 22, 1999 (the
``Joint Committee staff study'').
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B. Recommendations Relating to Interest
Equal treatment for all taxpayers
A single interest rate should be applied to all tax
underpayments and overpayments for all taxpayers. The single
interest rate should be set at the short-term applicable
federal rate plus five percentage points (``AFR+5'').
The Joint Committee staff recommendation is based on the
concept that the Federal government and taxpayers, to the
greatest extent possible, should be treated equally in the
payment of interest. Equal treatment of interest would enhance
perceptions of fairness and would simplify interest
computations in situations involving overpayments and
underpayments during overlapping periods of time. To achieve
equal treatment, the same rate of interest should apply to
payments by a taxpayer to the Federal government and to
payments by the Federal government to a taxpayer, irrespective
of whether the taxpayer is an individual or corporation, and
without regard to the amount of the underpayment or overpayment
of tax.
Present law does not embody this concept of equality.
Corporations are required to pay higher interest rates on
underpayments than the interest rates received on overpayments.
Under certain circumstances, the rate of interest paid by a
corporation on a large underpayment is four and one-half
percentage points higher than the interest rate that would be
paid by the Federal government on a large overpayment.\3\
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\3\ The current interest rate for a large corporate underpayment is
10 percent (so-called ``hot'' interest), compared with 5.5 percent paid
by the Federal government on a large corporate overpayment (so-called
``cold'' interest). Rev. Rul. 99-53, 1999-50 I.R.B. 657 (December 13,
1999).
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The IRS Reform Act moved toward equal treatment with
respect to interest by requiring that the same rate of interest
apply to underpayments and overpayments of individual
taxpayers. The IRS Reform Act also provided a net interest rate
of zero for interest payable by and allowable to a taxpayer on
equivalent amounts of underpayments and overpayments for the
same period. However, the implementation of the zero net
interest rate is expected to be complicated. The legislative
history to the 1998 Act recognizes that implementation of the
zero net interest rate may be dependent on taxpayer initiative
while the IRS develops procedures for the automatic application
of the zero net interest rate. The Joint Committee staff
recommendation to apply a single interest rate to underpayments
and overpayments of all taxpayers would eliminate most of the
implementation issues for taxpayers and the IRS.
Equal treatment of interest for an individual taxpayer
should be accomplished by excluding from income interest paid
to an individual taxpayer on an overpayment of tax.
Interest paid by the Federal government to a taxpayer
should be treated for federal income tax purposes in the same
manner as interest paid by a taxpayer to the Federal
government. Under present law, individual taxpayers are
required to include in gross income interest received from the
Federal government, but they are not allowed to deduct interest
paid to the Federal government.\4\ This inequality in treatment
may cause individual taxpayers to believe that the federal
income tax laws are not fair.
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\4\ This disparity in treatment does not exist for corporations.
Under present law, corporations generally are allowed to deduct
interest paid to the Federal government and interest received from the
Federal government is included in gross income.
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Prior to 1987, interest paid by an individual was generally
deductible so long as it was not incurred as a cost of carrying
tax-exempt bonds. However, as part of an effort to eliminate
the deduction of various personal expenses, the Tax Reform Act
of 1986 made most types of personal interest nondeductible.
Treasury regulations take the position that nondeductible
personal interest includes interest paid on underpayments of
federal income tax, regardless of the source of the income
generating the tax liability.\5\
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\5\ Treas. Reg. sec. 1.163-9T(b)(2).
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It is noteworthy that no deduction is allowed under the
Treasury regulations even if the interest relates to a
deficiency in tax on business activities. Other interest
incurred in the course of operating a business generally is
deductible. The Tax Court has held the regulation position to
be unreasonable, and therefore invalid.\6\ However, the U.S.
Courts of Appeals have consistently upheld the validity of the
regulation,\7\ although these courts have expressed some
reservations as to its wisdom.
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\6\ Redlark v. Commissioner, 106 T.C. 31 (1996), rev'd 141 F. 3d
936 (9th Cir., 1998).
\7\ The validity of the temporary regulation has been upheld in
those Circuits that have considered the issue, including the Fourth,
Sixth, Seventh, Eighth, and Ninth Circuits.
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The Joint Committee recommends excluding interest paid to
an individual on an overpayment of tax to eliminate the
inequality in treatment of individual taxpayers and the Federal
government. Equal treatment of taxpayers and the IRS can be
achieved so long as interest is either included and deductible,
or excluded and nondeductible. Allowing individual taxpayers to
exclude interest on overpayments, rather than deduct interest
on underpayments, insures that individual taxpayers will be
treated equally, whether or not they itemize deductions.
Abatement of interest
Under present law, the Secretary of the Treasury is
authorized to abate interest in limited instances. Such
circumstances include an unreasonable delay by the IRS in the
performance of a managerial or ministerial act, a failure by
the IRS to contact an individual taxpayer in a timely manner,
an erroneous refund by the IRS of $50,000 or less, and during
periods when the taxpayer is serving in a combat zone or is
located in a designated disaster area.
Numerous situations arise in which the resolution of a
taxpayer's case has been delayed as a result of events arising
in their dealings with the IRS. By allowing for interest
abatement only in specific situations that rarely occur,
present law ties the hands of the IRS and prevents it from
assisting taxpayers by abating the interest that accumulates
during such delays. Thus, the circumstances in which the
Secretary of the Treasury is authorized to abate interest
should be expanded to cover additional situations where the
collection of interest from the taxpayer is inappropriate.
The Secretary of the Treasury should be authorized to abate
interest that is attributable to unreasonable IRS errors or
delays, whether or not related to managerial or ministerial
acts.
It is not appropriate to require taxpayers to pay interest
for periods when the sole reason the taxpayer's case was not
resolved in a timely manner relates to error or delay on the
part of the IRS. The present-law rule prevents abatement in
situations in which unreasonable delay on the part of the IRS
is clearly present, but the reason for the delay does not meet
the technical and limited definition of a managerial or
ministerial act or the taxpayer cannot identify the specific
act on the part of the IRS causing the delay. The present-law
rule also serves as an excuse for IRS refusals to consider the
abatement of interest. For example, a taxpayer's application
for abatement would automatically be rejected under present law
if the IRS spent excessive time due to obvious errors by a
revenue agent in interpreting and applying the tax laws, the
choice by an examining agent of which of his or her assigned
cases to handle at a point in time, or the perceived need of
the IRS to resolve other cases first.
The $50,000 limitation for abatement of interest on
erroneous refunds should be removed.
Under present law, the Secretary is required to abate
interest on erroneous refunds of $50,000 or less, provided the
taxpayer has not in any way caused the erroneous refund. The
Joint Committee staff recommends that the $50,000 limitation
should be eliminated. If the taxpayer has done nothing to cause
the erroneous refund, interest should not be charged until
after the IRS requests the return of the money.
The Secretary should be allowed to abate interest on an
underpayment if the underpayment is attributable to erroneous
advice furnished to the taxpayer in writing by an officer or
employee of the IRS acting in his or her official capacity.
Under present law, penalties and additions to tax (but not
interest) must be abated if they are attributable to erroneous
advice furnished to the taxpayer in writing by an officer or
employee of the IRS acting in his or her official capacity. A
taxpayer who follows the erroneous written advice of the IRS
should not be charged interest for following that advice.
The Secretary should be granted the authority to abate
interest if a gross injustice would result if interest is
charged.
The Secretary should not be precluded from preventing a
gross injustice solely because the particulars of a situation
have not been provided for by law. It is anticipated that this
authority would be used infrequently and only in situations in
which the taxpayer has not materially contributed to the
accrual of the interest.
Interest on disputed underpayments
Taxpayers should be allowed to establish interest-bearing
accounts within the Treasury to stop the running of interest on
taxes expected to be in dispute with the IRS.
Present law provides limited opportunities for a taxpayer
to stop the accrual of interest prior to or during an IRS
audit. A taxpayer may make a payment in the nature of a cash
bond. However, such a cash bond does not earn interest and is
ineffective to the extent the taxpayer recovers any portion of
the deposit prior to final determination of the tax liability.
Taxpayers and their representatives rarely consider this
procedure for these reasons. As a result, taxpayers incur
significant interest charges while waiting for their cases to
be resolved.
The Joint Committee staff believes that tax administration
would be benefitted by a mechanism that would allow taxpayers
to manage exposure to underpayment interest without requiring
the taxpayer to prepay tax on disputed items or to make a
potentially indefinite-term investment in a non-interest
bearing account. The Joint Committee recommends that taxpayers
should be allowed to deposit amounts in a new ``dispute reserve
account.'' A dispute reserve account would be a special
interest-bearing account within the U.S. Treasury that could be
established by a taxpayer for any type of tax that is due for
any period. Amounts could be withdrawn from a dispute reserve
account at any time, and would earn interest from the date of
deposit at a rate equal to the short term AFR. If an amount in
the dispute reserve account is applied to pay an underpayment
of tax, it is treated as a payment of tax on the original
deposit date. The dispute reserve account could be especially
helpful for lengthy audits with difficult issues or open audits
of related passthrough entities.
C. Recommendations Relating to Accuracy-Related Return Standards for
Taxpayers and Tax Preparers
The Joint Committee staff recommends (1) harmonizing the
standards for taxpayers and tax preparers applicable under the
accuracy-related penalties and (2) increasing the amount of the
return preparer penalty. The Joint Committee staff believes
that these recommendations will improve both the equity and
administrability of the accuracy-related penalty system.
Undisclosed tax return positions
The minimum standard for each undisclosed position on a tax
return should be that the taxpayer or tax preparer reasonably
believes the return position is ``more likely than not'' the
correct tax treatment under the Code.\8\
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\8\ Under the Joint Committee staff recommendations relating to
corporate tax shelters, a higher standard would apply with respect to
corporate tax shelter transactions.
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This standard, which would apply equally to taxpayers and
tax preparers, would imply that, at the time the return was
signed, there was a greater than 50 percent likelihood that all
undisclosed positions would be sustained if challenged. The
reasonable cause exception for the substantial understatement
penalty would be eliminated.
Disclosed tax return positions
The minimum standard for each disclosed position taken or
advised to be taken on a tax return should be that the taxpayer
or tax preparer has ``substantial authority'' for such
position.\9\
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\9\ Under the Joint Committee staff recommendations relating to
corporate tax shelters, a higher standard would apply with respect to
corporate tax shelter transactions. For tax shelter transactions not
involving corporations, the present-law standard of ``more likely than
not'' would continue to apply as a means to avoid an understatement
penalty with respect to disclosed positions.
This standard, which would apply equally to taxpayers and
tax preparers, would imply that, at the time the return was
signed, there was a greater than 40 percent likelihood that all
adequately disclosed positions would be sustained if
challenged.
Revise tax preparer penalty amounts
The preparer penalty should be revised to better reflect
the potential tax liabilities involved. The penalty for
understatements due to unrealistic positions should be changed
from a flat $250 to the greater of $250 or 50 percent of the
tax preparer's fee. The penalty for willful or reckless conduct
should be changed from a flat $1,000 to the greater of $1,000
or 100 percent of the preparer's fee.
The accuracy-related and tax preparer penalties are
designed to delineate (1) when an erroneous position taken on a
tax return should be considered innocent and not subject to
penalty, (2) when taxpayers should specifically notify the IRS
that they are adopting controversial positions, and (3) when
taxpayers are taking unduly aggressive positions and should be
penalized for any resulting tax deficiency regardless of
disclosure. The flat $250 penalty of present law, for example,
may have little deterrent effect if the tax preparer's fee is
many times that amount.
Discussion of accuracy-related standards
Because federal tax law is complex and constantly evolving,
it is unrealistic to expect taxpayers to file ``perfect''
returns, on which every position taken is unquestionably
correct. Still, the U.S. Supreme Court has pointed out that
``self assessment. . .is the basis of our American scheme of
income taxation.'' \10\ Self assessment requires a high degree
of cooperation from the taxpayer to file an accurate tax
return. A self-assessment system will work properly if
taxpayers perceive the system to be fair and believe that the
costs of noncompliance outweigh the benefits of such
noncompliance.
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\10\ Commissioner of Internal Revenue v. Lane Wells Co., 321 U.S.
219, 223 (1944).
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Under present law, a taxpayer is not subject to an
accuracy-related penalty for an undisclosed improper return
position provided there is ``substantial authority'' for the
position. The regulations describe substantial authority in
terms of a spectrum,\11\ with most practitioners assuming
substantial authority implies a 40-percent chance of success if
challenged by the IRS. In assessing whether a position is
supported by substantial authority, certain specified sources
of authority may be consulted.
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\11\ Treas. Reg. sec. 1.6662-4(d)(2).
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Under present law, a taxpayer is not subject to the
substantial understatement penalty for a disclosed improper
return position provided there is a ``reasonable basis'' for
the position. Most practitioners assume a reasonable basis
exists for a position if there is at least a 20 percent
likelihood of success if challenged by the IRS.
However, under present law, tax preparers are held to lower
standards than taxpayers. For nondisclosed return positions,
the tax preparer is not subject to the tax preparer penalty if
the return position has a ``realistic possibility of being
sustained,'' which most practitioners believe falls between
substantial authority and reasonable basis standards for
taxpayers. If a return position is disclosed, a tax preparer
need only ensure that the return position is ``not frivolous.''
The ``not frivolous'' standard has been interpreted to mean
there exists a five to ten percent chance of the return
position being successful if challenged by the IRS.
The accuracy-related penalty generally is abated if the
taxpayer can demonstrate there was a ``reasonable cause'' for
the underpayment. Generally, if the taxpayer relies in good
faith on the advice of a tax professional, the taxpayer would
satisfy the reasonable cause requirement. Thus, the standards
for taxpayers and tax preparers are interrelated and it is
inappropriate for tax preparers to be held to a lower standard
than taxpayers.
These present-law standards for imposition of accuracy-
related penalties on taxpayers and return preparers arguably
permit taxpayers to take positions on tax returns that have an
inappropriately low chance of success if challenged by the IRS.
These low standards have the effect of increasing perceptions
of unfairness in our tax system because taxpayers who take
aggressive positions on their returns and their advisors are
unlikely to be penalized. If taxpayers and preparers are not
held to standards which require them to believe information
reported on tax returns is in fact correct, the IRS will have
the impossible task of examining greater percentages of returns
in order to maintain the fairness of our tax system.
D. Recommendations Relating to the Penalty for Failure to Pay Taxes
The failure to pay taxes penalty should be repealed.
Interest would continue to apply to the underpaid amount, but
at the single rate of AFR+5 discussed above. An annual late
payment service charge would also apply to taxpayers who have
not paid their taxes or have not entered into installment
agreements in a timely manner.
Under the Joint Committee staff recommendation, the failure
to pay taxes penalty would be repealed and taxpayers would be
given four months after assessment \12\ in which to pay their
tax obligations and be charged interest only. At the end of
that four-month period, if the taxpayer still has not fully
paid the taxpayer's tax obligation, or entered into an
installment agreement to pay such obligation, the taxpayer
would be charged an annual 5-percent late payment service
charge on the remaining outstanding balance. This service
charge would be similar to late payment charges that are widely
imposed in the private sector. Thus, taxpayers would easily
understand the purpose of the charge--to encourage timely
payment. To avoid the service charge, taxpayers would have a
strong incentive to enter into an installment agreement in a
timely fashion, rather than waiting for a long period of time
and letting interest continue to mount without making further
payments. The repeal of the penalty for failure to pay taxes
and its replacement with the service charge would further a
policy initiative to encourage the use of installment
agreements that was begun by the IRS Reform Act, which reduced
this penalty for taxpayers who enter into installment
agreements.\13\
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\12\ This provision would apply to self-assessments (amounts shown
on an original return but not paid with that return) as well as
assessments later made by the IRS.
\13\ Code sec. 6651(h).
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The late payment service charge would operate in the
following way. If a taxpayer has not entered into an
installment agreement by the fourth month after assessment, a
5-percent late payment service charge would be imposed on the
balance remaining unpaid at the end of that four-month period.
This 5-percent late payment service charge would also be
imposed each year on the anniversary of its original imposition
on the balance remaining unpaid at that anniversary date,
unless the taxpayer has entered into an installment agreement
with the IRS and has remained current on that agreement. For
example, if an individual files an income tax return on April
15, but the full amount shown as due on that return is not paid
with that return, the taxpayer must either pay the remaining
taxes or enter into an installment agreement by August 15 to
avoid paying the late payment service charge. A taxpayer could
entirely avoid this service charge, however, by entering into
an installment agreement with the IRS and remaining current on
that agreement. Abrogation of the installment agreement by the
taxpayer would result in the immediate imposition of the 5-
percent late payment service charge.
Taxpayers who enter into installment agreements and who
also agree to an automated withdrawal of each installment
payment directly from their bank account would not be required
to pay the present-law $43 fee for entering into an installment
agreement.
The elimination of the $43 user fee for installment
agreements for taxpayers who both enter into installment
agreements and who agree to use automated mechanisms, such as
automated debits from a bank account, to pay their installment
payments is designed to increase the certainty of timely
payment, simplify the payment process for taxpayers, decrease
administrative costs of collection for the IRS, and eliminate
what some taxpayers may view as a barrier to entering into an
installment agreement.\14\
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\14\ The cost to the IRS of administering these automated payment
mechanisms is less than one dollar per payment. See, Tax Notes, ``OIC,
Third-Party Contact Guidance Imminent, Ex Parte Guidance Soon,'' June
14, 1999, at 1544.
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E. Recommendations Relating to Estimated Tax Penalties
The estimated tax penalty should be repealed and replaced
with an interest charge using the single interest rate of AFR+5
discussed above. Many computational details also should be
simplified. The threshold below which individuals are not
subject to the estimated tax penalty (currently $1,000) should
be increased to $2,000 and the calculation of this threshold
would be modified to take into account certain estimated tax
payments.\15\
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\15\ In calculating the $2,000 threshold, amounts withheld (such as
income tax withholding from wages) would be taken into account as under
present law.
Approximately 12 million individuals make estimated tax
payments. Many of these individuals find that calculating the
correct amount of estimated tax payments is complex and
confusing. The Joint Committee staff recommendations would
provide significant simplification for many of these
individuals.
The Joint Committee staff recommends converting both the
individual and the corporate estimated tax penalties into
interest charges to more closely conform the titles and
descriptions of those provisions with their effect. Because
these penalties in fact are computed as an interest charge,
conforming their title to the substance of their function may
improve taxpayers' perceptions of the fairness of the tax
system. The present-law penalties are essentially a time value
of money computation which is not punitive in nature. The Joint
Committee staff also recommends that no interest on
underdeposits of estimated tax should be required for
individual taxpayers if the balance due shown on the return is
less than $2,000.\16\ This would considerably simplify the
computation of estimated tax payments and interest for many
individuals, and eliminate the need for many of these
individuals to calculate a penalty on underpayments of
estimated tax altogether.
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\16\ No interest would be charged as a result of underpaid
estimated taxes. However, if the full balance due shown on the return
is not paid with the return, taxpayers would be charged interest from
the due date of the return on the resulting underpayment.
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In addition to the recommendations to convert the present-
law estimated tax penalty into an interest provision and to
increase the threshold from $1,000 to $2,000, the Joint
Committee staff recommends making several specific changes to
the estimated tax rules that would significantly reduce
complexity in calculating the penalty for failure to pay
estimated tax.
The modified safe harbor should be repealed.
Under present law, taxpayers with an adjusted gross income
over $150,000 ($75,000 for married taxpayers filing separate
returns) who make estimated tax payments based on the prior
year's tax generally must do so based on 110 percent of the
prior year's tax.\17\ By repealing this rule, the same
estimated tax safe harbor would apply to all individual
taxpayers. Thus, to the extent that the special rule is
eliminated, the estimated tax rules would be simplified,
because all individual taxpayers would meet the estimated tax
safe harbor if they made estimated payments equal to (1) 90
percent of the tax shown on the current year's return or (2)
100 percent of the prior year's tax.
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\17\ The applicable 110 percent is modified when the prior taxable
year begins in 1998 through 2001. The applicable percentage is 105 when
the prior taxable year begins in 1998, 108.6 when the prior taxable
year begins in 1999, 110 when the prior taxable year begins in 2000,
and 112 when the prior taxable year begins in 2001.
Eliminate the need for numerous separate interest rate
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calculations.
Under present law, if interest rates change while an
estimated tax underpayment is outstanding, taxpayers are
required to make separate calculations of interest for the
periods before and after the interest rate change. The Joint
Committee staff recommends applying a single interest rate for
any given estimated tax underpayment period. This would be the
rate applicable to the first day of the quarter in which the
pertinent estimated tax payment due date arises.
The definition of ``underpayment'' should be changed to
allow existing underpayment balances to be used in underpayment
calculations for succeeding estimated tax payment periods.
Under the current estimated tax rules, underpayment
balances are not cumulative, and each underpayment must be
tracked separately in determining the penalty for underpayment
of estimated tax. Thus, each underpayment balance runs from its
respective estimated payment due date through the earlier of
the date it is paid or the following April 15th. This often
requires multiple interest calculations for each underpayment.
Under the Joint Committee staff recommendation, taxpayers would
calculate the cumulative estimated tax underpayment for each
period or quarter and apply the appropriate interest rate as of
that date. Thus, only one calculation would be needed for each
underpayment period. This change would reduce complexity in
calculating a penalty for underpayment of estimated tax by
significantly reducing the number of calculations required to
compute the penalty.
A 365-day year should be used for all estimated tax penalty
calculations.
Under current IRS procedures, taxpayers with underpayment
balances that extend between a leap year and a non-leap year
are required to make separate calculations solely to account
for the difference in the number of days during each year. By
requiring a 365-day year for all estimated tax calculations,
this extra calculation would be eliminated.
F. Other Recommendations
Pension-related penalties
The number of potential penalties for failure to file the
Form 5500 series annual return should be reduced from six to
one. The IRS should have the sole responsibility for
enforcement of the Code and ERISA reporting requirements.
This reduction in the number of potential penalties would
result from the consolidation of the ERISA and Code penalties
for failure to file an annual return, and the repeal of the
separate Code penalties for failure to file the required
schedules and plan status change notification. The IRS should
be designated as the agency responsible for enforcement of the
Code and ERISA reporting requirements applicable to pension and
deferred compensation plans, thereby reducing from three to one
the number of government agencies authorized to assess, waive,
and reduce penalties for failure to file the Form 5500 series
annual return.
Under present law, the Code and ERISA require a plan
administrator of a pension or other funded plan of deferred
compensation to file a Form 5500 series annual return with the
Secretary of the Treasury, the Department of Labor, and, for
some plans, the Pension Benefit Guaranty Corporation
(``PBGC''). For failure to file a timely and complete annual
return, the Code imposes on the plan administrator a penalty
equal to $25 per day, not to exceed $15,000 per return. In
addition, ERISA provides that both the Secretary of Labor and
the PBGC may impose on the plan administrator a penalty of up
to $1,100 per day. The Secretary of the Treasury, the Secretary
of Labor, and the PBGC may waive their respective penalties if
the plan administrator demonstrates that the failure to file is
due to reasonable cause. Separate Code penalties also apply if
administrators fail to file Schedules SSA, Schedule B, or plan
status change notification.
The separate Code and ERISA penalty provisions, and the
separate Code penalty provisions for Schedule SSA, Schedule B,
and notification of a plan status change, complicate the Form
5500 series annual return penalty structure and create the
possibility that a plan administrator may face multiple
penalties for a failure to file one return. A plan
administrator that fails to file an annual return may be
required to pay six different penalties to three different
government agencies. A plan administrator who seeks abatement
of the penalties may be required to demonstrate the existence
of reasonable cause to three different government agencies and
may receive a different determination from each agency as to
the sufficiency of the demonstration.
Penalty for failure to file annual information returns for charitable
remainder trusts
The penalty for failure to file annual trust information
returns should expressly apply to the failure of a split-
interest trust to file Form 5227. The penalty imposed on trusts
for failure to file Form 5227 should be set at amounts
comparable to the penalties imposed on tax-exempt organizations
for failure to file annual information returns.
Under present law, it is not clear that the statute
imposing a penalty for failure to file annual trust information
returns applies to a split-interest trust's failure to file
Form 5227. Form 5227, however, is critical to the enforcement
efforts of the IRS as it provides detailed information
regarding the financial activities of split-interest trusts
\18\ and possible liabilities for private foundation excise
taxes to which these trusts are subject. Increasing the penalty
imposed on trusts that fail to file required information
returns and ensuring that all relevant returns are subject to
such penalty would encourage voluntary compliance by delinquent
filers and would assist the IRS in obtaining information about
the activities of such trusts.
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\18\ Split-interest trusts are trusts in which some but not all of
the interest is held for charitable purposes. Although these trusts are
not private foundations, they are subject to some private foundation
rules.
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G. Conclusion
The Joint Committee staff recommendations on penalties and
interest are intended to increase compliance and enhance the
fairness and administrability of the federal tax laws. In many
cases, the recommendations build on the provisions of, and
policies embodied in, the IRS Reform Act. As stated in our
published study, the Joint Committee staff believes that any
legislative changes regarding penalties and interest should be
undertaken only after careful and deliberative review by the
Congress and the opportunity for input from the public, the
Treasury Department, and the IRS. This hearing is an important
step in that review process.
I thank the Subcommittee for the opportunity to present the
Joint Committee staff recommendations on penalties and interest
and I welcome the opportunity to answer any questions you may
have now or in the future.
[The attachment ``Comparison of Joint Committee Staff and
treasury Recommendations Relating to Penalty and Interest
Provision of the Internal Revenue Code,'' JCX-79-99 is being
retained in the Committee files.)
Chairman Houghton. Well, thank you. We welcome it too.
Mr. Oveson.
STATEMENT OF W. VAL OVESON, NATIONAL TAXPAYER ADVOCATE,
INTERNAL REVENUE SERVICE
Mr. Oveson. Mr. Chairman and Mr. Coyne, distinguished
Members of the committee, thank you for inviting me here today.
I am delighted to be with you to address this important topic.
I congratulate you for commissioning these studies by the Joint
Committee and the Treasury on the ongoing process of evaluating
interest and penalty issues. It certainly is not a new issue,
as pointed out in both of those reports.
Few tax administration topics generate the emotional
response from taxpayers as do penalty and interest. While most
taxpayers pay their taxes willingly, they chafe under the
strict imposition of penalties and interest assessed on
taxpayers who make mistakes on their returns, but are trying to
comply with the law. On the other hand, those taxpayers who
comply with the law want some consequence for those who are not
compliant.
Penalties are imposed to punish noncompliant taxpayers and
deter compliant taxpayers from being noncompliant, while
interest is imposed to compensate either the taxpayer or the
government for the time-value of money. Some incentives are
necessary in our system, but the incentives have become way too
complex, too burdensome, and even are contributing to
noncompliance, in my opinion. We must reexamine these
incentives.
Some research that I have seen suggests that compliance is
more a function of citizens' respect for the institution of
government and their confidence in those who are administering
the laws and is not influenced as much by civil fines and
penalties. Although more research should be done on this topic
that I have just raised, I question the underlying assumption
that compliance can be obtained through penalties alone.
Indeed, as Treasury has just mentioned, we have had an increase
in penalties from 10 to nearly over 100 in the last 10 years,
and I do not think compliance has proportionately increased, so
it has not solved the problem.
In my opinion, we are currently at the point of diminishing
returns with our penalty and interest system. These laws have
become so burdensome that they may be driving taxpayers away
from compliance rather than toward. We see many cases where
taxpayers want to comply or pay their tax and to come into full
compliance, but they cannot pay the penalties and interest
without going bankrupt or jeopardizing the funds needed to
avoid hardships, including reasonable retirement savings.
An example of this situation that we are seeing with
increasing frequency in the field involves individuals who are
partners in tax shelters. Taxpayers, as early as the 1970s, as
Chairman Houghton has already explained earlier, and up through
the 1990s, have invested in partnerships whose major, if not
only, purpose was to shelter income from tax. Litigation on
these cases has been extensive and court proceedings have been
extremely lengthy. Thus, for taxpayers who did not settle these
cases, but awaited the results of litigation, final resolution
can leave them without the ability to pay these liabilities
dating back 10 years or more and penalty and interest accruals
to match. The enormity of these liabilities has caused
taxpayers to seek assistance from any source they can. They are
coming to their congressional representatives and they are
coming to my office to seek abatement of these penalties and
interest and to have collection action suspended. Some
taxpayers have filed for bankruptcy protection.
The tax liability has been established. That is not at
issue here, and I am not talking about the underlying tax
liability. We are dealing with the question of collectibility
and fairness. We need to work to get these taxpayers back into
full compliance, particularly where they are eager to do so.
I believe that the tax shelters are an abuse of our system,
and that investors should be penalized, and that they owe
interest for the time that they use the government's money.
However, I question whether it is the function of government
through the penalty and interest laws to punish these taxpayers
to the point of insolvency when they are not able to even pay a
fraction of the liabilities.
We frequently see requests for interest abatement because
of service delays in taxpayer cases. I have raised this issue
in the past and I would like to state again that I believe that
the situations in which the Service may abate interest are too
narrow under the current law. As the study explains, the
Service may abate interest where an unreasonable delay results
from managerial and ministerial acts. I believe limiting
abatement of interest to these acts is unfair to taxpayers and
should be expanded.
I believe that for reasons of fundamental fairness, the IRS
should be permitted to abate interest whenever the Service
causes unreasonable errors or delays and the taxpayer has not
contributed significantly to those errors or delays. For
example, the Commissioner directed the temporary reassignment
of IRS examination personnel to customer service in order to
provide our 24-hour a day phone service to taxpayers. Not
unexpectedly, these personnel were taken away from their audits
and other examination work, thus delaying resolution of the
taxpayer cases. The Service may be unable to abate interest
under current law because the delay resulted from a staffing
decision. Such a decision may be a general administrative
decision for which the statute does not permit abatement. I
believe the Service should have the discretion to abate
interest in such cases where taxpayers, through no fault of
their own, bear additional financial burden because of the
Service.
In my written testimony, which I would like to be made a
part of the record, I have expressed my opinion on various
issues from both Treasury and the Joint Committee studies. For
example, I support the elimination of the failure to pay
penalty but would not impose an annual surcharge, however. I
believe the interest rate is the best vehicle to use to
discourage taxpayers from using the Treasury Department as a
bank. I agree with many of the recommendations in the study
before you and believe that if they are used as a starting
point, Congress will eventually alleviate a good deal of burden
for taxpayers. The recommendations attempt to provide better
incentives for taxpayers to comply with the law and to simplify
the penalty and interest administration where possible. For the
most part, they address the major issues that are causing
taxpayers difficulty in creating undue burdens that we are
seeing in the field.
Again, thank you for inviting me today. I am looking
forward to answering questions and the rest of the hearing.
Thank you.
[The prepared statement follows:]
STATEMENT OF W. VAL OVESON,
NATIONAL TAXPAYER ADVOCATE, INTERNAL REVENUE SERVICE
Mr. Chairman and Distinguished Members of the Subcommittee:
I am pleased to be here today to address the Subcommittee
on the subject of the penalty and interest provisions of the
Internal Revenue Code and the studies by the Joint Committee on
Taxation and the Department of the Treasury on the
implementation and administration of those provisions. I
commend Congress for commissioning the studies in the Internal
Revenue Service Restructuring and Reform Act of 1998. I would
also like to congratulate both the Joint Committee and Treasury
for such comprehensive reviews of areas in distinct need of
this kind of evaluation. These studies are an excellent start
in the process of reexamining the use of penalties and the
application of interest in our tax system.
I agree with the Joint Committee and the Treasury
Department when they caution that changes to the penalty and
interest systems should be the result of deliberative review by
Congress. Of course, all modifications to the tax laws deserve
such review, but penalties and interest are designed to provide
taxpayers with such basic incentives to comply with the law and
are so fundamental to our system of taxation that changes to
the current structure and the related consequences should be
considered carefully.
I. General Comments
Few tax administration topics generate the emotional
response from taxpayers as the imposition of penalties and the
accrual of interest on tax liabilities. Most taxpayers pay
their taxes willingly. They chafe, however, at the strict
imposition of penalties and interest when they make small
mistakes in their efforts to comply with the law. Many
taxpayers who file and pay timely and comply with the laws,
nevertheless, are concerned that there be some consequence for
those who are late and do not comply.
Penalties are supposed to function in our tax system by
punishing noncompliant taxpayers and deterring compliant
taxpayers from noncompliant behavior; interest is supposed to
compensate either taxpayers or the government for the use of
money. These incentives are necessary in our system, but there
is risk that the incentives may become too complex and the
burdens too great, which may even contribute to noncompliance.
In the penalty and interest regimes, the questions focus
for the most part on the severity of the penalties, the
applicable interest rate and how much leniency there should be
in waiving penalties or abating interest. I believe, however,
that we must re-examine what incentives our systems provide. In
fact, some research recently suggested that compliance is more
a function of the citizens' respect for the institution of
government and their confidence in those who are administering
the laws and is not influenced by civil fines and penalties as
much as we traditionally believe.\1\ Although more research
should be done on this topic, I think we need to question the
underlying assumption that compliance can be attained through
imposing penalties.
---------------------------------------------------------------------------
\1\ Tom R. Tyler, Beyond Self-Interest: Why People Obey Laws and
Accept Decisions, The Responsive Community, Fall 1998, at 44.
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In my opinion, we are currently at the point of diminishing
returns with our penalty and interest regimes. In other words,
these systems have become so burdensome that they may be
driving taxpayers toward noncompliance rather than toward
compliance. In the Taxpayer Advocate Service, we see many cases
in which a taxpayer understands why penalties and interest have
been assessed and would like to come into full compliance. In a
large number of those cases, however, the taxpayer cannot
reasonably expect to pay off their liabilities over time with
the amount of the penalties assessed and with further penalties
and interest continuing to accrue.
One of the problems taxpayers are bringing to the Taxpayer
Advocate Service with increasing frequency involves TEFRA
partnerships determined to be tax shelters. Taxpayers, as early
as the 1970s and up through the 1990s, invested in a number of
partnerships whose major, if not only, purpose was to shelter
income from tax liability. For a number of reasons, audits of
shelter cases can be quite extensive and Tax Court proceedings
fairly lengthy. Thus, for taxpayers who do not settle these
cases, but await the results of litigation, final resolution
can leave them with liabilities dating back 10 years or more
with penalty and interest accruals to match.
The enormity of these liabilities has caused taxpayers to
seek assistance from a number of sources, including their
Congressional representatives and various functional areas
within the Service, including my office, to abate all or part
of the accumulated liabilities or to suspend collection action.
Some taxpayers have filed for bankruptcy protection. More than
most, shelter cases can reflect the burden associated with the
past and current penalty and interest structures. Very few
taxpayers are prepared to pay or can pay penalty and interest
accumulations that may date back to the 1970s.
Some say that these taxpayers should have known that the
results of their investments were too good to be true.
Nevertheless, I believe we should not focus on blame at this
point. We need to work to get these taxpayers back into full
compliance, possibly through installment agreements or the
expanded offer-in-compromise criteria. I believe that tax
shelters are an abuse of our system and the investors should be
penalized. I also concede that the investors owe interest for
the time they had the use of the government's money. I
question, however, whether it is the function of the government
and our penalty and interest regimes to punish these taxpayers
to the point that they become insolvent and unable to pay even
a fraction of these liabilities.
Of course, we also see other issues regarding penalty and
interest accruals in other areas, such as installment
agreements. For example, when entering into an installment
agreement, the taxpayer agrees to pay a certain dollar amount
(biweekly, monthly, quarterly) until the tax liability is paid
in full. General computations of how long a taxpayer will have
to pay on the agreement are based on the amounts accrued as of
the date the agreement is accepted. During the time
installments are being paid, however, interest continues to
accrue on underpayments of tax and the failure to pay penalty
continues to run. At the end of the payment term, the taxpayer
receives a bill for amounts of penalty and interest that
accrued during the course of the agreement. This is an
unpleasant surprise to many installment agreement taxpayers,
who generally believe that they have met their obligations by
keeping up with their payments.
On a related note, the Taxpayer Advocate Service frequently
sees other issues regarding requests for interest abatement
because of Service delays in a taxpayer's case. I have raised
this issue in the past and would like to state again that I
believe that the situations in which the Service may abate
interest are too narrow under current law. As the studies
explain, the Service may abate interest where an unreasonable
error or delay results from managerial or ministerial acts. I
believe limiting abatement of interest to these situations is
unfair to taxpayers.
In my FY 1998 Annual Report to Congress and when I came
before you this past February, I informed you that I had issued
the first-ever Taxpayer Advocate Directive (``TAD'') regarding
waiving penalties and abating interest in innocent spouse
cases. While considering the TAD, it became apparent that,
because of the effective date of the managerial exception, I
could not direct abatement of interest caused by managerial
delays for tax years beginning before 1997. Moreover, it was
clear that the law in this area is quite restrictive. Section
6404(e) permits abatement only where the assessment of interest
is attributable to unreasonable error or delay by the Service
in performing a ministerial or managerial act. I believe that,
for reasons of fundamental fairness, the Service should be
permitted to abate interest whenever the Service causes
unreasonable error or delay and the taxpayer has not
contributed significantly to that error or delay.
For example, the Commissioner directed the temporary
reassignment of IRS Examination personnel to work in Customer
Service offices in order to provide 24-hour phone assistance to
taxpayers. Not unexpectedly, these personnel were taken away
from audits and other examination work, thus delaying
resolution of taxpayer cases. Under current law, the Service
may be unable to abate interest attributable to that delay.
Depending on the facts and circumstances, such a decision may
be a ``general administrative decision'' for which the statute
does not permit abatement. I believe that the Service should
have the discretion to abate interest in such cases where
taxpayers, through no fault of their own, bear an additional
financial burden because of the actions of the Service.
II. National Taxpayer Advocate's Report to Congress for FY 1999
In the National Taxpayer Advocate's Report to Congress for
FY 1999, we reported again this year on the significant
compliance burden penalties and interest cause for taxpayers.
For the second year in my tenure as National Taxpayer Advocate,
we determined that penalties remained one of the most litigated
issues for individual and self-employed taxpayers and penalty
administration one of the most serious problems facing
taxpayers.
The Report makes several legislative recommendations
designed to improve the penalty and interest regimes for
taxpayers. With regard to penalties, we proposed that Congress
eliminate the failure to pay penalty. Absent elimination,
however, we proposed further mitigation or waiver of the
failure to pay penalty for taxpayers in installment agreements.
We also proposed the simplification or elimination of the
estimated tax penalty and the creation of a reasonable cause
exception for the frivolous return penalty. With regard to
interest, we proposed that Congress expand interest abatement
authority to all taxes, instead of limiting it to income,
estate, gift, generation skipping and certain excise taxes,
expand interest abatement authority in any circumstance in
which there is unreasonable error or delay, allow the Service
to use a fixed interest rate on installment agreements,
restrict compounding of interest to the underlying tax only and
not to penalties and additions to tax, limit interest on a tax
liability to 200 percent of the liability and allow the IRS to
abate interest where the taxpayer is experiencing a significant
hardship. We hope that Congress will consider these proposals
that we believe will alleviate taxpayer burden and improve the
fairness and equity of the tax system for taxpayers.
III. Reactions to Specific Recommendations in Penalty and
Interest Studies
I agree with many of the recommendations in the studies
before you and believe that, if they are used as a starting
point, Congress will eventually alleviate a good deal of burden
for taxpayers. The recommendations attempt to provide better
incentives for taxpayers to comply with the law and to simplify
the penalty and interest systems. For the most part, they
address the major issues that are causing taxpayers
difficulties and creating undue burdens. In addressing my
comments on the specific recommendations, I have focused on
those issues affecting individual taxpayers.
A. Recommendations regarding Interest Provisions
1. Interest Rate
I believe you should consider the concept of using one
interest rate for taxpayers and applying that rate to both
underpayments and overpayments. Applying one interest rate will
increase fairness and reduce complexity and will preclude the
government making money from taxpayers. Linking the rate to the
market should prevent taxpayers from treating the government as
a preferred lender or borrower. In determining an applicable
interest rate, however, I would suggest a range along the lines
of the Treasury Department recommendation of AFR plus 2 to 5
percent. Such a rate should reasonably compensate the
government and provide sufficient incentive for taxpayers to
comply with the law.
Should you consider this proposal, I believe you also
should evaluate the possible complexity caused by quarterly
adjustments to the applicable interest rate. Because the
Service changes the rate every quarter, it is more difficult to
administer. If the Service changes it too infrequently,
however, the link to the market rate will diminish. To strike a
balance between the two extremes and to more closely reflect
private industry practice, I recommend that the rate change
yearly.
2. Interest Paid by the IRS to Individual Taxpayers
I believe that interest paid by the IRS should be treated
differently than other types of interest and be excludable from
income. The present system, which denies individual taxpayers a
deduction for interest paid on taxes, treats those taxpayers
less advantageously than corporate taxpayers and creates a
mismatch for individuals between overpayment and underpayment
interest. I believe the Joint Committee's proposal to exclude
interest paid by the IRS from the income of individual
taxpayers should make the system fairer than it is currently,
especially when considered in conjunction with the first
proposal of a single interest rate that applies to all
taxpayers.
3. Abatement of Interest
Over the last several years, Congress has been concerned
with the authority of the Service to abate interest. In 1996,
Congress expanded the Service's authority to
abate interest to include instances in which managerial
acts caused unreasonable error or delay. In 1998, Congress
enacted a provision requiring suspension of interest where the
Service has taken longer than a specified period of time to
issue a deficiency notice to a taxpayer. I agreed with both of
those changes, but I also believe that we need to go farther to
be fair to taxpayers.
I support the Joint Committee's proposals regarding
abatement of interest. If Congress chooses to enact these
proposals, however, I believe the intent of the law must be
clear in order to minimize any difficulties in interpreting the
provision.
4. Dispute Reserve Accounts
The Joint Committee's recommendation to provide taxpayers
with ``dispute reserve accounts'' to stop the running of
interest is certainly an idea that has merit. However, I raise
two issues for your consideration. First, as you know, it is
already difficult for the Service to keep track of taxpayer
accounts. Over the last two years, we have heard about many
problems that are caused, at least in part, by the Service's
computer systems. Allowing taxpayers to set up such accounts
before new systems are put in place would create an
administrative burden for the Service, which could lead to
greater difficulties for taxpayers.
Second, current law provides two methods by which taxpayers
may pay disputed amounts, stop the running of interest and
preserve the right to petition the Tax Court. As the Joint
Committee points out, a taxpayer may submit a cash bond to stop
the running of interest on the amount of proposed tax and
preserve the right to petition the Tax Court prior to the
mailing of a notice of deficiency. Payments designated as a
cash bond do not earn interest, however, but do stop the
running of interest.
After receiving the notice of deficiency or initiating Tax
Court litigation, the taxpayer also may make payments on the
liability that will stop the running of interest and will not
preclude further proceedings in the Tax Court. These payments
will be applied to the tax liability. If the taxpayer
ultimately prevails in Tax Court, any amount the court
determines is an overpayment will be refunded with interest to
the taxpayer.
Rather than establishing dispute reserve accounts at this
point, I recommend that the Service publicize the current
options for payment and how these options affect the taxpayer's
ability to seek a judicial determination from the Tax Court.
B. Recommendations regarding Penalty Provisions
1. Penalty for Failure to Pay Tax
As I have testified to you before, I support the complete
repeal of the failure to pay penalty. We do not need to replace
the penalty with some alternative system, such as a five
percent late payment charge. By setting the interest rate
slightly above the market rate, we compensate the government
for the use of the money and provide taxpayers with the
incentive to pay. In my experience, few taxpayers are aware of
the failure to pay penalty and, thus, it does not effectively
motivate taxpayers to comply. In fact, when a taxpayer is in
financial trouble or has not filed returns for several years,
the failure to pay penalty becomes a barrier to compliance
rather than an inducement.
I also support Treasury's proposal to fix the interest rate
on installment agreements. With a fixed rate, the Service could
work with the taxpayer to include interest accruals over the
life of the agreement in the payment schedule. This would
permit taxpayers to avoid the balloon-type payment due at the
end of the agreement. A fixed interest rate would also permit
taxpayers to better understand the agreements, which would
become more like other consumer payment agreements, such as
mortgages.
2. Penalty for Failure to File
I agree with the Treasury Department that Congress should
restructure the application of the failure to file penalty.
Treasury's recommendation, if enacted, would both provide a
continuing incentive to correct filing failures and make the
application of the penalty more consistent with the four-month
automatic extension to file.
I think it is premature to assess a ``fee'' or ``service
charge'' for taxpayers who file late, but do not owe money with
the return. Before Congress enhances penalties in this area, I
believe we should publicize the issue and reinforce to
taxpayers and preparers the importance of filing, whether or
not a balance is due with the return.
Finally, I believe that Congress should permit the Service
to waive outright the failure to file penalty and possibly the
failure to pay penalty for first-time filers and for first-time
offenders, similar to the Treasury proposals for first-time
estimated taxpayers. In my experience, taxpayers who have
either not been in the system or who have always been compliant
may not even understand that, in addition to an interest
charge, there are penalties for failing to file or pay. We
should strive to identify these taxpayers and to encourage them
to remain compliant, rather than penalize them immediately.
3. Estimated Tax Penalties
I agree with the Joint Committee's recommendations
concerning the estimated tax penalties. The penalty has always
operated as an interest charge on money that should have been
paid to the government. Properly calling this interest is more
honest than continuing to refer to the scheme as a penalty. I
raise the same concern that Treasury raised regarding waiving
this penalty for reasonable cause. I feel it is essential that
the Service have this authority regardless of what it is
called.
I also agree with Treasury's suggestion that Congress
consider some sort of reasonable cause waiver from this penalty
for first-time estimated taxpayers, but I would encourage the
waiver to apply regardless of the amount due. As I said above
with regard to penalties for failing to file and pay,
identifying these taxpayers and working with them will prevent
future mistakes and help keep them in compliance.
I also urge you to consider a more meaningful change to the
underpayment threshold for the estimated tax penalty, such as
$5,000. The higher threshold would help eliminate the burden of
this provision for many taxpayers who are starting small
businesses or who receive supplemental income from such a
business. As an alternative to simply raising the threshold for
application of a penalty or interest charge, I suggest that
Congress consider indexing the threshold. While it might add
back some complexity, it would be fairer in the future.
4. Accuracy-Related Penalties
I believe that individual taxpayers do not have an
appreciation for the legalistic standards of ``substantial
authority'' and ``reasonable basis,'' along with their
attendant percentage of success calculations. I feel that most
taxpayers are filling out their returns to the best of their
ability and are not aware of these rules.
If Congress undertakes a review of this area, however,
simplification is in order. The ``sliding-scale'' nature of the
current standards is confusing. Taxpayers and preparers need a
brighter line so that understanding obligations is easier. I
also support making the standards consistent for tax preparers
and taxpayers.
Regarding the level of the preparer penalties, I believe
Congress should consider not only raising the amounts of the
penalties, but also how these penalties relate to Circular 230
standards for tax practitioners. Effective enforcement of the
standards of practice can go a long way toward ensuring
practitioner accountability.
5. Frivolous Return Penalty
I support Treasury's recommendation to raise the frivolous
return penalty and provide for a reasonable cause exception.
Currently, the Service cannot waive this penalty for reasonable
cause. The Taxpayer Advocate Service has seen several cases in
which taxpayers were misled or even duped into filing a
frivolous return. After intervention and education from the
Service, these taxpayers have understood their mistakes and
would like to correct the error. Particularly where the
taxpayer has a good compliance history, it seems unfair not to
waive the penalty. Additionally and as Treasury points out,
permitting a reasonable cause waiver would provide an incentive
for taxpayers to file correctly.
Essentially, frivolous filers would be given a second
chance with regard to this penalty after the IRS educates them
as to their obligations. I would like to suggest that Congress
consider treating all taxpayers in this manner, particularly
those who fail to comply in less egregious ways.
C. General Administrative Provisions
Overall, I agree with the administrative recommendations
the studies make. I believe that the results of the changes
could be good for taxpayers, as long as the Service can
reasonably and effectively accomplish the changes. For example,
I believe that developing better information systems to track
data will yield positive results, but note with caution that
the current capacity of the Service to create this type of
system is limited. With the implementation of the new computer
systems currently under design, however, the ability of the
Service to respond to this type of recommendation will be much
greater and, therefore, of greater benefit to taxpayers.
From a practical point of view, I would like to add a
caveat to the recommendation regarding improved supervisory
review of penalty and interest administration and application.
Although uniformity and consistency are important goals in any
tax system, where multiple reviews of employee decisions are
required, employees can feel disenfranchised and may, in an
attempt to guard against making mistakes, simply avoid making
any decisions. While abatement decisions are inherently a
judgment call, it is impossible, if not inadvisable, to force
so much consistency that the process is paralyzed. I have seen
this happen in other tax agencies with penalty and interest
abatement programs with disastrous results. In my opinion, the
Service should train employees well and then let them do their
work. Review is necessary for the purpose of adjusting the
training and correcting misunderstandings.
Finally, I would like to address the Joint Committee's
recommendation requiring the IRS to consider using alternative
means, such as email or fax, to communicate with taxpayers. I
believe this is a reasonable recommendation. There are many new
ways to communicate with the taxpayers that could speed
processes and improve the system. In fact, I believe the
Service is ready and willing to embrace these new technologies.
However, because of issues with the confidentiality of tax
information and the security of the Internet and the Service's
systems in general, Congress may need to reconcile any
competing interests by reexamining the restrictions on
confidentiality and security.
IV. Conclusion
Thank you for allowing me to testify before you today on
this important topic. I am delighted that you now have in front
of you two studies making recommendations to improve the
administration of the penalty and interest provisions of the
Internal Revenue Code. There is a great need to simplify this
area. Taxpayers are overburdened by the number and complexity
of the provisions for penalty and interest.
I urge you to carefully consider these recommendations and
enact laws that will make compliance easier and less burdensome
for taxpayers.
Thank you.
Chairman Houghton. Thanks very much, Mr. Oveson.
I would like to ask a quick question and then I will pass
it along to Mr. Coyne and the other Members of the panel.
Obviously, we want--this is really directed to you, Mr.
Mikrut. Obviously, we want to have a disciplined system.
Obviously we want to have people be fair and honest with our
system. Yet, at the same time, there seems to me sort of a
dichotomy between what the Treasury wants to do and what the
Joint Committee on Taxation and also Mr. Oveson has suggested
that they have made, I think the Joint Committee made some 11
different suggestions, really sort of taxpayer-friendly, and I
don't think there has been any response at all from the
Treasury.
I mean, for example, the Joint Committee talks about
abating interest attributable to unreasonable IRS errors;
nothing from the Treasury. Payment of interest on erroneous
refunds should be removed; nothing from Treasury. Abating
interest on underpayment; nothing. Abating interest that causes
injustice; nothing.
So maybe you could explain this. Because at the end of the
day, we have to be on the same page here. Because I mean the
most important things are our constituents. So maybe you could
help me on that.
Mr. Mikrut. Surely, Mr. Chairman.
With respect to abatements of interest, we have made a
recommendation that to the extent that a taxpayer relies on
written advice from the IRS, interest should be abated; that we
should expand present law that deals with managerial-
administerial acts, which Congress has somewhat limited our
abilities to include that case, in addition.
However, in looking again at the nature of interest versus
the nature of a penalty, we think that it is more appropriate
that abatements for interest be more narrowly drawn, simply to
reflect the time value money of interest. However, we certainly
recognize that whatever provisions are adopted by Congress, we
would propose that there be very objective standards for
purposes of determining when interest or penalties can be
abated so that we are not in a position where it is unclear
amongst taxpayers and the IRS when they can and cannot abate
interest, and we are looking primarily for guidance in that
area from the direction of Congress.
Chairman Houghton. Yes. I guess it is not only an objective
test, but it is a human test, and I think that this has to be
part and parcel of our thinking here. Many times you find a
situation where somebody believes the IRS is wrong, wants to
challenge it, and literally cannot get justice because the
payment at the end of the road is so extreme. That is one of
the things that concerns me. You may have other answers to
that.
What I would like to do, however, is to go through the rest
of the panel and let them ask questions.
Mr. Coyne, would you like to ask questions?
Mr. Coyne. Thank you, Mr. Chairman.
Mr. Mikrut, Treasury does not agree with the Joint
Committee on recommendations to, number one, equalize the
interest rate charged to taxpayers and paid by the IRS; number
two, to make interest paid to taxpayers on overpayments
excludable from income; or three, allow abatement of interest
to prevent gross injustice and for all unreasonable delays
caused by the IRS.
I wonder if you could explain why does Treasury object to
these suggestions, or could you expand on why Treasury objects
to these suggestions?
Mr. Mikrut. Certainly, Mr. Coyne. With respect to
equalization of interest rates, as you know, in 1998, Congress
equalized the rates for individuals, so what we are dealing
with then is the rates that apply to corporations. Congress, in
1989 and again in 1994, created a divergence of rates between
overpayments and underpayments with respect to corporations to
address certain specific concerns. Those concerns were, one,
that corporations perhaps may have been playing the audit
lottery and were relying on a relatively low interest rate to
the extent they were eventually--deficiencies were later
determined, so they put in the AFR plus 5 rate in the late
1980s.
In 1994, the concern was that the corporations could be, in
effect, investing with the Federal Government and getting an
AFR plus 2 return, when a normal investor with the U.S.
Treasury gets a point AFR return. So they reduce the rate on
large overpayments of AFR plus a half of a percentage point. We
think the policy underlying those two decisions was solid and
should be respected.
In addition, Congress has put in global interest netting so
that to the extent that there is an overpayment and
underpayment running from a corporation at the same time, those
two amounts can be netted together if the 4-1/2 percent
potential differential is eliminated. And we are working on
regulations to further implement global interest netting on a
broader basis.
Finally, your last question with respect to the
excludability of interest overpayments again relates to the
fact that if an individual or a corporation buys a T-bill and
earns interest on the T-bill, those amounts are includable in
income. However, if they simply invest in the Federal
Government by overpaying their taxes, we would think you should
get the same result in either case. So the excludability and
includability of interest should follow the normal operating
rules whether those overpayments, underpayments or the interest
thereon relate to taxes or some other form of investment.
Mr. Coyne. I wonder if you could tell me how many times the
IRS in fact has abated interest during the calendar year 1994.
Do you have any information about that?
Mr. Mikrut. I don't believe we have the 1999 data yet, Mr.
Coyne, but we can supply that to your office as soon as it
becomes available.
Mr. Coyne. Would you supply that to us?
Mr. Mikrut. Yes.
[The following was subseqently received:]
In fiscal year 1999, there were 837,557 abatements of
interest with respect to individual taxpayers (totaling $179
million) and 306,326 abatements of interest with respect to
business taxpayers (totaling $801 million).
Mr. Coyne. If Congress was to pass legislation in the area
of interest and penalty reform this year, in 2000, what changes
would be your priorities; that is, Treasury's priorities, and
why?
Mr. Mikrut. I think you should look at again the provisions
that affect the most number of taxpayers and where there is
this perception of the greatest amount of injustice. We think
the failure to file and failure to pay penalties should be
restructured, separated, and a lower rate apply. We think doing
this would create greater compliance with respect to those
provisions and would promote equity.
We also think that there should be some minor tweaks to the
deposit penalties, because in those cases, a 10 percent penalty
may apply solely because the taxpayer made an error in
determining which method to which deposit of payroll taxes, so
we think there should be some tweaks there. We think those are
the major provisions.
We also believe that in consideration of these legislative
changes, we have to take into account again how the IRS can
administer them and, again, that really relates to when these
provisions should become effective.
Mr. Coyne. Well, both Treasury and the Joint Committee
recommend increases in the tax preparer personalities. What are
some of the examples of how tax preparers are abusing the tax
system?
Mr. Mikrut. Ms. Paull can also talk to the Joint
Committee's recommendations, but what we have observed is that
the standards for avoiding the penalty for tax preparers are
very much lower than the same standards that we apply to
taxpayers. To the extent that taxpayers, particularly
individuals, rely upon paid preparers to interpret the law and
help with their compliance needs, we think the standards should
be the same between taxpayers and their advisors, paid
preparers. So we would elevate both standards to be exactly the
same.
We also suggest that perhaps in order to be a more
effective sanction, the penalty on preparers should be similar
to the penalty on taxpayers, the taxpayers as a percentage of
the underpayment with the preparers be a percentage of the
underpayment or perhaps a percentage of the fees that they
generate in that regard.
So I think with respect to paid preparers, the views of the
Joint Committee and Treasury are consistent with the goals; it
is just the execution of those goals where we may have slight
differences.
Ms. Paull. I would agree.
Mr. Coyne. Thank you.
Chairman Houghton. Mr. Hayworth.
Mr. Hayworth. Mr. Chairman, I thank you, and again to our
witnesses, welcome.
Mr. Mikrut, I want to follow up on an observation made by
the chairman that I think necessitates some amplification and
clarification. As I examine the comparison of what the Joint
Committee staff and Treasury are recommending, I was struck not
only by your testimony, but also by just taking a look, on no
fewer than 13 occasions, by my count, I read, ``retain present
law, no recommendation. Retain present law, no
recommendation,'' again, a baker's dozen times from Treasury.
The Taxpayer Advocate recommends 11 changes to the penalty and
interest regime.
I would just like to know for the record, did Treasury
adopt any of the Taxpayer Advocate's recommendations?
Mr. Mikrut. The Taxpayer Advocate's recommendations came
out after ours, but I think there is some consistency between
the two, yes.
Mr. Hayworth. The question is, did you adopt any of the
recommendations? You put out your report before the Taxpayer
Advocate's report?
Mr. Mikrut. Yes.
Mr. Hayworth. So the answer would be no?
Mr. Mikrut. Well, I think yes, if possible--.
Mr. Hayworth. Are you prepared to issue an addendum to
formally accept any of the Taxpayer Advocate's recommendations,
or is Treasury happy with the status quo?
Mr. Mikrut. I think we have made several recommendations,
Mr. Hayworth, so we are not happy with the status quo. We think
with respect to the penalty and interest provisions of the Code
a certain amount of caution is warranted for two reasons. One,
we have currently a very high degree of compliance and we want
to maintain that high degree of compliance. It is often very
difficult when you talk to the economists and when you look at
the economic literature to determine exactly what the
behavioral effects of any interest and penalty change may be,
so that is one reason to go slowly.
Second, as I indicated to Mr. Coyne, one of the things you
have to take into account is how the IRS can implement these
provisions. The IRS is currently going through a major
restructuring as mandated by the 1998 act. There were several
changes in the Taxpayer Bill of Rights that required
reevaluation of some of the provisions that affect taxpayers,
particularly with respect to interest and penalties. It may be
prudent to see how exactly those programs work before changing
them once again. So again although you may think that our
recommendations were modest, we think that in a large extent,
the compliance program is not necessarily broken, and so
caution might be warranted in this case.
Mr. Hayworth. You mentioned in your answer behavioral
effects. Let me revisit one area. You are recommending,
Treasury is recommending, that taxpayers who do not owe taxes
or are owed a refund should be charged a service fee for filing
a late return. Again, for amplification, how large a fee do you
folks at Treasury envision charging these taxpayers?
Mr. Mikrut. Well, we wouldn't charge anything, Mr.
Hayworth. This is something that Congress would have to adopt.
But what we are considering--.
Mr. Hayworth. Well, let me--what would you recommend that
Congress adopt? How would you like to see these folks that owe
taxes be penalized? Do you have a fee in mind?
Mr. Mikrut. Yes. I think the fee would be relatively
modest, in the nature of about $50, which would approximate the
cost of the IRS to contact the taxpayer for the IRS to prepare
a substitute return which is required in these cases. The fee
would not apply for first-time offenders, necessarily. It would
have to only apply if the taxpayer had a history of not filing
tax returns. So it would be more in the nature of we believe a
service charge as opposed to a penalty, just reflect the
additional cost of the service.
Mr. Hayworth. I see. So the citizen--I have it. So you guys
aren't really in the service business. The citizen should be
held accountable for your extra paperwork. Under current law,
is it not true there is no sanction for filing a late return if
a taxpayer does not owe taxes or is owed a refund?
Mr. Mikrut. That is true, Mr. Hayworth.
Mr. Hayworth. Here is the fundamental difference in
philosophy, Mr. Mikrut, and I thank you for your candor. The
Internal Revenue Service should be a service. What you are
doing is completely, in the buzz words of the 21st century,
reversing the paradigm. You are saying for folks who don't owe
anything, by golly, you are going to pay up because you made us
spend some time on this case. I would respectfully suggest that
in terms of behavioral effects, I believe that is the wrong
course of action to take. I thank the Chairman, and I thank you
for your answer.
Chairman Houghton. Mr. Watkins.
Mr. Watkins. Thank you, Mr. Chairman.
You know, I mentioned earlier, and I would like to get back
to a letter I sent to Chairman Archer, Chairman Houghton and
also the distinguished--I started to say Senator, but House
Member from Arizona, J.D. Hayworth and myself sent a letter
about global netting, and it looks like to me the Treasury is
taking again the most narrow view in dealing with the
application and implementation of the global interest netting
rules. Let me say that the IRS has come forward in a very
narrow way in denying the taxpayer the full measure of relief
intended under global netting. The IRS, in the letter I pointed
out, is arguing that no interest literally is allowable under
subchapter B during the 45-day interest-free period. However,
we believe that these interest-free periods, it is just common
sense, clearly should be excluded from the interest netting
computation there. To do otherwise, it would introduce
unnecessary complexity there and also the process would
contravene the underlying rationale of our connecting global
interest rate equalization.
Why are they taking such a narrow view? Why are they taking
such a narrow scope? It is like they totally want to slap the
Congress in the face and take the pharaoh's view on this whole
situation. And that is not the intent, I can assure you, of
those of us up here.
Can you answer that for me?
Mr. Mikrut. Yes, Mr. Watkins. In looking at the provision
that Congress enacted in 1998, we used certain terms,
underpayment, overpayment, and the netting of interest. We
believe that the use of those terms has to dovetail with the
current provisions of the Code so that if interest is not
allowable because the IRS would act within 45 days or to the
extent that a taxpayer would credit his overpayment to
estimated tax payments and therefore does not get any interest,
the provision is not applicable, simply by the definition of
the terms that Congress used.
If I could use an analogy, for instance, if one taxpayer
had an overpayment and petitioned the government for the refund
of that, he would automatically get it, without any interest.
So it would seem that the intent of Congress would be to
treat that taxpayer the same as a taxpayer that also had at the
same time an underpayment running. So that in effect, if you
allowed the netting of the two, the taxpayer then who had the
underpayment would in effect be getting interest at the AFR
plus 2 rate or potentially even the AFR plus 5 rate, which
would be against the intent of Congress in not applying or not
granting any interest to the first taxpayer. So we try to
reconcile those two cases.
Mr. Watkins. It seems like to me you are making it a lot
more complex in the understanding of what you are doing. That
is not unusual. We all know if you read a lot of the
regulations and all of the other things and some of these
revisions and approximations you have made and all. But trying
to find that level playing field and making sure we are not
penalizing unnecessarily, and if you are not allowing the
interest-free periods, that is one area even I think where it
is very clear that they are trying to get as much revenue as
they can.
I just think, Mr. Chairman, and I would like to--I just
want to say thank you for having these hearings today. But I
think in some way we are going to have to try to deal into the
meat of the coconut and see what we can do about getting down
to some of the details. Because it seems very obvious that, as
our friend from Arizona has pointed out, not taking any of the
recommendations that we have made and trying to work through
them, and as a result, we are not getting anywhere, and it is a
shame that we have to go to in-depth statutory provisions to
try to get something done.
So let me say I look forward to kind of proceeding on this
in even greater detail as we go forth. Thank you, Mr. Chairman.
Chairman Houghton. Thank you, Mr. Watkins.
Mr. Portman.
Mr. Portman. Thank you, Mr. Chairman.
I want to commend you for having this important hearing and
for directing the subcommittee to try to make sense of the
various reports we have before us. I hope we can come up with
some recommendations that we can either enact or promote
Treasury taking action under its existing authority to relieve
some of the taxpayer issues that Mr. Oveson talked about.
I particularly want to thank the Joint Committee on
Taxation and Treasury for their reports and then for Mr.
Oveson, you getting into it in the Taxpayer Advocate's report
that recently came out. This is a tough issue and it is one
that there is going to have to be a balance on. It is also a
big picture issue in the sense that we have to understand
better whether the current provisions of law are increasing or
decreasing compliance. I tend to take the point of view
expressed this morning, at least indirectly, by Mr. Oveson,
which is that the ``service'' in IRS should mean that taxpayers
can get their problems resolved more quickly and with less
frustration with the government and that will lead to better
compliance. That was really the theory behind so many of the
changes that came in 1998, some of which are still not being
implemented.
I would just have to take this moment to say that these are
the ``big picture'' kinds of issues that the IRS Oversight
Board was meant to look at. Not micromanaging, not specific
enforcement matters, but these are the big picture issues that
we still are not grappling with at the IRS. I, for one, am
extremely frustrated that with all of the changes at the IRS
and this continued discussion on this particular issue, and I
do have some specific questions for Treasury on this, that we
do not have the benefit of the Oversight Board in place. Here
we are a year-and-a-half since enactment of the law; one year
and, what is today, the 27th, one year and five days after the
Administration was required under law to send the names to the
U.S. Senate and we still do not have all the names up. I am
told every day the final names are going to be up this week or
next week. It is an outrage.
Again, I would just say, Mr. Chairman, with all due
respect, these are the kinds of issues this subcommittee should
be grappling with, but we should also have the benefit of this
overview from the IRS Oversight Board which would be private
and public members who could look at some of these bigger
picture questions.
Mr. Oveson got into this notion that in many cases,
taxpayers want to comply but they cannot pay the penalties and
interest, and you mentioned, Mr. Oveson, some of the specific
cases you are grappling with every day, for instance
partnerships and tax shelter litigation. I will agree that the
intention of the Treasury with the RRA, the IRS Restructuring
Reform Act, that was passed in 1998, does deal with this issue,
particularly in the area of offers and compromises, and it
deals with the abatement issue. I am disappointed that the
Treasury has not been more aggressive in following the
direction of the RRA. It specifically directed the IRS to
prescribe guidelines to determine when an offer and compromise
should be accepted. I refer you to the report language of the
conference report that says that in formulating these rules,
the IRS should take into account such factors as equity,
hardship and public policy where a compromise of an individual
taxpayer's income tax liability would promote effective tax
administration.
That is in the report. The legislative history also
specified that IRS should utilize its new authority ``to
resolve long-standing cases by foregoing penalties and interest
which have accumulated as a result of delay in determining the
taxpayer's liability.'' Per Mr. Oveson's comments, here is a
guy who has to deal with this all the time because he has said
these taxpayers are calling his office, they are calling his
taxpayer advocates in districts around the country. I know in
July of 1999, July 21st, the IRS issued proposed regulations,
but they failed to incorporate this goal of using the offer and
compromise to abate accumulated interest charges in these long-
standing cases Mr. Oveson talked about. The preamble to the
proposed regulations actually acknowledges this failure and
asks for public comment.
My question to you this morning, Mr. Mikrut, if I might, is
can you explain what Treasury's position is on this and whether
you expect to incorporate, this what I think is clear
congressional intent, more fully in your final regulations?
Mr. Mikrut. Sure, Mr. Portman.
As you mentioned, the conference report says that it is the
anticipation that the IRS would put into the regulations, in
consideration of the offer and compromise program, factors of
equity, hardship and public policy which we interpret to
promote effective tax administration. Our goal in putting out
the regulations last year was for the need for immediate
guidance. We believe that the rationale for amending section
7122, the offer and compromise program, was a perception that
there was inconsistent treatment perhaps amongst different
taxpayers in different parts of the country under the existing
standards. So what we wanted to do was provide immediate
guidance to the field on how the program should be used. We
wanted to use as many objective standards to promote such
consistency as possible, recognizing that we could not cover
all cases immediately. For that reason, we went out as
temporary and proposed regulations, so that the temporary
nature would obviate the cases that we knew we had a handle on,
cases of hardship and equity, and to try to ask for comments on
the more difficult cases, and delay is admittedly one of those
cases. Because there may, in fact, be somewhat of a tension
between delay and equity, two things that the conference report
tries to get at.
For instance, it is often unclear when delay is caused by
the taxpayer as opposed to delay caused by the IRS, and how to
you unscramble the eggs in that case. To the extent that delay
is caused by the taxpayer, equity would seem to say that you
should not abate interest, or to the extent that delay is
caused by a taxpayer, which would seem to indicate that you
should not abate the interest. On the other hand, the
regulations do provide, though, that even if delay is caused by
the taxpayer, if charging the taxpayer interest would create a
hardship, the abatement is still possible in the offer and
compromise program.
So what we propose to do is put out the three standards
that we currently put out. We are closely monitoring the
program. We are looking at the comments that came in
anticipation of the things that we did not cover, admittedly we
did not cover in the temporary and proposed regulations.
Mr. Portman. Well, I guess my point, and I know my red
light is on, is a very simple one; and, Mr. Oveson, perhaps you
can comment on this later, which is that I think you have the
authority under current law to be much more aggressive in
resolving these cases, particularly with regard to delay. I am
disappointed you haven't already come out with those
regulations. I understand the need for consistency. I think
that was not inconsistent in also dealing with some of the
other issues. I would just hope that Mr. Oveson will continue
to push internally and perhaps we need additional direction
from Congress, although I don't think it is necessary. In
response to the Chairman earlier, you indicated that you were
looking for some more legislative direction with regard to
abatement. I think in this area of offer and compromise you
have it, and I would hope the Treasury would take advantage of
that.
Thank you, Mr. Chairman.
Chairman Houghton. Thank you very much, Mr. Portman. Mr.
McInnis.
Mr. McInnis. I have a couple of questions here I would like
to ask and then have you answer them after I conclude my
questions.
First of all, there are some very, what you would probably
consider minor penalties that are extremely aggravating to
taxpayers out there, that I am not sure are being addressed in
your notes. Maybe I missed those notes. One of them, for
example, if a payment falls below a certain amount; for
example, one penny, the tax is short one penny, your computer
banking kicks out an automatic penalty letter which is entirely
unproportionate to the one penny of tax not paid. That letter
contains within it certain threats to garnish accounts and so
on.
I asked the IRS and did not receive a satisfactory--I got a
response, it seemed to be satisfactory, but no satisfactory
action, in which why couldn't the IRS put into their computer
program that any underpayment say of $20 or use some percentage
that before an automatic action is kicked out by the computer,
that a supervisor would have to approve it, so you are not
sending out threatening letters which only put a black eye on
the IRS, which is exactly what they did for one penny in a
couple or two or three different cases that I have, number one.
Number two, another penalty, I have a rancher in my area,
he hired, had some hired help, had he sent in the payroll tax,
apparently the IRS sent you a payment book with coupons after
you have had the employee for a year. So he is accustomed to
sending in the payment, he made his tax payment on time, after
the year he got his coupon book, he failed to send in the
coupon. He sent in the payment, but anyway, he sends in the
payment, doesn't have the coupon with it, so they nail him with
a 10 percent tax, only because of the fact that the coupon
itself, not the payment, but the coupon itself was not in the
envelope. I mean those kinds of things that don't make any
sense.
The other thing that I would ask you to respond to and that
is that the Taxpayer Advocate, I would like to know your
official response that the IRS should have the discretion to
abate interest in such cases where taxpayers, through no fault
of their own, bear additional financial burden because of
actions of the Service. For example, if a taxpayer is trying to
get you on a phone or if a taxpayer is trying to schedule an
audit or sit down with the IRS because they are so busy, cannot
schedule for a period of time or cannot get back to these
people, it would seem to me that in fact, it was a good faith
effort on behalf of the taxpayer and it was truly the fault of
the IRS that they should have the authority to abate the
interest that is accumulating between the period of time that
they should have been able to meet with the client and the
period of time that due to their own fault they were able to
meet with the client. So those are the three areas, the two you
could probably put into one class, and then the third. If you
could comment on those, I would appreciate it.
Mr. Mikrut. Mr. McInnis, let me respond to at least your
first two hypotheticals, or perhaps real cases.
Mr. McInnis. Let me just say they are not hypotheticals,
first of all. They are factual cases. Thank you.
Mr. Mikrut. Again, the thing to keep in mind in proposing
legislation and when we propose regulations with respect to the
penalty and interest provisions is what exactly can the IRS
administer at this time, and we try to work closely with the
IRS with respect to all of these proposals. I would agree that
it would seem very strange that computer-generated deficiency
for a penny would go out with everything that is normally
intended to these sorts of things. On the other hand, without
automation and requiring each notification to taxpayers be
reviewed by someone, we create even further delay, which
somewhat gets into your last case of what is unreasonable delay
and what is not.
With respect to your issue on the rancher, we have
proposed, to the extent that a deposit payment was made in the
wrong form or in the wrong manner that we would not impose the
10 percent penalty and that if the payment is there on time, we
would only look to the lateness of the payment and then perhaps
only charge an interest-like fee to the extent that the payment
was one day or less late. So to that extent we have addressed
that case.
Finally, we have had a discussion earlier today on the
unreasonable delay for interest abatement, and again, I think
the difficulty there is trying to promulgate objective
standards so both taxpayers and the Service know who has the
burden for delay and how do you rationalize between who has the
responsibility for moving the case forward. Those are my
answers to your three questions.
Mr. McInnis. Thank you.
Chairman Houghton. Thanks very much.
Mr. Weller.
Mr. Weller. Thank you, Mr. Chairman. I would just begin by
wishing you a happy new year. It is good to be here for the
first subcommittee hearing of the year. I also want to
congratulate you for the new technology I see we are using for
the light out there. No longer have those little bulbs, now
modern and concise in green, yellow and red, but still right
where it should be.
I have a question for the gentleman from Treasury, actually
a couple of questions, and they built really on what Mr.
McInnis was referring to. The gentleman from Treasury referred
to the example of someone underpaying by a penalty and the
gentleman from Treasury referred to that as hypothetical. Well,
I happen to have one of those hypothetical examples right here.
I am going to, of course, put this letter into the record. But
Dr. Bruce Smith, who operates a foot and ankle clinic in
Frankfurt, Illinois in the south suburbs of Chicago that I have
the privilege of representing, has a computer-generated form
here dated, it looks like March 22, 1999. It is a request for
payment. It says, ``Our records show you owe 1 penny on your
return for the above tax period.''.
The letter goes on to say, ``To avoid additional failure to
pay penalty and interest, please allow enough mailing time so
that we receive your payment by a certain date. Make your check
or money order payment to the United States Treasury, including
the taxpayer identification number'' and so forth. It says,
``If you feel we have made a mistake, please call us,'' and of
course points out on the tax statement that the underpayment
was one penny, one cent, and of course they were penalized $100
for being one cent short in paying their taxes. Since you are
the representative of the Treasury, I would just like to ask
you to explain that and justify it.
Mr. Mikrut. Well, that is both difficult to explain, since
I am--other than your letter, I don't know the facts and what
the penalty relates to.
Mr. Weller. It is on your letterhead, the Department of the
Treasury, IRS.
Mr. Mikrut. And it is even harder to justify. Just as
saying that it is hard to justify why Visa sends my dog a
request to get a credit card. I think computerization both
facilitates tax administration and will create some anomalous
results, and I think without knowing more about the facts in
your case, it sounds like this is one of those anomalous
results.
Mr. Weller. Do you have a certain threshold if, in this
case someone owes one cent in which somehow a program you have
developed to kick them out so you reconsider? I imagine the
cost of generating this letter was far more than 1 cent, and
the amount of time that was invested in it, as well as computer
time and paper and so forth. Do you have some sort of program
in place where you watch for these things?
Mr. Mikrut. I am probably not the right person to respond
to exactly what current computer capabilities of the IRS are,
Mr. Weller, but I can get back to you with respect to that.
In our report to Congress on the interest and penalty
provisions, we had made recommendations that in cases where the
amounts are de minimis, particularly with respect to the
estimated taxes where some very de minimis amounts generate
automatic penalties, that those penalties be waived. So we
agree with the spirit of what you are--the case you are
pointing out. There are certain instances where it may be
appropriate that even though an amount is due and owing, that
it is not worth the effort to generate the correspondence
between the taxpayer and the IRS.
Mr. Weller. Have you ever figured out what the actual cost
of generating this letter and sending it to the taxpayer would
be?
Mr. Mikrut. I don't have that with me either, Mr. Weller.
[The following was subsequently received:]
The cost of generating notices to taxpayers depends in part
on whether the notice is systemically generated or manually
prepared by IRS personnel. A systemically-generated notice
costs, on average, $1.05 (including postage, paper and direct
labor costs).
[GRAPHIC] [TIFF OMITTED] T7952.034
Mr. Weller. Okay. That would be an interesting number to
know, particularly if that cost you $100 to send this form
letter out and timewise, staffwise and so forth. But I would
very much like to--I look forward to hearing your response, if
you can get us the information.
The other issue I want to ask you about is something a
number of us on this committee were greatly concerned about as
we worked to move the legislation to reform the IRS, and it was
an issue where we really met great resistance from your
department, and that was the issue of dealing with the unlucky,
innocent spouse, in many cases where you had in most cases a
divorced single mom with the kids, in many cases the
struggling, working mom not always responsible for having the
kids, but found out that her former spouse was a deadbeat in
paying child support and then later on discovered that thanks
to being contacted by the IRS, that there is a problem with the
taxes. And in many of those cases, that unlucky, innocent
spouse had no responsibility, no involvement, but because the
IRS could find her, they sent her the bill and of course were
trying to hold her accountable.
One of the key reforms that we were successful in doing and
we were able to change around your department, because you
resisted us during this process, and I really wanted to get a
report from you on what the status of our reforms to help those
unlucky, innocent spouses, what kind of information you can
provide me on how many have qualified for the provisions that
we included in the IRS reforms and of course how your
department has been responding to those requests to be
qualified as an unlucky and innocent spouse.
Mr. Mikrut. Again, I can get you that information. The
program is ongoing. We have recently just this last month
issued additional guidance with respect to when an innocent
spouse would qualify for relief. We have directed the field
that there are certain cases where relief would be automatic.
We also gave a list of facts and circumstances that should be
taken into account. The guidance we released I believe greatly
liberalizes the areas. It piggybacks quite extensively with the
offers and compromise guidance we put out earlier in the year
to look at when there would be hardship with respect to trying
to collect amounts due and owing from the innocent spouse.
Again, it will take some time before this guidance trickles
down to the district level and is actually applied on a case-
by-case basis, but I will try to get you the preliminary
numbers.
[The following was subsequently received:]
As of March 1999, the IRS implemented an administrative
tracking system to monitor the number of innocent spouse claims
received and the processing of such claims. Based on
information provided by the IRS from its new tracking system,
approximately 56,000 innocent spouse claims were received since
inception of the tracking system through December 31, 1999. The
IRS estimates an additional 7,000 claims were received and
addressed prior to implementation of the tracking system. Of
the 63,000 claims received, as of December 31, 1999,
approximately 34,000 claims were awaiting consideration or in
the process of review. The remainder either were resolved on
the merits, were in various stages of post-determination
administrative or judicial review, or did not satisfy the
minimum criteria for consideration (for example, no liability
remained). The IRS is taking steps, where resources permit, to
shorten the processing time and reduce its inventory of
unresolved claims to ensure that innocent spouse claims receive
timely and careful review. Treasury's Office of Tax Policy is
working with the IRS to issue timely guidance with respect to
these new provisions.
Mr. Weller. Mr. Chairman, I see my red light, if I could
just have one follow-up question on this.
This issue, of course, has brought the attention of my
constituents. I have about a dozen unlucky spouses a year
contact my office throwing up their hands in frustration
because of their circumstances and of course having the IRS
showing up at their door, so this was an important reform.
Let me ask this. Obviously, you are implementing this now,
and I look forward to getting the information from you if you
would send it to me in answer to my questions.
Do you have any idea what the timetable is, the amount of
time it takes you to process that claim and respond, when
someone makes that, from a penalty and interest standpoint, how
do you treat that individual that is applying to be qualified
as an unlucky, innocent spouse.
Mr. Mikrut. I will try to get you that information as well,
Mr. Weller.
[The information was not available at the time of
printing.]
Mr. Weller. Okay. Thank you, Mr. Chairman.
Chairman Houghton. Mr. Coyne.
Mr. Coyne. Thank you, Mr. Chairman.
Ms. Paull, your committee recommends making interest paid
to taxpayers by the IRS excludable from income.
Ms. Paull. To individual taxpayers, that is correct, Mr.
Coyne.
Mr. Coyne. How would you suggest that this helps the IRS
and how does it help the individual taxpayer?
Ms. Paull. Well, right now I think the individual taxpayer
perceives the tax system as somewhat unfair because even if
their interest relates to an underpayment from their business
activities where most interest is deductible, they do not get
to deduct the interest paid to the IRS.
In our looking at the data, there is not a lot of interest
paid to individual taxpayers by the IRS. Most people try to
kind of get their taxes as close to their liability as they can
and pay them in, you know, through withholding or estimated tax
payments. But to the extent you overpay your taxes, we felt
there was a perception that the Tax Code was unfair in the
sense that if you underpay, you pay interest on it, you don't
get a tax deduction. Also, of course, if you--and then if you
overpay, the interest is taxed to you.
So rather than revisiting the decision that was hard-
thought, I think, during the 1986 act, that interest paid to
the IRS on an underpayment is not deductible, we thought it
would be useful to recommend, really for fairness reasons, to
exclude the interest that is paid to individual taxpayers. Our
recommendation specifically did not go to corporate taxpayers
who do get a tax deduction for interest paid to the IRS, and
therefore, the interest, any interest that would be paid by the
IRS or the Federal Government to the corporate taxpayer should
be includable income. There would be equality of treatment of
those payments.
Mr. Coyne. I would like to ask both you and Mr. Oveson the
same question I asked Mr. Mikrut. If Congress was to pass
legislation in the area of interest and penalty reform this
year, what changes would be each of your priorities and why
would you make those recommendations?
Ms. Paull. Well, I would have to say that the overhaul of
the interest provisions would be a very high priority. I guess
we think--we like all of our recommendations, so we would hope
that you would seriously consider them all, because we spent a
lot of time and effort working both with the administration and
outside groups on them. But I would say that there is--we had
kind of a global interest set of proposals and I would hope
that would be given the highest priority, because as you
probably know, many people do complain a lot about the interest
provisions in the Tax Code and they are very complicated.
Mr. Coyne. So each of them carries about the same priority?
Each recommendation that you have made carries about the same
priority?
Ms. Paull. Well, all of the recommendations we hope you
will consider, but I would also hope that you would give the
highest priority to the interest recommendations, especially
for a single interest rate and that would reduce a lot of
complexity, and also converting the estimated tax payments into
interest payments and also allowing taxpayers to place money on
deposit that are in dispute to stop the running of interest.
All of those really do work together, and we would hope you
would give some serious consideration to that.
Mr. Coyne. Mr. Oveson.
Mr. Oveson. Mr. Coyne, I would agree with Ms. Paull that
abatement of interest would be my top priority. I think I have
made that pretty clear over the last year-and-a-half, of having
more ability and authority to deal with the abatement of
interest. The reconciling of the rates to a single interest
rate, I think that is really important. And the whole interest
netting issue would basically go away if you were to equalize
those interest rates. The interest netting provisions and the
interest netting issue is phenomenally complicated and
extremely difficult for the IRS to deal with, as well as
industry to deal with. It is a big deal.
The failure to pay issue, I think that affects a lot of
taxpayers, and it is a complicating issue to the Code. I would
put it number 3.
Mr. Coyne. On the issue of the IRS charging taxpayers
interest due and it is due, in part, because the IRS caused the
delay for which the taxpayers have no control, could you give
us some examples of that?
Mr. Oveson. I gave you one example in my testimony where an
examination is in process and the examiner is called away to go
to customer service phone lines. If the exam were finished
earlier, that interest would stop sooner, because then the
taxpayer would know there was an assessment. Because the
examiner went away, they did not know they owed anything, and
therefore, I think that is a problem that is caused by the IRS.
Mr. Coyne. Is there any other?
Mr. Oveson. Oh, there are all kinds of them. Where--I am
drawing a blank right now in thinking of them, but maybe I can
think of something later.
Mr. Coyne. Well, maybe you can make some available to us.
Thank you.
[The following was subsequently received:]
All of the following examples assume that the taxpayer did not
significantly contribute to the delay.
A taxpayer received a notice from IRS involving a
complicated situation. The taxpayer frequently asked the IRS to
transfer the case to a field office so the taxpayer could meet
face to face with IRS. The request was consistently ignored but
eventually, the case was transferred to the field and settled.
Once the decision to transfer the case was made, the transfer
was accomplished timely. Interest could not be abated.
A taxpayer was audited and disagreed with the
adjustments. The taxpayer went to Appeals, but the case was
delayed and there was no activity for over one year. The
taxpayer presented letters to the Appeals Officer to have the
case transferred to another office due to the length of time it
was taking to work the case. The Appeals Officer did not work
on the case, due to his workload, and the transfer was denied.
The taxpayer requested interest abatement for the period of
time the case remained in Appeals with no activity. The request
was denied.
An account is restricted from generating penalty
and interest and a manual computation must be done whenever tax
changes or payments post. A notice is generated in the service
center for a re-computation. This is low priority work and it
can be a long time before the taxpayer gets a bill with the
recomputed amount. During this time, interest continues to
accrue.
An IRS employee advised a taxpayer of the wrong
balance due. The taxpayer paid that balance believing he/she
was paid in full. However, the employee computed penalty and/or
interest incorrectly.
An IRS employee provided an incorrect payoff
amount to a taxpayer. The taxpayer's account had an ``interest
computation hold'' indicator on the module. The employee who
gave the payoff amount neglected to take the ``interest
computation hold'' on the account into consideration. The
taxpayer borrowed money and took a second mortgage to full pay
the account. The taxpayer later received a bill for the
Interest.
A taxpayer liquidated assets to pay the balance due as
computed by IRS. The Revenue Officer entered the incorrect year
when calculating penalties and interest and the taxpayer still
owes a years worth of interest.
A Corporation was audited and the Revenue Agent
gave the taxpayer a payoff amount. The Revenue Agent used the
wrong calculation in computing the interest. The Corporation
paid the entire pay off amount to the Revenue Agent. Then the
Corporation received a notice for the correct amount of
interest.
A deceased taxpayer's 1995 return was filed
reflecting estimated tax payments of $58,986.00. The Center
input this amount as withholding and refunded the amount to the
taxpayer on March 20, 1998. The check was voided and returned
to the IRS. IRS again released the overpayment and refunded it
to the taxpayer. Again the check was voided and returned to the
IRS. Then the IRS manually refunded the money on July 10, 1998.
This time the taxpayer's representative deposited the money
until the error could be cleared up. IRC 6404(e)(2) allows us
to abate interest that accrued on the refund from the refund
date to the date of demand for repayment, (regardless of how
long the taxpayer had use of the refund) as long as the
taxpayer did not cause the erroneous refund and the erroneous
refund is less than $50,000. In this case, the interest could
not be abated.
A taxpayer was one of four partners and the other
partners were involved in fraud. When the taxpayer was made
aware of the fraud, he assisted IRS in securing the information
for conviction. He had no fraud involvement. In November 1990,
the taxpayer asked IRS for a pay-off amount. He was advised
that the information could not be provided at that time and not
to worry until he got a bill. The taxpayer was informed of the
proposed tax liability of $113,767 in December 1997. The
taxpayer full paid this liability in February 1998, which was
before the actual assessment date in March 1998. The taxpayer
then received a bill for $115,667.89 in interest, covering the
full eight years of the investigation. The taxpayer appealed
and it was denied.
Taxpayers invested in TEFRA shelters. The cases are
suspended in the TEFRA Unit while a key case is worked. When a
case is ready for final closure, the 120 percent interest rate
frequently makes it impossible for the taxpayer to pay.
A taxpayer was not notified of a balance due
because the amount of tax owed was so small. The taxpayer paid
the balance due immediately upon notification and now asks for
abatement/refund stating he had not received statements
advising him that interest was owed.
Chairman Houghton. Thank you very much. We are going to
close off this panel and we thank Mr. Oveson and Mr. Mikrut and
Ms. Paull.
Mr. Watkins. Mr. Chairman, could I have one quick question.
Chairman Houghton. Okay. Shoot.
Mr. Watkins. Maybe to each of you quickly, it will not
require a long answer, and, Ms. Paull, we will start with you.
Do you have any question at all that the intent of this
subcommittee was to provide that interest rates be equalized,
so that neither the government or the taxpayer was financially
disadvantaged by the interest rate differential during all
periods of overlapping mutual indebtedness? Do you have any
question that was our intent at that time?
Ms. Paull. Are you referring to the 1998 change that
affected the global netting?
Mr. Watkins. Yes.
Ms. Paull. I would have to say, although I do not know what
this committee's intent was, but I was working for the Senate
Finance Committee, and we were aware, to be perfectly frank
with you, Mr. Watkins, that there were complicating issues like
the 45-day period for which interest did not--the taxpayer was
not entitled to interest on an overpayment during those 45-day
periods. We were aware that, and I believe, I am pretty sure
the revenue estimate did not take into account giving interest
netting during that period. I would say that we, in doing this
report, we took a hard look at the interest netting rules and
decided it would be more--it would be a--a better approach
would be to have a single interest rate rather than to have to
go through a lot of complicating--this is a very complicated
proposal.
So unfortunately, it was not in connection with this
committee.
Mr. Watkins. I think the intent was very clear. That is the
point I want to try to make of our actions here, Mr. Chairman.
That is what I am trying to get across. I think it is very
clear and I think we need to see that Treasury takes some
action to meet the intent of this subcommittee. Thank you.
Chairman Houghton. Okay. Thanks, Mr. Watkins. Well, thank
you very much, Ms. Paull, Mr. Mikrut, Mr. Oveson. We certainly
appreciate you being here.
Now I will introduce our second panel. Ms. Judith Akin, who
is an Enrolled Agent in Gaithersburg, Maryland and a member of
the National Association of Enrolled Agents. We have Mr. Ronald
Pearlman, Chairman of the Task Force on Corporate Tax Shelters
of the American Bar Association Section of Taxation, and a
professor at Georgetown University Law Center; Mr. Mark H. Ely,
on behalf of the Tax Division of the American Institute of
Certified Public Accountants; and Mr. Charles W. Shewbridge,
Chief Tax Executive of the BellSouth Corporation in Atlanta,
Georgia, and President of Tax Executives Institute,
Incorporated.
Thank you very much for being here. We look forward to
hearing your testimony. We are going to try to move this thing
along so that we are through here at 12 o'clock. I am sorry it
has taken so long. So if you would take your place, we would
appreciate moving along.
Ms. Akin, would you like to start your testimony, or Mr.
Watkins, would you like to introduce Ms. Akin?
Mr. Watkins. Well, I am glad she arrived. I told her I
would see her here.
Chairman Houghton. All right, great. Ms. Akin, please start
your testimony.
STATEMENT OF JUDITH AKIN, ENROLLED AGENT, JAA ENTERPRISE,
L.L.C., OKLAHOMA CITY, OKLAHOMA, AND MEMBER, BOARD OF
DIRECTORS, NATIONAL ASSOCIATION OF ENROLLED AGENTS,
GAITHERSBURG, MARYLAND
Ms. Akin. Mr. Chairman, members of the subcommittee, I am
Judy Akin, an Enrolled Agent, and I am the immediate past chair
of the IRS Information Reporting Program Advisory Committee and
an officer and member of the board of directors of the National
Association of Enrolled Agents. I have been an Enrolled Agent
for more than 25 years and maintain a private practice in
Oklahoma City, where I work with individual and small business
taxpayers.
Today, I am representing the National Association of
Enrolled Agents whose more than 10,000 members are tax
professionals licensed by the Department of the Treasury to
represent taxpayers before all administrative levels of the
Internal Revenue Service.
I am pleased to have this opportunity to testify before you
on the subject of interest and penalty reform. I would like to
summarize my testimony, and without objection, submit my
written testimony for the record.
We appreciate that these hearings are being held today and
hope that penalty oversight will become a regular part of this
subcommittee's schedule. We do applaud the IRS's recent steps
to improve the administration of penalties. These include
permitting taxpayers to designate the application of tax
deposits to minimize tax deposit penalties, the resolution of
crediting payroll and self-employment taxes in certain
nonfiling situations, and the continuation of problem-solving
days. We would also like to mention that the IRS has decided to
expand the ability for both individuals and Businesses to
warehouse tax payments under the Electronic Federal Tax Payment
System (EFTPS). While the system will not be up and running
until after July 1, we believe this will go a long ways towards
remedying problems some taxpayers have in meeting Federal
payroll deposit rules and estimated tax payments. We have found
continual problems with the assessment of penalties on small
businesses, individual taxpayers, particularly the elderly, and
small nonprofit organizations.
This is, indeed, a difficult area of administration perhaps
exemplified in a recent article in Tax Notes which uses the
following phrase in describing Treasury as having trouble
figuring out where one liability ends and punishment begins. It
is an extremely apt phrase capturing in a nutshell the effect
of the provisions requiring moderate income taxpayers to pay
approximately 110 percent of the prior year's tax in order to
avoid penalties. In addition, it penalizes the taxpayer for
having to pay extra tax advisory fees to see their practitioner
to help avoid the penalty. Our list of suggested changes
includes simplifying and streamlining the assessment of tax
penalties. We believe the IRS has the right to collect interest
for time value of money used, but we also believe that
penalties which are predetermined as harsh provide a
counterproductive effect that does not encourage taxpayers to
come forward.
We believe the IRS is doing an excellent job of outreach to
the small business community. However, even more needs to be
done. With respect to small community-based nonprofits, we find
understanding of their tax responsibilities to be a perennial
problem. Often, these organizations have volunteer leadership
which changes from year to year and frequently we find there is
no permanent staff or records or if they have them, they are
very incomplete and spotty. We are looking at the new tax-
exempt government entities division of the Internal Revenue
Service to provide leadership in this area.
We have also received many comments about taxpayers,
particularly senior citizens, being caught up in penalties
where they are caught unaware. Steps need to be taken
immediately to lessen the impact of penalties on these
taxpayers. As our society moves toward more self-managed
retirement plans such as IRAs and 401(k)s with required
distributions, there are many opportunities for senior citizens
to run afoul and have these savings taxed away.
In our testimony we have provided many examples of what is
happening to small businesses as well as individual taxpayers.
These are real problems; these are problems that we are facing
every day.
At this time I would like to thank you for the opportunity
to present our views and I would be happy to answer any
questions.
[The prepared statement follows:]
STATEMENT OF JUDITH AKIN, ENROLLED AGENT, JAA ENTERPRISE, L.L.C.,
OKLAHOMA CITY, OKLAHOMA, AND MEMBER, BOARD OF DIRECTORS, NATIONAL
ASSOCIATION OF ENROLLED AGENTS, GAITHERSBURG, MARYLAND
Mr. Chairman and members of the subcommittee, I am Judith
Akin, Enrolled Agent. I am the immediate past chair of the IRS
Information Reporting Program Advisory Committee and I am an
officer and member of the Board of Directors of the National
Association of Enrolled Agents. I have been an EA for more than
25 years and maintain a private practice in Oklahoma City,
Oklahoma where I work with individual and small business
taxpayers.
Today I am representing NAEA whose more than 10,000 members
are tax professionals licensed by the U.S. Department of the
Treasury to represent taxpayers before all administrative
levels of the Internal Revenue Service. I am pleased to have
this opportunity to testify before you on the subject of
penalty reform.
As you know, Enrolled Agents were created in 1884 to ensure
ethical and professional representation of claims brought to
the Treasury Department. Members of NAEA ascribe to a Code of
Ethics and Rules of Professional Conduct and adhere to annual
Continuing Professional Education standards, which exceed IRS
requirements. Like attorneys and Certified Public
Accountants, we are governed by Treasury Circular 230 in
our practice before the Internal Revenue Service. We are the
only tax professionals who are tested by the IRS on our
knowledge of tax law. Since we collectively work with millions
of taxpayers and small businesses each year, Enrolled Agents
are uniquely positioned to observe and comment on the average
American taxpayer's experience with our system of tax
administration.
The Need for Penalty Reform
Since our testimony before the Commission on Restructuring
the IRS in 1997, NAEA members have frequently spoken out on the
need for penalty reform. We were pleased to see this issue
addressed by the Joint Committee on Taxation and the Treasury
in recent reports to Congress. Portions of the National
Taxpayer Advocate's Report add to the discourse. However, we
would not wish you to think that reforms are not already
underway. We are pleased to note that a major ``fairness''
issue has been resolved. Full credit is now being given for
Social Security and self-employment taxes paid in. In the past,
if a taxpayer failed to file a tax return for more than three
years, even if there was a refund due and all taxes were paid
in timely, the taxpayer was not credited by the Social Security
Administration for the FICA and SE taxes paid in. Yet the IRS
insisted on collecting these same taxes. The procedure is now
that, if the government is paid the taxes, it credits the
taxpayer's account. We are very pleased that the procedure has
changed.
IRS problem solving days continue to provide a safety valve
for resolution of some long-standing cases. We applaud IRS'
consistent effort in this area. At the end of the day, we
believe they are doing the right thing in making their best
people available to help get cases resolved and closed, thus
reducing penalties and interest imposed on taxpayers.
Corporate Tax Shelters
We realize that the issue of corporate tax shelters is not
before us today and was addressed at a hearing in November. We
would respectfully urge the members of this subcommittee to
understand the impact of these devices on the compliance of
average taxpayers. Our tax system is based on voluntary
assessment. If average taxpayers believe that those who
faithfully pay their taxes are foolish, then you will see a
commensurate increase in noncompliance.
You may recall that one impetus for the Tax Reform Act of
1986 was that large corporations were ``zeroing out'' on their
taxes. Middle class taxpayers realized they were paying more in
taxes than major corporations. Were the tax breaks of the time
legal? Yes, but they undermined our tax system. Its perceived
fairness is critical to its success. Speaking as someone from
the heartland, I urge you to maintain taxpayer confidence in
the integrity of our tax system.
Response to the National Taxpayer Advocate's Report
While the National Taxpayer Advocate's Report covers a
variety of topics, I would like to comment on several that
concern penalty issues.
Problem #5: Penalty Administration
Consistency in imposing penalties and consistency in
abating them is an issue that needs the continued attention of
appropriate IRS personnel. We would agree with our colleagues
at the Tax Executives Institute that this is a problem needing
prompt attention in order to maintain confidence in the
fairness of the system. The coordinated review recommended by
TEI is one we would endorse.
Problem #8: Innocent Spouse
We are pleased that on January 18, 2000 IRS issued final
guidance for taxpayers seeking equitable relief from federal
tax liaiblity under IRC Sections 6015(f) and 66(c) pursuant to
the Tax Restructuring and Reform Act of 1998. These claims for
innocent spouse relief are among the most difficult and time-
consuming for practitioners to deal with and we welcome IRS
guidance in resolving them.
Problem #10: Misapplication of Payments
NAEA concurs with the National Taxpayer Advocate that this
is a continuing problem but not a severe one based on our
considerable experience with the Electronic Federal Tax Payment
System. Our direct experience is that mistakes are few and that
they are, for the most part, quickly corrected. We remain
optimistic that as IRS personnel, taxpayers and practitioners
become more accustomed to this and other new methods of
payment, errors will be even fewer than they are now and will
be quickly resolved.
Problem #15: Compliance Burden on Small Business
We would agree that the IRS has made significant strides in
terms of reaching out to the small business community to help
educate and thereby reduce the compliance burden on this sector
of the taxpaying public. The Small Business CD-ROM developed by
the Office of Public Liaison and Small Business Affairs is an
excellent tool that can help small business owners maximize the
assistance available through the IRS. Another excellent program
is the Federal Tax Deposit School that is run much like
``traffic school'' which a business owner must attend when he/
she has run afoul of the deposit rules. It is being replicated
around the country with Enrolled Agents working with IRS
employees to ensure that small business gets the information
early, understands the importance of tax withholding, and has
the opportunity to get back into compliance and remain there.
We are also very pleased with IRS' recent decision to
permit taxpayers to designate the payment of federal tax
deposits so as to minimize penalties. Taken together, these are
very positive steps leading to greater fairness in the system.
Problem #18: Understanding Federal Tax Deposit Problems
NAEA concurs with the National Taxpayer Advocate that this
area is in need of revision. At present, many of the rules are
overly complex and subject to change which the small business
community, in particular, is unable to keep up with. We are
also concerned about the impact of frequent changes upon the
newest and smallest businesses, those that do not yet have the
resources to hire professional assistance for tax and
accounting work.
Dispute Mitigation
NAEA concurs with the National Taxpayer Advocate that
penalty administration contributes to significant problems
facing taxpayers. It would be extremely helpful if penalty
abatement could be consistently available, particularly in
those areas where taxpayers have made innocent mistakes. The
cases NAEA has brought to the subcommittee should provide some
understanding of the dimensions of this problem in that affects
not only small businesses but also elderly taxpayers and small,
community-based nonprofit organizations.
Case Studies
More than half of NAEA's members are online. As a result,
NAEA regularly surveys its members for their views and
experience on various issues. The survey on penalty reform
generated scores of replies. They break down into several
areas: those affecting small business, those affecting senior
citizens, and those affecting small nonprofits. We examined
these reports from our Members through the prism of 1)
voluntary compliance; 2) fairness in operation; 3) whether a
deterrent to undesirable behavior; and 4) whether the penalties
were capable of effective and efficient administration by the
IRS.
A. Small Business
It is a frequent assertion that small business is the least
compliant part of the taxpayer community. However, as frontline
tax practitioners, we find that noncompliance is often due to a
lack of information and understanding of the tax code. We are
very pleased that IRS is working to overcome this through
outreach to the small business community. However, there
remains much work to be done as the following anecdotes from
our members indicate.
*A retail store owner in New Hampshire with an impeccable
record of making timely--even early--deposits of payroll taxes
stretching back 20 years, was not aware that effective 1/1/99
he would be required to make semi-weekly deposits. By the time
the error was caught, the penalty due was $2,000, even though
he was still making timely deposits each month.
*A young businessman in Virginia was advised to set up his
small company, in which he was the sole person involved, as
an'S Corporation but did not know he was supposed to pay
himself a salary. A couple of years went by and this individual
did not withhold taxes on the amounts he withdrew from the
corporation. An accountant, upon finding this error, went back
through the records and grossed up his pay, filed the necessary
payroll tax reports, and told the client how much in tax he had
to pay. The client agreed this was reasonable and began paying
the back taxes in installments and kept current with the
reporting. The IRS came in and assessed the 100% penalty on the
back taxes, refusing to abate any of the penalties and
interest. The young man was forced into bankruptcy. This was a
clear example of a person who was trying to do the right thing
and was not trying to ``beat the government.'' A reasonable
penalty and interest charge in this situation would have been
warranted but not the 100% penalty.
*In 1983, a small businessman in Texas, faced with his wife
leaving him and his son being sent to prison for murder, became
a non-filer. He had had his tax return prepared but in the
midst of the family tragedy, neglected to sign and send it in.
When contacted by the IRS in 1990, he filed his returns from
1986 forward but, wanting to be completely honest, he
volunteered to file for 1983, 1984 and 1985. The years he
volunteered to file were then chosen for audit. He was assessed
$19,000 in additional income and self-employment taxes and
$75,000 in penalties and interest. IRS refused to accept an
offer in compromise. He was forced into bankruptcy. When he
sold his business he owed $31,000 in income tax. The funds from
selling the business were put into bankruptcy and the court
would not release the funds to pay the tax. When the funds were
finally released, IRS assessed him penalties and interest for
not paying his taxes on time.
*A cabinetmaker in California tried to get back in business
after declaring bankruptcy in the early 1990s. Faced with cash
flow problems, he made payroll deposits late. Penalties and
interest on his account now total 52.6% of his tax liability,
although he has made every effort to get current. When asked
about penalty abatement, IRS declined, even though the taxpayer
has kept his account current and recently made a $3,000 lump
sum payment.
*A client who did her own payroll did not do the ``look
back'' on tax deposit frequency. The four-quarter deposits in
that ``look back'' totaled $50,005, $5 over the amount that
required her to pay semi-monthly. IRS has discontinued sending
notices and thus she continued her monthly deposits in 1999.
The penalty for first quarter was in excess of $500, with the
same true for the second quarter. She sought professional help
and the penalties were finally abated but the process was quite
time consuming and required assistance from a tax professional.
*Taxpayer died last December 25 after a lengthy illness.
His wife was unable to get the 941 (payroll tax deposit) taxes
paid on time. IRS said she would have to pay the penalties and
interest first, in order to be considered for the abatement. If
she could pay the penalties and interest, she would, obviously,
not have to request any assistance. Because of the penalties,
she cannot pay the taxes owed and it keeps growing faster than
she can pay.
B. Small Nonprofits
Understanding of the tax laws as they apply to nonprofits
is a perennial issue for those of us who work with small
nonprofit organizations. Often, community-based organizations
have volunteer leadership, which changes from year to year.
Frequently we find they have no permanent staff, no records, or
if they have them, they are very spotty and incomplete.
Sometimes the leader is a visionary who is focused upon the
mission of the organization and fails to think about taxes at
all. There is a widely held view at the grassroots level that
nonprofits are exempt from all taxes. Imagine the surprise when
a tax notice is received.
*A social club in Alabama was penalized $440 for late
filing of the Form 990EZ. It was due May 15, 1998 and was filed
22 days late.
*A small nonprofit received a penalty for late filing
totaling $1,640 when the administrator, in attempting to obtain
an extension to file the return, used the guidelines for the
individual extension. He sent in the request but neglected to
give a ``reason'' for the request. When IRS notified the
nonprofit that the extension was not accepted, the nonprofit
quickly sent in the return so that it was only 2 weeks late.
However the penalty was assessed anyway.
*Two payroll tax checks were inadvertently buried on the
desk of the pastor of a small church. The payments were mailed
in but, of course, were late. IRS assessed a penalty. Abatement
was requested on the grounds that payroll tax deposits had not
been late in over 5 years and that although the circumstances
may not be ``reasonable cause'' in nature they were certainly
not a case of ``willful neglect.'' Penalty abatement denied.
*The pastor of a small church in Florida applied for and
received recognition as a not for profit more than a dozen
years ago. The pastor believed the organization did not need to
file any tax returns because of its nonprofit status. IRS wiped
the client from its records because a return has never been
filed. When the church sought an EA to put together financial
records for a bank loan, they were asked for copies of their
tax return. In the words of the EA, they hadn't a clue. The
pastor decided to file all returns that had never been filed.
Meanwhile, IRS could find no record of their being approved as
a not for profit but fortunately, the taxpayer had held onto
that document so it was sent to IRS. Information is being
reconstructed for tax years 1995-1998. IRS has assessed a
penalty of $5,000 for 1995 but has yet to bill for the other
years. True, the client was negligent but it could be argued
that so was the IRS for not following up when the nonprofit did
not file originally.
C. Individual Taxpayers
We received many comments about taxpayers--particularly
senior citizens--being caught up in penalties where they truly
did not understand the situation and were caught unaware. Steps
need to be taken immediately to lessen the impact on taxpayers
who are completely in the dark about the penalties and interest
they face if they try to come back into compliance after an
innocent mistake.
Furthermore, as our society moves toward self-managed
retirement plans such as IRAs and 401(k)s, there will be many
more opportunities for individuals to inadvertently run afoul
of the system with disastrous consequences. Some examples of
the problems senior citizens face are cited below:
*A senior citizen was drawing out his IRA, using the
minimum distribution. Last November his wife was sick with
pneumonia and she was hospitalized for 9 days. With his stress,
he forgot, and the bank neglected to remind him, to take out
his minimum distribution of $1,692. When he realized his
mistake, he withdrew it on February 1, 1999. When he did the
return on March 6th, the EA had to prepare a Form 5329 and he
paid the $846 (50%) penalty. Without the penalty, he owed $15.
As directed in Publication 590, a letter was included
explaining the situation but apparently it was never read.
Nothing was heard from the IRS for 6 months. About 3 weeks ago
his EA followed up with a Power of Attorney, letter and copies
of all documents. The most aggravating thing about this is he
is a retired person who is trying to comply with the tax law
and gets hit with a 50% penalty. If he had committed civil
fraud and willfully understated his taxes by the same $1,692,
his penalty would have been 25% or $423.
*Taxpayer is a widow in her late seventies who is still
working as a secretary in a federal agency. She has a small IRA
in the agency's credit union. In August, the credit union sent
her a form stating that because she was past 70 l/2 years of
age, she must withdraw a certain amount. If she agreed to the
withdrawal, she merely had to check a box and return the form.
She suffered a heart attack and was hospitalized for several
weeks. Consequently she failed to return the form. The penalty
for failing to make the required withdrawals is 50%. A request
that penalty be waived has been made, but this is an example of
the type of circumstance affecting potentially millions of
taxpayers of ordinary means.
*Taxpayers, age 78 and 76 years old, have an outstanding
tax liability from 1967 and 1968. Thirty years later, it's
still open as the IRS has threatened action on these retired
people and had repeated statute extensions signed. For tax year
1967, original debt was assessed at $27,015.25 in 1975. Current
debt is now at $236,255.26 after more than $40,000 has already
been paid on the debt. For 1968, liability was assessed at
$9,813.28 as of 1975; $14,000 was paid in 1975 with a current
balance due of $13,130.07. Both the 1967 and 1968 returns were
filed timely. They are paying off the debt at the rate of $150
to $300 per month with no hope of ever paying it off. Each
payment made shows an equal amount of interest assessed each
month so no progress is ever made and then the additional
interest that they couldn't pay is incurred. This couple has
few assets: a 1987 Chevy, a little life insurance. They owe
$15,000 in credit card bills; they pay $900 per month for
medical care and are in very poor health. They have lived with
this situation hanging over their heads all these years.
Increasingly complicated estimated tax rules are making it
difficult, if not impossible, for taxpayers to stay in
compliance. Just one example of several that were sent in:
*Taxpayer's liability for the 1998 1040 was $9,000 which
was satisfied with estimated payments of $5,800 made before the
submission of the return and $3,200 paid with the submission of
the return. IRS null and voided her Form 4868 Request for
Automatic Extension of Time to File, charging a penalty of
$676. The interest tab was $106.99. The taxpayer managed to
find herself in this situation despite having overpaid (paid in
advance) her estimated tax, even through the 4th quarter.
We are finding that once taxpayers fall behind, they may
never be able to catch up. A typical example:
*In 1989, a low wage individual went to work for a company.
He did not realize taxes were not being withheld. He was given
a 1099-MISC at year-end but had no money to pay taxes. His 1989
tax debt is now $17,262 of which $1,598 is penalty and $9,079--
one-third more than the tax owed--is interest. Given his spotty
work history, he owes from 1990 and also 1997 and 1998. Most
low-income taxpayers do not question employers. They want the
work and just don't understand when employers hand them a 1099-
MISC instead of a W-2 at the end of the year. This is
particularly true for low-income workers who are often very
naive about employment taxes and who are not in a position of
strength to bargain with a prospective employer.
NAEA Recommendations
1. Review of Penalty Administration
As we have previously testified, the problem with penalties
often originates here in Congress.
We are very pleased that these hearings are being held and
hope that they will be done on a regular basis in the future,
much as the IRS budget and filing season readiness hearings
are. The reports by the Joint Committee on Taxation and
Treasury, along with portions of the National Taxpayer
Advocate's Report provide very useful guidance on areas in need
of attention.
2. Tax Penalties Should Not be Used for Revenue Raising
There are too many penalties for too many infractions and
no one could reasonably expect taxpayers to comprehend their
applicability. We think the current code's proliferation of
penalties has accomplished nothing but create taxpayer
perceptions of a system run amok which acts like a hidden tax
rate. This feeling is reinforced by the fact that, in the past,
various committees scored penalties for revenue raising
purposes. Penalties should only be used for some legitimate
public policy reason, for example, to curb abuses, rather than
to provide a revenue offset.
3. Payment and Abatement Should Be Separate Considerations
As some of our earlier examples indicate, we believe that
insisting that tax and interest be paid before a request to
abate a penalty for reasonable cause can be considered should
be eliminated. Payment of tax and abatement of penalties should
be separate considerations and the facts and circumstances of
each case should be weighed.
4. Trust Fund Recovery Penalty
This penalty should be assessed against officers, rather
than against just those who were responsible. Once the actual
outstanding taxes have been paid to protect the employees
benefits, the penalties and interest should be stopped or
limited to a maximum amount. In addition, IRS needs to ensure
that proper procedures are in place. To prevent future loss of
taxes, interest and penalties by IRS, a new law should be
considered which would allow the IRS and State Agency be
notified of ALL bankruptcies in which an outstanding IRS
account is on file.
5. Eliminate or Restrict the Failure to Pay Penalty
Too often Enrolled Agents are called upon to seek abatement
of this penalty. It should only be imposed in cases of
egregious fraud or negligence. Again, facts and circumstances
of each case should be taken into consideration.
6. Simplify the FTD deposit rules and the Related Penalties
Too often we are called upon to straighten out problems
when common sense should prevail. The facts and circumstances
of each case should be considered. We are heartened by IRS'
recent decision on application of federal tax deposit payments.
It's a step in the right direction.
7. Offer to Eliminate or Reduce Penalties
Enrolled Agents, as a rule, strive to return taxpayers to
compliance and search for ways to enable them to stay that way.
It would be very helpful if IRS would look to the facts and
circumstances of cases and offer to eliminate or reduce
penalties. Several comments from our Members noted that rather
than encouraging taxpayers to come into compliance, the
severity of penalties can force a taxpayer to continue to not
file and/or pay his or her taxes.
Perhaps a two-tier system could be implemented so that if
the taxpayer comes forward and files his/her return
voluntarily, the penalty would be waived or at least greatly
reduced. If the IRS must come to the taxpayer, then the penalty
would be higher.
In addition, it would be helpful if no penalties, only
interest, were charged for a taxpayer or paid preparer who
makes an honest mistake. Given the complexity of our tax laws,
penalties should only be applied where there is a clear and
deliberate effort on the part of the taxpayer or paid preparer
to cheat the government.
8. Standardize the Forms 1099
The current system frequently hammers individuals who make
a simple mistake such as overlooking an interest or dividend
payment. This is particularly true for the elderly who have
great difficulty following the law and keeping track of these
payments. This confusion could be dramatically reduced if there
were standard Forms 1099, which would be required to be used by
every information reporter with no substitutions allowed. We
are seeing an ever-increasing number of interest and dividend
statements that look much more like a letter than a reporting
document. There is no reason why, with today's modern computer
systems, all information reporters cannot have and use
identical forms. This is also true for W-2s.
9. Eliminate Frivolous Penalties
Many clients are being affected by the Failure to File the
Information Return, Form 1065, when there are fewer than 10
partners. Practitioners in the know use PL 95-600 to get the
penalty abated but the mere fact that this Public Law exists
and IRS continues to ignore the Committee's directives causes
clients grief and worry. IRS employees need to recognize that
there is no ``assessable penalty'' on a partnership with fewer
than 10 partners and all partners reporting their distributive
share on their individual tax returns.
The $100 minimum penalty for returns filed more than 60
days late is sometimes excessive. For example, taxpayer had a
1998 tax liability of $197. He had withholding of $88 and a
payment of $109 was filed when the return was submitted in
early August. IRS assessed a late filing penalty of $100, late
payment penalty of $2.72 and interest. Combining the late
filing and late payment penalties would make things simpler,
fairer and easier for the taxpayer to comprehend.
10. Eliminate the Daily Compounding of Interest on Penalties
The compounding factor does not help collect the taxes any
faster and creates just that much more that the taxpayer cannot
pay. Again, perhaps a facts and circumstances approach could be
used to eliminate daily compounding of interest on penalties
when taxpayers have made an innocent mistake.
11. Continue Education Outreach to Taxpayers
It is important that IRS continue its outreach to
taxpayers. We believe IRS is doing an excellent job with
respect to individual and small business taxpayers. We are very
concerned about the lack of information for small nonprofits.
This area needs immediate attention.
12. Provide Adequate Training for IRS Employees
There is always tension between having a consistent
national standard and having the ability to make judgments on a
case by case basis. NAEA does not wish to make a recommendation
which would be impossible for IRS personnel to carry out.
However, the hardship cases we have described necessitate IRS
personnel having the ability to mitigate penalties where there
is no intent to cheat the government. Perhaps a well-defined
national standard coupled with adequate training as well as the
ability to exercise judgment in difficult cases would benefit
both the IRS and taxpayers.
Conclusion
I would like to thank you, Mr. Chairman and the members of
the Oversight Subcommittee, for the invitation to share our
members' views with you today. I will be happy to respond to
your questions and comments about our recommendations.
[The attached report: ``Report to the Congress on Penalty
and Interest provisions of the Internal Revenue Code,'' Dated
October 1999, is being retained in the Committee files. The
Report can also be viewed electronically from the Treasury's
website at ``http: www.treas.gov/taxpolicy/library/
intpenal.pdf''.]
Chairman Houghton. Thanks very much, Ms. Akin.
Now I would like to introduce Mr. Pearlman, who, of course,
as you remember, used to be the head of the Joint Committee on
Taxation. Chairman, great to have you here today.
STATEMENT OF RONALD A. PEARLMAN, CHAIR, TASK FORCE ON CORPORATE
TAX SHELTERS, SECTION OF TAXATION, AMERICAN BAR ASSOCIATION
Mr. Pearlman. Good morning, Mr. Chairman, Mr. Coyne,
Members of this distinguished committee, it is a pleasure to be
here. Today I am here on behalf of the Tax Section of the
American Bar Association. The Section appreciates the
opportunity to appear before the subcommittee. We believe that
both the Joint Committee and the Treasury penalty and interest
studies address important issues and we take our hats off to
them for the preparation of their studies and to you, Mr.
Chairman, for scheduling this hearing.
In the interest of time, I am going to limit my remarks to
just two items relating to penalties that we believe are
particularly important. Our written statement and our previous
submissions to the Joint Committee and Treasury staffs provide
much more detail on the views of the Tax Section on the penalty
and interest provisions of the Code.
Let me say these two issues, the two items I am going to
address, relate broadly to the topics of level of rates, level
of penalty rates, and the flexibility which the tax collector
has regarding the administration of the penalty system.
The first matter I would like to address is the Joint
Committee's proposal, which I think has not been discussed this
morning, to eliminate the present law reasonable cause
exception to the substantial understatement penalty of section
6662. As you know, under existing law, the courts and the IRS
are given discretion to waive a penalty based on a standard of
reasonable cause. This discretion permits the Service and the
courts to take into consideration the particular circumstances
underlying the position the taxpayer took on his or her return
in determining whether the penalty should be sustained. We
oppose repeal of the reasonable cause exception. In our view,
it would create a rigid, inflexible penalty structure and would
preclude the application of discretion by the IRS or a court
that we think is very important to a properly functioning
penalty system.
I would say as a broader matter, it seems to me as you
review the penalty provisions of the Code, an appropriate
question continually asked is what kind of degree of
flexibility are you giving the tax collector to address
instances where penalties should be abated. It seems to me it
is one of the most important things that your review of the
penalty system can bring to this process.
Some might think the repeal of the reasonable cause
exception will have the effect of making it more difficult for
unsympathetic taxpayers to avoid application of a penalty, and
it may. But the subcommittee should understand that two other
results also are likely. First, if the IRS has no discretion to
waive a penalty, it is likely that fewer penalties will be
asserted in cases where they should be. Second, if the
reasonable cause exception were to be repealed, I suspect that
in the future this subcommittee will be forced to hold hearings
to listen to stories of taxpayers who had sympathetic cases for
penalty waivers based on reasonable cause, but whose cases
could not be favorably disposed of by the IRS because the
standard was no longer in the statute.
The second item I want to discuss is the item of size of
penalties. Review of the history of penalty rates will reveal
that this is not a new issue. It is always a dilemma. If the
penalty rate is too low, it will not have the desired deterrent
effect. If the rate is too high and is considered too harsh,
the IRS will anticipate adverse taxpayer reactions and will be
less inclined to assert penalties even in cases where the
penalty is appropriate. The accuracy-related penalty rates now
range from a low of 20 percent to a high of 40 percent in the
so-called gross misvaluation statements.
Now, we do not mean to suggest that the gross misvaluation
statements are not appropriate cases for the imposition of a
penalty, but we do suggest that 40 percent is too high.
Anecdotally, we think the penalty is very rarely imposed. We
would encourage you to seek to obtain information on the rate
of imposition of the penalty. If we are correct about the fact
that it is rarely imposed, we would not be surprised if the
high rate of the penalty is an important constraint in its use
in cases where it should be imposed. Reduction of the penalty
rate to a more realistic number may make the penalty a more
useful tool in trying to discourage valuation misstatements.
We also, as the staffs indicated this morning, think that
the failure-to-deposit penalties are too large. It is
interesting that if you assume a $10,000 failure to deposit
payment is one day late, a $200 penalty is imposed. And if it
is two weeks late, at a 10 percent penalty, the penalty
approximates an interest rate of 260 percent. We think these
cases in which taxpayers are trying to comply with the law by
paying their taxes and yet are subjected to relatively large
penalties are inappropriate. The Treasury Department report
contains recommendations for reducing the failure to deposit
penalty. We think those recommendations are constructive and we
encourage the subcommittee to seriously consider them.
That concludes my remarks. I am pleased to try to answer
any questions.
[The prepared statement follows:]
STATEMENT OF RONALD A. PEARLMAN, CHAIR, TASK FORCE ON CORPORATE TAX
SHELTERS, SECTION OF TAXATION, AMERICAN BAR ASSOCIATION
My name is Ronald A. Pearlman. I appear before you today in
my capacity as Chair, Task Force on Corporate Tax Shelters of
the American Bar Association Section of Taxation. This
testimony is presented on behalf of the Section of Taxation. It
has not been approved by the House of Delegates or the Board of
Governors of the American Bar Association and, accordingly,
should not be construed as representing the policy of the
Association.
The Section of Taxation appreciates the opportunity to
appear before the Committee today. We believe the
recommendations in the penalty and interest studies by the
Joint Committee on Taxation \1\ (hereafter ``JCT Study'') and
Department of the Treasury's Office of Tax Policy \2\
(hereafter ``Treasury Report'') address very important issues.
Our testimony today will not include comments on each and every
item in the studies. Individual members of the Tax Section
would be pleased, however, to provide assistance and comments
to members of the House Ways and Means Committee's Oversight
Subcommittee and your Staff on any recommendations you might
identify.
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\1\ Joint Committee on Taxation, Study of Present-Law Penalty and
Interest Provisions as Required by Section 3801 of the Internal Revenue
Service Restructuring and Reform Act of 1998 (Including Provisions
Relating to Corporate Tax Shelters) (JCS-3-99), July 22, 1999.
\2\ Department of the Treasury, Office of Tax Policy, Report to The
Congress on Penalty and Interest Provisions of the Internal Revenue
Code, October 1999.
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As you know, the ABA Tax Section is comprised of
approximately 20,000 tax lawyers. As the largest and broadest
based professional organization of tax lawyers in the country,
we serve as the national representative of the legal profession
with regard to the tax system. We advise individuals, trusts
and estates, small businesses, exempt organizations and major
national and multi-national corporations. We serve as attorneys
in law firms, as in-house counsel, and as advisors in other,
multidisciplinary practices. Many of the Section's members have
served on the staffs of the Congressional tax-writing
committees, in the Treasury Department or the Internal Revenue
Service, and the Tax Division of the Department of Justice.
Virtually every former Assistant Secretary of the Treasury for
Tax Policy, Commissioner of Internal Revenue, Chief Counsel of
the Internal Revenue Service and Chief of Staff of the Joint
Committee on Taxation is a member of the Section.
At the outset, I would like to recognize the time and
energy this Subcommittee, the Joint Committee on Taxation, and
the Treasury Department's Office of Tax Policy are devoting and
have already devoted to examining the Internal Revenue Code's
penalty and interest provisions. Your thoughtful consideration
of this area is important because the law's approach to
penalties and interest affects taxpayers' views of, and, thus
their compliance with, our self-assessment tax system.
We have limited our specific comments today to five areas:
(1) accuracy-related penalties, (2) preparer penalties, (3)
interest, (4) the failure to file penalty, and (5) late payment
penalties. The accuracy-related and preparer penalties are
important because they set the standards for what taxpayers and
preparers are permitted to report on returns. Interest and the
filing and payment penalties are important because they are the
additions to tax that a taxpayer is most likely to encounter
and that most commonly create hardship for less well off
individual taxpayers. We will not be addressing any penalties
related to tax shelters; they will be discussed in the
testimony we anticipate giving in the House Ways and Means
Committee hearing tomorrow on corporate tax shelters.
Before we shift to the specific issues we discuss today, I
would like to briefly summarize our views on civil penalties
and interest. Penalties should be structured to encourage
taxpayers to approach their tax obligations carefully and
responsibly, but with due regard for the complexity and
sometimes uncertain application of our tax laws. If a penalty
is too small, or the taxpayer's duty is expressed in too vague
a way, it is unlikely that a penalty will accomplish this goal.
On the other hand, if a penalty is too large, or too much is
expected of the taxpayer, the penalty may lead to excessive
burdens on taxpayers and perceptions that our tax system is
unfair. Accordingly, our comments are guided by the views that
penalties should be straightforward enough for taxpayers to
understand and for the IRS to efficiently administer. Penalties
should penalize similarly situated taxpayers similarly and
should impose sanctions proportional to a clearly defined
transgression. Penalties should reinforce reasonable
expectations of taxpayers and should encourage compliance even
if untimely.
Accuracy-Related and Preparer Penalties
The accuracy-related and preparer penalties set forth the
duties of taxpayers and preparers to prepare returns carefully,
taking only realistic positions and disclosing those where the
tax treatment is unclear or questionable. We think the current
structure of these penalties is reasonably sound, but has
features that legislation can improve.
Reporting Standards for Taxpayers and Preparers.\3\ At
present, the two penalties are not completely coordinated,
since what is expectated of preparers is somewhat less than
what is expected of taxpayers. Both the JCT Study and the
Treasury Report recommend conforming the reporting standards
for taxpayers and preparers. However, the JCT Study would set
standards for taxpayers and preparers much higher than the
standards of current law, while the Treasury Report would set
standards at levels nearer those of current law.
---------------------------------------------------------------------------
\3\ We do not address tax shelter penalties, whether corporate or
non-corporate, here; we will address them in separate tax shelter
comments.
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Undisclosed Positions. At present, Section 6662 penalizes a
taxpayer if a position on a return lacks substantial authority
and is not disclosed. Section 6694 penalizes a preparer when a
position on a return lacks a realistic possibility of being
sustained on its merits and is not disclosed. In general, we
think that a ``substantial authority'' standard for undisclosed
positions works best for both taxpayers and preparers. The
substantial authority standard has now been in the law for 17
years. The regulations defining the standard do an excellent
job of guiding both taxpayers and preparers, and a substantial
body of case law is developing that gives both taxpayers and
preparers useful guidance. Further, the expectation that an
undisclosed position should be supported by substantial
authority is intuitively reasonable. The objective nature of
the standard, which turns on whether adequate legal and factual
support for a position exists, avoids messy and difficult
inquiries into the taxpayer's state of mind. Accordingly, we
support the Treasury Report's recommendation that a
``substantial authority'' standard be retained in Section 6662
for undisclosed return positions and that Section 6694 be
amended to establish this standard for preparers as well.
The Joint Committee Staff recommended changing the standard
for undisclosed positions from substantial authority to a
reasonable belief that the position taken is ``more likely than
not'' correct. We do not believe that this proposal is an
improvement on the ``substantial authority'' standard; it would
be less objective, would encourage difficult factual inquiries
into the state of mind of the taxpayer and preparer, could
encourage excessive disclosure, and would fail to give adequate
weight to the complexity and uncertainty of existing tax law.
Disclosed Positions. At present, Section 6662 imposes a
penalty on a return position for which adequate disclosure has
been made only if, in the case of the taxpayer, the position
lacks a reasonable basis. Section 6694 imposes a similar
penalty in the case of preparers if the position is frivolous.
Historically, this has been the function of the negligence
penalty, and the standard for disclosed positions in current
law in essence defines a negligence standard.
We believe that the Joint Committee Staff recommendation
that the standard for disclosed positions be elevated to
``substantial authority'' is unwise.We think that it is very
important to preserve the essential nature of this expectation
of taxpayers and preparers as a negligence standard. The vast
majority of taxpayers in this country spend a relatively short
period each year preparing and filing their returns. They have
a generalized understanding that they must do so carefully and
fairly. However, it is doubtful that they ever would spend the
time and effort necessary to understand the details of a
complex penalty standard. We think it important that the
standard for disclosed positions in Section 6662 be viewed as
fair and reasonable, and we think that this requires this
standard to reflect taxpayers' general understanding that they
must be careful and even-handed in preparing their returns. If
the standard were elevated, so that a taxpayer was required to
do more than one would expect of a prudent but relatively
unsophisticated individual, then we think penalty impositions
would likely increase because the expectations of our tax
system would exceed the behavior that most taxpayers
intuitively think is appropriate. We believe that penalizing
taxpayers who have acted in a reasonably careful way would
create anger toward our tax system.
Our understanding of the Treasury Report's proposal for
disclosed positions (other than those involving a tax shelter)
is that Treasury would retain the essential ``negligence''
standard of existing law, but conform the definitions in
Sections 6662 and 6694 in the language ``realistic possibility
of success on the merits.'' We support this proposal. For the
last several decades, the overriding debate with respect to the
negligence penalty has been to arrive at a definition of
negligence conveying the idea that the conduct expected is more
than an empty appearance of compliance, but rather reflects the
serious effort that a careful and prudent person should make.
We think that the language suggested in the Treasury Report for
non-tax shelter positions does this. Further, it would conform
Section 6694 to existing standards of professional
responsibility promulgated by the ABA and the AICPA.
Reasonable Cause Exception. Under existing law, the IRS and
the courts have the flexibility to waive a Section 6662 penalty
to which a taxpayer may become subject. This waiver authority
permits IRS and the courts to take into account a person's
education, a personal tragedy, or an isolated failure to
identify an issue. We think that this waiver authority is
critically important to the smooth functioning of Section 6662.
The JCT Study, but not the Treasury Report, recommends
repealing the reasonable cause exception for substantial
understatement penalties. We oppose repeal of the reasonable
cause exception because we think that repeal would result in a
penalty that is too rigid and inflexible and would eliminate
the discretion of the IRS and courts to waive a penalty even
when any reasonable view of the situation would support waiver.
Repealing the waiver authority also runs counter to the
provisions enacted in the IRS Restructuring and Reform Act that
vest IRS with more discretion in administering the interest
provisions and collecting late payments.
Threshold for Imposing the Substantial Understatement
Penalty. At present, the substantial understatement prong of
the Section 6662 penalty applies, in the case of corporations,
only if the understatement at issue exceeds the greater of
$10,000 or 10% of tax liability. The practical effect of this
threshold is that, for very large corporations with very large
tax liabilities, the substantial understatement penalty is
seldom applicable.
The Treasury Report, but not the JCT Study, suggests
changing the definition of a substantial understatement in the
case of corporations to the lesser of $10 million or 10% of the
tax required to be shown on the return. This proposal would
have the practical effect of making the substantial
understatement penalty potentially applicable to very large
corporations for any issue that exceeds $10 million in amount.
We think that this proposal provides a reasonable way to
encourage disclosure of significant issues by large
corporations, and we support it.
A change in threshold would, we believe, also be warranted
for individuals. At present, the threshold (the greater of
$5,000 or 10% of tax liability) may encompass many very small
cases for which a more general negligence penalty is more
appropriate. We suggest that the existing ``greater of'' format
for this threshold works well, but that the dollar threshold
should be raised and the percentage threshold dropped, so that
the minimum size of an issue subject to disclosure is increased
and it is less likely that the overall size of the taxpayer's
liability will prevent the application of the penalty. While we
do not feel strongly about any specific numbers, a revised
individual threshold along the lines of ``the greater of
$25,000 or 5% of tax liability'' would constitute an
improvement over existing law.
Amount of Penalty. The percentages at which the Section
6662 penalty is applied are a targeted 20% for the negligence
and substantial understatement prongs of the penalty and either
20% or 40% for the valuation penalties, depending on the extent
to which the taxpayer's valuation departs from the correct
valuation. These are high rates in comparison to the 5% rate at
which the negligence penalty was imposed prior to 1989 and the
10% rate at which the substantial understatement penalty was
imposed when it was enacted in 1982. The rates were increased
in the mid-80's with little empirical support. We think that
penalty rates that are too high are more difficult to
administer consistently and may have the paradoxical result of
making the penalty less effective because of a reluctance to
impose it. A review of case law indicates that very few 40%
penalties have been imposed over the years. We encourage repeal
of the 40% rate for gross valuation misstatements.
Fee-based Preparer Penalties. Both studies recommend a fee-
based measure for preparer penalties. The Joint Committee
suggests that, instead of the current flat $250 penalty, first-
tier violations incur a penalty of the greater of $250 or 50%
of the preparer's fee, and that the penalty for second-tier
violations be the greater of $1,000 or 100% of the preparer's
fee rather than a flat $1,000 penalty. Treasury, without
recommending specific thresholds, suggests consideration of a
fee-based approach because, it contends, current preparer
penalties are low compared with the tax liabilities involved
and thus discourage IRS assessment on a cost-benefit basis.
Any concern that the preparer penalties are not an
effective deterrent to inappropriate conduct should first focus
on the effectiveness of the compliance programs for preparers.
A review of decided cases suggests that cases involving
preparers very rarely arise. A compliance regime that is not
effectively policed is unlikely to be improved by increasing
sanctions that are infrequently imposed. Tying preparer
penalties to a preparer's fee creates significant complexity
and enforcement issues. Perhaps the issue of greatest concern
is that it seems likely to increase the costs of return
preparation, as preparers seek to protect themselves from large
penalties. This problem is likely particularly to affect small
taxpayers.
In situations in which the preparer performs a variety of
services for the taxpayer, such a penalty would require an
analysis of what portion of the fee relates to actual return
preparation, in as much as the fee will vary substantially
depending on the nature of the client and the extent of the
representation. Because the size of the penalty may be
substantial but would not vary based on the size of the
position in dispute and is calculated on the preparer's gross
(rather than net) fee, it seems likely that those subject to
the penalty will think it unfair as actually applied. For these
and other reasons, we think that a tying of widely applicable
preparer penalties to a percentage of the preparer's fee is
unwise. We express no view on whether the $250 and $1,000
amounts of these penalties are adequate to support expectations
of preparers. However, we would note that the primary factors
encouraging professional conduct from preparers are probably
the professional standards of conduct of the preparer's chosen
profession, the professional liability that a preparer may face
from a client for a job poorly done, and the possibility of
referral to the IRS's Director of Practice. We are convinced
that these factors far more strongly encourage professional and
careful conduct and that substantial increases in infrequently
asserted penalties are unlikely to elevate conduct
substantially.
Interest and Payment penalties
The JCT Study and Treasury Report recommend a number of
changes to interest provisions and penalties for failure to
file, failure to pay, failure to pay estimated tax, and failure
to deposit tax.
Interest Provisions. The studies suggest various changes
for interest, including (1) eliminating the differential
between the interest rate the IRS charges on underpayments and
the interest rate the IRS pays on overpayments, (2) pegging the
interest rate at the applicable federal rate (``AFR'') plus
five percent, (3) excluding IRS interest from individuals'
income, (4) providing additional interest abatement rules, and
(5) instituting ``dispute reserve accounts.''
Elimination of Rate Differential. The JCT Study proposes
eliminating the differential between the interest rates charged
on underpayments and paid on overpayments to make the system
simpler and fairer. In contrast, the Treasury Report recommends
retaining the interest rate differential for the time being in
view of the recent enactment of the global interest netting
rules and because retaining the differential mirrors the
commercial sector model. We support the Joint Committee's
recommendation to eliminate the rate differential because we
believe that a uniform interest rate for under-and overpayments
will be perceived as evenhanded, simple and fair, while the
rate differential of present law creates significant and
unnecessary complexity without any significant compliance
benefit.
While we accept as a conceptual matter the Treasury
Report's observation that commercial organizations attempt to
achieve a profit on their lending and borrowing activities, we
think that this observation has little to do with whether a
differential in interest rates has a positive effect on tax
compliance. Because the relationship between a taxpayer and the
IRS is an involuntary one, because it is not always possible
for a taxpayer to know whether at the moment the taxpayer is a
borrower or lender from the government, and because different
taxpayers are able to borrow money from commercial lenders at
rates that differ substantially from the underpayment rate, we
think it likely that the existing rate differential is viewed
as unfair. For taxpayers with complex affairs, the concurrent
accrual of the differential rates is a labyrinth of complexity
and time is not needed to prove that one can cope with this
complexity when a simple solution is available. We strongly
encourage the enactment of uniform over-and underpayment
interest rates. This will be a significant simplification in
the law and is an opportunity to strengthen the image of the
tax system as evenhanded and fair.
Interest Rate Increase. Both the Joint Committee and
Treasury recommend a higher interest rate: the Joint Committee
at the AFR plus 5%, and Treasury at the AFR plus 2-5%. While we
have no specific recommendation to make on the most appropriate
rate, we note that a significant divergence from market rates,
in either direction, may result in taxpayer conduct oriented
toward the arbitrage of this differential. Thus, if rates are
set too low, taxpayers may be slow to pay their taxes, since
the government is a convenient source of cheap borrowings. On
the other hand, if rates are set too high, taxpayers may think
the tax system unfair or may find an overpayment to be a
relatively attractive investment. Accordingly, we encourage the
interest rate to be set, as nearly as possible, at a rate that
approximates a market rate. We are also concerned that, at AFR
plus 5%, the underpayment rate will increase by two percentage
points. This increase will make it more difficult for IRS's
Collection Division to resolve the unpaid liabilities of
taxpayers who are in financial difficulty.
Exclusion of Refund Interest from Income. The JCT Study
recommends excluding IRS interest from individuals' income so
that the effective post-tax interest rates on underpayments and
overpayments are equivalent. Treasury does not agree with this
suggestion. We have reservations about making refund interest
tax free for individuals, particularly if the interest rate
exceeds that of tax-exempt investments. We understand the Joint
Committee Staff's view that refund and deficiency interest
should receive similar treatment. However, we think this
objective would be better served by permitting the deduction of
deficiency interest than by excluding refund interest from
income. We also note that the present regime, which taxes
refund interest but provides no deduction for deficiency
interest, is consistent with the law's general treatment of the
interest income and the non-business interest expense of
individuals.
Dispute Reserve Accounts. The JCT Study proposes the
establishment of rules for the creation of dispute reserve
accounts, which would be special interest-bearing accounts with
the Treasury where taxpayers could deposit amounts in dispute.
Under present law, a taxpayer can easily recover a disputed
amount paid over to the IRS only if the payment was made in the
form of a deposit in the nature of a cash bond, and such
deposits are returned without interest. We support the Joint
Committee Staff's recommendation because the government has the
use of the deposit until such time as it is returned to the
taxpayer, and the establishment of the mechanism of a dispute
reserve account will simplify taxpayers' thinking when faced
with a potential controversy.
Failure to File Penalty. At present, a failure to file a
return results in a penalty of 5% of the unpaid amount each
month for the first five months of the delinquency. The
Treasury Report recommends imposing a lower penalty over a
longer period, but with the same maximum amount. The JCT Study
suggests no changes in this area. We support Treasury's
proposal. Once the failure to file penalty has fully accrued,
it ceases to encourage the filing of the return; in fact, a
taxpayer's inability to pay the penalty along with any tax due
may deter the filing of the return. Further, we think that this
penalty, when added to other charges for noncompliance, may
exacerbate delinquent taxpayers' difficulties in returning to a
compliant condition. We believe that a penalty that accrues
more slowly will help to correct these problems within the
current regime.
Failure to Pay Penalty. The JCT Study recommends repeal of
the failure to pay penalty, replacing it with a five percent
annual service charge if the taxpayer does not enter into, and
adhere to, an installment agreement by the fourth month after
assessment. Treasury, on the other hand, suggests imposing
higher penalties, albeit with reductions if the taxpayer makes
and follows an IRS payment plan. We think it important that
delinquent taxpayers be subject to some significant sanctions
for their delinquencies. However, we prefer the Joint
Committee's approach, primarily because, in our view, the
totality of interest, failure to file, and failure to pay
penalties that currently apply in many delinquency situations
often functions as an impediment to full and timely resolution
of the delinquency, rather than as an incentive to correction.
Failure to Pay Estimated Tax. The Joint Committee
recommends converting the failure to pay estimated tax penalty
to interest because it is essentially a time-value-of-money
computation, and calling it interest rather than a penalty may
enhance taxpayers' view of the tax system's fairness. Treasury
does not support this conversion because it would enable
corporations to deduct this charge for the first time. Both
studies recommend changes in individuals' estimated tax
thresholds and various simplifications. We support converting
the estimated tax penalty to an interest charge and endorse
measures to simplify the estimated tax rules. We do note that
frequent changes in the safe harbor threshold in Section
6654(d)(1)(C)(i) make compliance with estimated tax rules more
burdensome and cannot be justified on the basis of broad
compliance objectives. Accordingly, we strongly encourage both
simplification and permanence in the establishment of these
thresholds.
Failure to Deposit Tax. Both the Treasury and Joint
Committee studies note that the Internal Revenue Service
Restructuring and Reform Act of 1998 changed rules in this
area, so Treasury suggests just two changes, and the Joint
Committee recommends no new legislation be enacted in this
area. We view Treasury's penalty-reduction proposals as
improvements and encourage Congress to do more to lessen the
size of this penalty, which, in our view, is out of proportion
to the conduct that it punishes.
Conclusion
Mr. Chairman, thank you for the opportunity to appear
before the Subcommittee today. I will be pleased to respond to
any questions.
Chairman Houghton. Thank you, Mr. Pearlman. Mr. Ely.
STATEMENT OF MARK H. ELY, CHAIR, PENALTY AND INTEREST TASK
FORCE, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Mr. Ely. Thank you, Mr. Chairman and Members of this
distinguished subcommittee. Thank you for inviting the American
Institute of Certified Public Accountants to testify before you
today. I am Mark Ely and I am representing the AICPA as chair
of its Penalty and Interest Task Force. The AICPA is a national
professional organization of certified public accountants
comprised of more than 330,000 members, many of whom advise
clients on tax matters and prepare income and other tax
returns. It is from this broad base of experience that we offer
our comments.
The AICPA worked with Congress, the IRS, other tax
practitioners and business groups in 1989 on the last major
reform of the Federal tax penalty provisions. We believe that
there once again is a need to take a comprehensive look at the
interest and penalty regime and make needed reforms to ensure
the provisions are appropriately and fairly applied and are
designed to accomplish their true purpose. We offer you and
your staff our assistance with such undertaking.
Because of the limited time, we will comment today on only
a few items. We have, however, submitted written testimony for
the record which contains our detailed comments on the penalty
and interest reform proposals contained in Treasury and the
Joint Committee's 1999 studies and the Taxpayer Advocate's 1999
annual report to Congress.
We appreciate that those studies contain many proposals to
simplify the penalty and interest provisions and their
administration. Consistent therewith, we have included in our
comments recommendations for the use of safe harbors to
simplify penalty administration. We also compliment the
Advocate on the interest he has shown for reforms in the
penalty and interest area. Our comments are based on our
continued belief in the philosophy that the purpose of
penalties is to encourage compliance, not to raise revenue; in
addition, the philosophy that interest is not imposed as a
penalty, but rather is solely compensation for the use of
money. We urge Congress to adhere to these philosophies.
I will now comment on a few of the reform proposals;
specifically, the standards applicable to taxpayers, tax return
preparers and IRS employees regarding tax return filing
positions and fundamental changes to the interest regime. Both
Joint Committee staff and Treasury recommend that the same
standard should apply for tax return positions to taxpayers and
tax return preparers. We do not object to that recommendation,
but request that in making such a change, Congress clarify that
the imposition of the penalty against a taxpayer and an
imposition of the penalty against a tax return preparer must be
based on separate determinations.
For disclosed positions, the Joint Committee staff
recommends that the minimum standard for both taxpayers and
return preparers be substantial authority. Treasury recommends
that the standard be a realistic possibility of being sustained
on the merits. We have serious concerns about raising the
standard for disclosed positions above the reasonable basis
standard which is currently applicable to taxpayers. The
Federal tax law is forever changing. As a result, there may be
virtually no authority with respect to the tax treatment of an
item at the time the return is filed. Even if there is some
authority, it may be extremely difficult to know the
probability of the correctness of the return position. Under
the proposed higher standards, taxpayers may be forced to avoid
taking otherwise meritorious provisions on their returns.
For undisclosed positions, the Joint Committee staff
recommends that the taxpayer and the return preparer must
reasonably believe that the tax treatment is more likely than
not the correct treatment. Treasury believes the standard
should be substantial authority.
We agree with Treasury that the substantial authority
standard is more appropriate. The Joint Committee approach
would require taxpayers to assume the responsibility of judges
who must weigh the merits of competing valid positions to
determine the best ``position.'' such an approach would be
unduly burdensome for taxpayers, particularly those with
limited resources. Moreover, a more likely than not standard
could require taxpayers to disclose in their returns even
though the position comports with applicable authorities. This
would unnecessarily increase compliance costs for taxpayers and
burden on the IRS, and would literally inundate the IRS with
countless, inconsequential disclosures, weakening the overall
effectiveness of the disclosure regime. Thus, we believe the
standard for the disclosed positions should be substantial
authority.
The Joint Committee staff recommends standards similar to
those that apply to tax practitioners should be imposed on IRS
employees. We agree. IRS employees should be held to the same
standards of responsibility as others in the tax system and
sanctions should be specified to encourage enforcement.
Finally, with respect to the interest regime, which is a very
high priority for the AICPA, we are pleased that there are
several proposals for fundamental changes for which we have
persistently advocated, such as the Joint Committee staff's
proposal to eliminate interest rate differentials by
establishing a single rate applicable to both understatements
and overpayments. We strongly believe that adopting a single
rate for overpayments and underpayments for all taxpayers will
substantially reduce the administrative difficulties and
financial inequities associated with numerous interest rate
differentials contained in the current regime. We have other
comments in our written testimony as to the interest regime.
We would be happy to meet with you and your staff at a
later date to discuss reform proposals, and I am happy to
answer any questions. Thank you.
[The prepared statement follows:]
STATEMENT OF MARK H. ELY, CHAIR, PENALTY AND INTEREST TASKFORCE,
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Mr. Chairman and members of this distinguished Subcommittee:
The American Institute of Certified Public Accountants
(``AICPA'') offers you these comments on the penalty and
interest provisions in the Internal Revenue Code (``Code'').
The AICPA is the national, professional organization of
certified public accountants comprised of more than 330,000
members. Our members advise clients on federal, state and
international tax matters and prepare income and other tax
returns for millions of Americans. They provide services to
individuals, not-for-profit organizations, small and medium-
size businesses, as well as America's major businesses,
including multi-national corporations. Many serve businesses as
employees. It is from this broad base of experience that we
offer our comments.
Introduction
The AICPA worked with Members of Congress, the Internal
Revenue Service, and other tax practitioners and business
groups in 1989 in connection with the last major reform of the
federal tax penalty provisions. The result of those efforts was
the Improved Penalty Administration and Compliance Tax Act of
1989 (``IMPACT''). Since then, questions have been raised
regarding the appropriate administration of the interest and
penalty provisions, such as the use of penalties as a
bargaining tool by the IRS. Also since that time, a number of
revisions to the interest and penalty provisions have been made
or proposed. We believe there once again is a need to take a
comprehensive look at the interest and penalty provisions and
make needed reforms to ensure the provisions are appropriately
and fairly applied and are designed to accomplish their
purpose. We encourage you to do so.
We offer you our assistance with such an undertaking, and,
as an initial step, provide you with our comments on: the Joint
Committee on Taxation's Study of Present-Law Penalty and
Interest Provisions as Required by Section 3801 of the Internal
Revenue Service Restructuring and Reform Act of 1998 (Including
Provisions Relating to Corporate Tax Shelters) (JCS-3-99), July
22, 1999; the Department of the Treasury's study, entitled
Penalty and Interest Provisions of the Internal Revenue Code,
released October 25, 1999; and the penalty and interest reform
provisions in the National Taxpayer Advocate's 1999 Annual
Report to Congress, released January 4, 2000.
Our comments regarding penalties are based on our continued
belief in the philosophy embraced by IMPACT, that the purpose
of penalties is to encourage compliance, not to raise revenue.
We urge Congress not to alter that philosophy. We also urge
Congress to adhere to the philosophy that interest is not to be
imposed as a penalty, but rather is solely compensation for the
use of money.
Our comments are based on considering the penalty and
interest regime in its entirety. Individual comments and
suggestions should not be accepted or rejected in a piecemeal
fashion since the appropriateness of one provision often
depends on the status of another.
Penalty Provisions
1. Accuracy-Related and Preparer Penalties
Note: The following discussion relates only to non-tax
shelter items.
Standards for Taxpayers and Preparers
Both the JCT staff and Treasury propose modifications to
the standards that must be satisfied with respect to a tax
return position in order to avoid the accuracy-related penalty
applicable to taxpayers under section 6662 for the substantial
understatement of tax and the preparer penalty under section
6694(a) for understatement of a taxpayer's liability due to an
unrealistic position. Under present law, to avoid the
substantial understatement penalty, a taxpayer must have
``substantial authority'' for an undisclosed position and a
``reasonable basis'' for a disclosed position; for a tax return
preparer to avoid the preparer penalty, an undisclosed position
must have a ``realistic possibility of being sustained on the
merits'' and a disclosed position must not be ``frivolous.''
Both the JCT staff and Treasury recommend that the same
standards apply to taxpayers and tax return preparers. We do
not object to that recommendation, but request that in making
such a change, Congress clarify in the statutory language that
the imposition of a penalty against a taxpayer and the
imposition of a penalty against the taxpayer's return preparer
must be based on separate determinations. The imposition of a
penalty against one is not evidence that the imposition of a
penalty against the other is appropriate. For example, a
taxpayer may pay a penalty for personal reasons, such as to
avoid expending additional time and money to contest the issue
even though the taxpayer might have been successful if the
matter had been pursued; an automatic imposition of a penalty
against the return preparer in such a case clearly would be
inappropriate. An independent review of the applicable
authorities and of the facts, including who had knowledge of
specific facts, must be considered in determining whether the
imposition of a penalty against a particular party is
appropriate.
Standards for Disclosed Positions
Under current law, to avoid a substantial understatement
penalty with respect to a disclosed position, a taxpayer must
have a ``reasonable basis'' for a return position; for a tax
return preparer to avoid a preparer penalty with respect to a
disclosed position, the position must not have been
``frivolous.'' The JCT staff recommends raising the minimum
standard for taxpayers and tax return preparers regarding
disclosed positions such that, to avoid a penalty for a
disclosed position, there must be at least ``substantial
authority.'' Treasury recommends raising the minimum standards
for taxpayers and tax return preparers regarding disclosed
positions such that, to avoid a penalty for a disclosed
position, there must be at least a ``realistic possibility of
being sustained on the merits.''
We have serious concerns about raising the standard for
taxpayers and tax return preparers above the ``reasonable
basis'' standard currently applicable to taxpayers. We are
particularly troubled by the JCT staff's proposal to establish
``substantial authority'' as the minimum standard for disclosed
positions. Such a high standard may be unworkable. While
taxpayers and tax return preparers may be able to ascertain
whether ``substantial authority'' exists with regard to some
issues, that is not true in all cases. The Federal tax law is
forever changing, and, as a result, there may be virtually no
guidance issued at the time a return is filed, and, therefore,
virtually no authority with respect to the proper tax treatment
of an item. Further, even if there is some authority, given the
exceedingly complex nature of the tax law, it may nevertheless
be extremely difficult for taxpayers and preparers to know the
probable correctness of many return positions. It is not only
unrealistic, in many cases it is impossible, to ensure such a
high degree of accuracy as is required by a ``substantial
authority'' standard or even the ``realistic possibility of
being sustained on the merits'' standard without forcing
taxpayers to avoid otherwise meritorious positions on the
return.
While taxpayers may be able to ascertain whether
``substantial authority'' or ``realistic possibility of being
sustained on the merits'' exists with regard to some issues,
that certainly is not true in all cases. This problem is
compounded by the fact that the IRS has failed to adhere to a
provision added to the Internal Revenue Code in 1989 to assist
taxpayers and preparers in determining whether ``substantial
authority'' is present for a position. IMPACT created section
6662(d)(2)(D) of the Code, requiring the IRS to publish, not
less frequently than annually, a list of positions for which
the IRS believes there is no ``substantial authority'' and
which affect a significant number of taxpayers. To date, the
IRS has never issued any such list for any year. If the IRS is
unable itself to determine which positions lack ``substantial
authority,'' it is unreasonable to adopt this threshold as the
minimum reporting standard for return positions by taxpayers
and tax return preparers.
In its 1989 civil tax penalty study, the IRS acknowledged
the practical limits on the probable correctness of returns. In
the Commissioner's Study of Civil Penalties, 1989, at VIII-11,
the IRS noted:
While not in and of themselves determinative of the
correct standard of behavior, a variety of factors limit the
ability of taxpayers to report positions disclosing a liability
that is probably correct. Perhaps the most significant
limitation is the ambiguity inherent in applying a complex and
changing set of tax rules to an infinite variety of factual
situations, which may themselves be of ambiguous import. These
complexities may result in failure to recognize issues,
incorrect conclusions as to the probability that a particular
position will prevail, and differences of opinion regarding
probability that are not resolvable short of the courthouse.
The complexity of modern financial affairs, when coupled with
the legal requirement to file a return by a statutory deadline
and the costs of making the best possible assessment of each
individual issue may also provide practical limits on the
pursuit of a theoretically perfect return.
For these reasons, we believe the standard for disclosed
positions should be the ``reasonable basis'' standard currently
applicable to taxpayers.
Standards for Undisclosed Positions
Under current law, to avoid the substantial understatement
penalty with respect to an undisclosed position, a taxpayer
must have ``substantial authority;'' for a tax return preparer
to avoid a preparer penalty with respect to an undisclosed
position, the position must have a ``realistic possibility of
being sustained on the merits.'' The JCT staff recommends that,
for an undisclosed position, the taxpayer and the tax return
preparer must reasonably believe that the tax treatment is
``more likely than not'' the correct tax treatment under the
Code. In contrast, Treasury does not propose raising the
standard for undisclosed positions above the ``substantial
authority'' standard that currently applies to taxpayers; it
would apply that standard to both taxpayers and tax return
preparers.
We agree with Treasury that the ``substantial authority''
standard is the more appropriate threshold standard for
undisclosed positions, rather than the higher ``more likely
than not'' standard recommended by the JCT staff. Currently,
the only authorities that can be relied upon to constitute
``substantial authority'' are those issued by the government
itself or the judiciary. Acceptable authorities include: the
Internal Revenue Code and other statutory provisions,
regulations, court decisions, and administrative pronouncements
(e.g. revenue rulings, revenue procedures, proposed
regulations, private letter rulings, technical advice
memoranda, actions on decisions, information releases, notices,
and other similar documents published by Treasury or the IRS).
In addition, the list of authorities includes General
Explanations of tax legislation prepared by the Joint Committee
on Taxation (the ``Blue Book''). Conclusions in treatises,
legal periodicals, legal opinions or opinions of other tax
professionals do not qualify under present IRS rules.
Taxpayers and preparers who take positions relying on the
government's own rules and pronouncements should be able to
feel comfortable that their positions are sufficiently accurate
so as to free them from the possibility of penalties. A ``more
likely than not'' standard for undisclosed positions would mean
disclosure would be required even though the ``substantial
authority'' threshold is satisfied with respect to a position.
Having taxpayers disclose items on their returns which comport
with the government's own list of authorities would
unnecessarily increase compliance costs for taxpayers and
burden for the IRS. Further, such an approach would literally
inundate the IRS with countless inconsequential disclosures,
weakening the overall effectiveness of the disclosure regime.
Thus, we believe the standard for undisclosed positions should
be ``substantial authority.''
Reasonable Cause Exception
The JCT staff recommends repeal of the reasonable cause
exception to the substantial understatement penalty. We
disagree, believing that the exception is necessary to provide
flexibility needed to waive the penalty in appropriate
situations.
Amount of Preparer Penalty
The JCT staff recommends increasing the amount of tax
return preparer penalties. For first-tier violations, i.e.,
preparation of a return with a position that does not meet the
minimum preparer standards, the JCT staff recommends changing
the preparer penalty from a flat $250 per occurrence to the
greater of $250 or 50% of the tax preparer's fee. For second-
tier violations, i.e., understatements that result from willful
or reckless disregard of the rules or regulations, the JCT
staff recommends increasing the amount from a flat $1,000 per
occurrence to the greater of $1,000 or 100% of the preparer's
fee.
Treasury also recommends increasing the tax return preparer
penalties. Treasury recommends that consideration be given to a
fee-based or other approach that more closely correlates the
preparer penalty to the amount of the underlying understatement
of tax rather than the flat dollar penalty amount under current
law.
We support retaining the two-tier flat dollar penalty under
current law. We base our recommendation on the lack of
empirical evidence indicating that the flat dollar amount is
not effective. In our opinion, deterrence for preparers results
not from a dollar penalty, but rather from the possible adverse
impact on the preparer's ability to practice and on his/her
reputation for integrity and ethical behavior.
2. Failure to File Penalty
Rate
The current law contains a failure to file penalty of 5%
of the net tax due, for each month (or portion thereof) the
return remains unfiled, up to a maximum of 25%. The JCT staff
proposes no change to the current provision. Treasury
recommends that the penalty be restructured to eliminate front-
loading; it proposes doing this by lowering the penalty rate in
the initial months and providing for the increase in the rate,
up to the 25% maximum, over a longer period of time. The
example Treasury presented was charging a rate of 0.5% per
month for the first 6 months and 1% per month thereafter, up to
the 25% maximum. Treasury recommends retaining the current rule
for fraudulent failure to file.
We agree with Treasury's reasoning that the front-loading
of the failure to file penalty in the first five months of a
filing delinquency does not provide a continuing incentive to
correct filing failures and imposes additional financial
burdens on taxpayers whose filing lapse may be coupled with
payment difficulties, thus, possibly impeding prompt
compliance. We also agree with Treasury that the current
structure seems especially harsh given the fact, by merely
requesting one, a taxpayer is entitled to an automatic
extension for most or all of those five months. (An individual
taxpayer is entitled to an automatic four-month extension; a
corporate taxpayer is entitled to an automatic six-month
extension.)
Given the significance to the tax system of taxpayers
fulfilling their filing obligations, the failure to file
penalty should be structured to provide a strong incentive for
timely compliance, and a continuing incentive to promptly
correct any failure to file.
Service Charge
Under current law, since the late filing penalty is a
percentage of the net tax due, no penalty applies with respect
to a late-filed return if the return reflects a refund due or
no tax due. Treasury recommends imposing a new de minimis
service charge for late returns that have a refund or no tax
due, at least in situations where the IRS has already contacted
the taxpayer regarding the failure to file the return.
We do not support this recommendation. We view such an
approach as unjustified. Such an approach is particularly
inequitable in situations where the taxpayer has a refund due,
since the IRS has had interest-free use of the taxpayer's
money.
Safe Harbor
Treasury recommends adoption of a provision that would
permit the IRS to take into account a taxpayer's compliance
history in determining if there is reasonable cause for
abatement of the failure to file penalty. Treasury does not
support providing automatic relief from the failure to file
penalty based on safe harbor rules, however.
Although we agree with Treasury that a taxpayer's
compliance history should be considered in determining the
appropriateness of a penalty, we recommend a more expansive
simplification of the penalty abatement provisions.
To reduce the burden on both taxpayers and the Service
resulting from the imposition of many inappropriate penalties,
we recommend that safe harbor provisions be established for a
variety of penalties (particularly those that are mechanical in
nature, such as the failure to file, failure to pay and failure
to deposit penalties) that would be deemed to represent
reasonable cause. The object of these safe harbors would be to
minimize the assessment and subsequent abatement of many
penalties. Safe harbor provisions could take the form of:
No penalty assessment for an initial occurrence;
however, the taxpayer should receive a notice that a subsequent
error would result in a penalty;
Automatic non-assertion of a penalty based upon a
record of a certain number of periods of compliance; and/or
Voluntary attendance at an educational seminar on
the issue in question, as the basis for non-assertion or
abatement.
Such safe harbors would encourage and create vested
interests in compliance, since a history of compliance would
result in relief. Additionally, the likelihood of future
abatements would diminish if the taxpayer has a history of non-
compliance. Furthermore, a system of automatic abatement would
reduce the time spent by both the Service and taxpayers on
proposing an assessment, initiating and responding to
correspondence, and on the subsequent abatement. The ability to
abate a penalty for a reasonable cause other than those used
for automatic abatements would continue; however, reasonable
cause abatements requiring independent evaluation should be
reduced.
3. Failure to Pay Penalty
Retention or Repeal
Current law contains a failure to pay penalty equal to 0.5%
per month (or fraction thereof), up to a maximum of 25%. This
penalty was created in 1969 to respond to the belief that the
then-applicable interest rate (a flat 6%) on underpayments was
not sufficient to encourage timely payment of tax and to
discourage the use of the government as a low-cost lender.
The JCT staff recommends repealing the penalty for failure
to pay taxes, noting the repeal would be consistent with a
policy initiative begun by RRA'98, in which the rate of the
penalty for failure to pay was reduced. The National Taxpayer
Advocate also recommends a repeal of the penalty. Treasury
acknowledges that the initial intent of the penalty was to
address the fact that the interest rate on underpayments did
not take into account the then market rate; nevertheless, it
recommends retaining the failure to pay penalty, but with a
restructured rate, as noted below.
We believe that, since the rate of interest on
underpayments is now tied to the market rate of interest, this
penalty, as a substitute for interest, should be repealed. If
the penalty is not repealed, we recommend adoption of the
mitigation and waiver provisions noted below.
Expansion of Mitigation of Penalty for Months During Period of
Installment Agreement
Under current law, the failure to pay penalty for
individuals with respect to a timely filed return is reduced
from .5% to .25% for any month in which an installment
agreement is in effect. This mitigation provision does not
apply to halve the penalty in any case in which a final notice
has been issued (at which time the penalty increases to 1% per
month).
The National Taxpayer Advocate recommends that this
mitigation provision be expanded to include reducing the
penalty rate from 1% to .5% in situations (1) when a final
notice is issued in error or as the result of an administrative
practice and (2) when a final notice has been issued, for any
month in which an installment agreement is in effect. We agree
with the recommendation.
Waiver of Penalty When an Installment Agreement is in Effect
The National Taxpayer Advocate also recommends that the
failure to pay penalty be waived for any month in which an
approved installment agreement is in effect, even if the 1% per
month penalty rate otherwise applies. Under the recommendation,
however, the failure to pay penalty would be reinstated for the
entire period if the taxpayer defaulted prior to completing the
agreement. We agree with that recommendation.
Rate
Treasury recommends restructuring the calculation of the
failure to pay penalty. The penalty would equal 0.5% per month
for the first 6 months and 1% per month thereafter, up to the
maximum of 25%. The penalty would be reduced to 0.25% per month
during the first 6 months and 0.5% per month thereafter if the
taxpayer makes and adheres to a payment agreement. As under
current law, a higher rate would apply once the IRS takes
action to enforce collection.
As noted above, we recommend repealing the failure to pay
penalty rather than revising the rate.
Service Charge
The JCT staff recommends imposing an annual 5% late payment
service charge on taxpayers that do not enter into an
installment agreement within 4 months after assessment. The
service charge would be imposed on the balance remaining unpaid
at the end of the 4-month period.
We do not support establishment of a service charge for
failure to enter into an installment agreement. We believe that
such a service charge will penalize taxpayers who already are
struggling to pay their tax obligations.
Related Installment Agreement Issues
Waiver of Fee. The JCT staff recommends waiving the
installment agreement fee for taxpayers that agree to the
automated withdrawal of each installment payment.
We support the JCT staff's recommendation. We believe that
waiving the fee for taxpayers that enter into agreements to pay
tax via an automated system of withdrawal will provide an
incentive to enter into these agreements and better ensure
payment of taxes. We have heard that some states that offer
automated withdrawal payment plans have shown high rates of
adherence to installment agreements. We believe that adoption
of this provision will similarly facilitate a higher rate of
adherence to installment agreements for the Federal government.
Installment Agreement Interest Rate. Treasury recommends
providing the IRS with the authority to use a fixed rather that
a floating interest rate on installment agreements in order to
facilitate adherence to such agreements and to avoid possible
balloon payments.
We support Treasury's recommendation to simplify the
installment interest rate calculation.
4. Estimated Tax Penalty
Status as Penalty or Interest
The JCT staff recommends repealing the individual and
corporate estimated tax penalties and replacing them with
interest charges. The National Taxpayer Advocate also
recommends eliminating the penalty and allowing interest to be
automatically asserted, or as an alternative, he calls for
simplification of the estimated tax penalty computations.
Treasury recommends retaining the individual and corporate
estimated tax penalties as penalties.
We support the recommendation of the JCT staff and the
National Taxpayer Advocate for converting the estimated tax
penalties for individuals and corporations into interest
provisions. The conversion of the estimated tax penalties into
interest charges would result in a more accurate
characterization since the penalties are essentially fees for
the use of money.
Deductibility of Interest
The JCT staff recommends that interest on underpayments of
estimated tax by individual taxpayers be nondeductible personal
interest, whereas interest paid on underpayments of estimated
tax by corporate taxpayers be deductible. We recommend that
deficiency interest be deductible by individual taxpayers to
the extent the deficiency to which the interest relates is
attributable to the taxpayer's trade or business or investment
activities.
$1,000 Threshold for Individuals
The JCT staff recommends increasing to $2,000 the threshold
below which individuals are not subject to the estimated tax
penalty. Currently the threshold amount is $1,000 after
reduction for withheld taxes. The JCT staff also recommends
that the calculation of the threshold be modified to take into
account certain estimated tax payments, i.e., estimated taxes
paid in four equal installments on or before their due date.
Accordingly, for qualifying individual taxpayers, no interest
on underdeposits of estimated tax would be imposed if the tax
shown on the tax return, reduced by withholding and certain
estimated tax payments, is less than $2,000.
Treasury recommends retaining the current $1,000 threshold,
but allowing estimated tax payments to be considered under a
proposed simplified averaging method in determining whether the
threshold is satisfied.
We support increasing to $2,000 the threshold below which
individuals are not subject to the estimated tax penalty. We
also support allowing estimated tax payments to be considered
under a simplified averaging method in determining if the
threshold is satisfied. Both recommendations should simplify
the computations required to calculate estimated tax payments
and the interest (JCT) or penalty (Treasury) on underpayments.
Safe Harbors
The JCT staff recommends repealing the modified safe harbor
that is applicable to individual taxpayers whose adjusted gross
income for the preceding taxable year exceeded $150,000. Under
the JCT staff's proposal, all taxpayers making estimated
payments based on the prior year's tax would do so based on
100% of the prior year's tax.
We support this JCT staff recommendation for simplification
of the safe harbor provisions.
Rate
The JCT staff recommends applying only one interest rate
per underpayment period -the rate applicable on the first day
of the quarter in which the payment is due. Currently, if
interest rates change while an underpayment is outstanding,
separate calculations are required for the periods before and
after the interest rate change. Having only one interest rate
apply per underpayment period would end the potential for
multiple interest calculations occurring within one estimated
tax underpayment period.
We support this JCT staff recommendation for simplification
of the computations.
Underpayment Balances
The JCT staff recommends changing the definition of
``underpayment'' to allow existing underpayment balances to be
used in underpayment calculations for succeeding estimated
payment periods, i.e., making underpayment balances cumulative.
Under the proposal, taxpayers would no longer be required to
track each outstanding underpayment balance until the earlier
of the date paid or the following April 15th.
We support this JCT staff recommendation for simplification
of the computations.
Leap Year Issue
The JCT staff recommends establishment of a 365-day year
for estimated tax penalty calculation purposes. Current IRS
procedures require separate calculations when outstanding
underpayment balances extend from a leap year through a non-
leap year.
We support this JCT staff recommendation for simplification
of the computations.
First-Time Offender
Treasury recommends providing a reasonable cause waiver of
the estimated tax penalty for individuals that are first-time
payers of estimated tax. The proposed waiver would be available
only if the balance due is below a certain amount and is paid
with a timely-filed return. Current law does not provide a
general reasonable cause waiver for failure to pay estimated
tax for individuals.
Although we do not support Treasury's position on retaining
the estimated tax penalty, if the penalty is continued, we do
support the recommendation for a reasonable cause waiver of the
penalty for individuals that are first-time offenders.
Penalty Waiver
Treasury recommends waiving the estimated tax penalty if
the penalty is below a certain de minimis amount -e.g., $10 to
$20. There is no current statutory authority permitting the IRS
to waive estimated tax penalties below a de minimis amount.
Although we do not support Treasury's position on retaining
the estimated tax penalty, if the penalty is continued, we
support the recommendation for establishing a de minimis
waiver, but recommend a higher de minimis amount.
Safe Harbor for Corporations
We recommend increasing the taxable income cut off point
from $1 million to $10 million for defining a ``large
corporation'' for purposes of the Section 6655(d)(1)(B)(ii)
safe harbor.
5. Failure to Deposit Penalty
Recently Enacted Provisions
Both the JCT staff and Treasury recommend that no major
changes be made to the failure to deposit penalty provisions,
to allow time for recent changes in these rules to be
implemented and evaluated.
We support the recommendations that no major changes be
made to the new rules until the provisions have been in effect
long enough to be evaluated, but we encourage the introduction
of any minor changes that add to the simplification of the
failure to deposit penalty.
Deposit Schedule
The JCT staff recommends that Treasury consider revisions
to the deposit regulations, particularly the change in deposit
schedule, to change in a later calendar quarter.
We support the JCT staff's recommendation as a
simplification of the failure to deposit provisions.
Penalty for Wrong Method of Deposit
Treasury recommends that it be provided with the authority
to reduce the penalty for use of the wrong deposit method from
10% to 2%. Currently, taxpayers who use the wrong deposit
method may be subject to the penalty rate of 10% and, thus, may
be treated as harshly as if they did not make the deposit at
all.
We support Treasury's recommendation; the lower rate would
not be unduly harsh and would accomplish the same objective of
encouraging payment by the proper method.
Systemic Problems of Payroll Services
The JCT staff and Treasury recommend that the IRS work with
payroll services to resolve systemic errors, rather that deal
with individual employers on a case by case basis.
We support the JCT staff and Treasury's recommendations.
Such an approach could greatly simplify the resolution of such
problems.
6. Pension Benefit Penalties
The JCT staff recommends consolidating the IRS and ERISA
penalties for failure to file timely and complete Form 5500,
and reducing from three to one the number of governmental
agencies authorized to assess, waive, and reduce penalties for
failure to file Form 5500. The JCT staff recommends designating
the IRS as the agency responsible for enforcement of reporting.
The JCT staff also recommends repealing the separate penalties
for failure to file Schedules SSA and B and for failure to
provide notification of changes in plan status. The JCT staff
recommends treating these situations as a failure to file a
complete Form 5500.
Treasury recommends consolidating the penalty for failure
to file Form 5500 into a single penalty that will not exceed a
specified dollar amount per day or a monetary cap per return.
Treasury proposes that the single penalty would be waived upon
a showing of reasonable cause. Welfare and fringe benefit plans
would be subject to a similar single penalty under Treasury's
proposal. Treasury recommends designating the Department of
Labor as the agency responsible for enforcement of reporting.
The Department of Labor's DFVC voluntary compliance program
would continue to provide relief from late filing or failure to
file penalties for Form 5500 under the proposed single penalty.
Although we do not have comments on the specific
recommendations, we do encourage proposals such as these that
promote simplification.
7. Uniformity of Administration
Statistical Information
The JCT staff and Treasury recommend that the IRS improve
its method of providing statistical information on abatements
and the reasons and criteria for abatements. We support this
recommendation.
Supervisory Review
The JCT staff and Treasury recommend improving the
supervisory review of the imposition and abatement of
penalties. We support this recommendation on the theory that
such improved review would promote equitable treatment of
taxpayers.
Abatement
The JCT staff recommends consideration by the IRS of
establishing a penalty oversight committee similar to the
Transfer Pricing Penalty Oversight Committee.
We support the JCT staff's recommendation as a means to
promote equitable treatment of taxpayers. Previously, the AICPA
has recommended the creation of a database regarding the
imposition and abatement of penalties and the establishment of
a coordinator of penalty administration to promote consistent
application.
Interest Provisions
Determining the amount of interest owed to or by taxpayers
in connection with their Federal tax liabilities is governed by
a rather complicated set of interest and procedural provisions
in the Internal Revenue Code. We believe simplification of the
interest regime is in order and commend the JCT staff for
proposing the establishment of a single interest rate
applicable to both underpayments and overpayments of all
taxpayers and the abatement of interest in various instances.
We agree that these proposals will greatly simplify interest
computations and are disappointed that Treasury essentially
recommends maintaining the current interest regime, including
interest rate differentials for corporate taxpayers. We think
the recommendations made by the JCT staff, coupled with our
proposed modifications, will result in a fairer, simpler, more
administrable interest regime. We also believe that the JCT
staff's interest simplification recommendations, with our
modifications, should be adopted in their entirety because the
benefits of each component necessarily depends upon the
enactment of the others.
Like both the JCT staff and Treasury, we believe the
Internal Revenue Code's interest provisions should provide for
compensation to the government for the time that the taxpayer
has use of the government's tax dollars and to the taxpayer for
the time the government has use of the taxpayer's money.
Interest is fundamentally a charge or compensation for the use
or forbearance of another's money -it is not a penalty. The
interest provisions should not be used to financially punish
taxpayers.
1. Interest Rate
The JCT staff recommends providing one interest rate for
overpayments and underpayments for both individuals and
corporations, equal to the short-term applicable federal rate
(``AFR'') plus 5 percentage points. Treasury recommends a
uniform interest rate in the range of AFR plus 2 to 5
percentage points except in the case of large corporate
overpayments or underpayments, for which Treasury recommends
retaining the current rate differential, including ``hot
interest.''
We strongly believe that adopting a single rate for
underpayments and overpayments of all taxpayers will
substantially reduce the administrative difficulties and
financial inequities associated with the numerous differentials
contained in the current regime. We, therefore, support the JCT
staff's single rate recommendation.
Establishing one rate for every taxpayer necessarily
entails blending the various market rates applicable to all
taxpayers; however, we are concerned that the JCT staff's
proposal may establish an excessively high interest rate. At
current market rates, raising the overpayment and underpayment
rates to AFR+5 percentage points would result in a 10 percent
rate; that would be the highest rate of interest for ordinary
underpayments in more than a decade. Individual taxpayers would
see their underpayment rate jump from 8% to 10% and the minimum
rate that would apply to corporate taxpayers would be equal to
the current ``hot interest'' rate. We concur with Treasury that
the appropriate rate should be in the range of the AFR plus 2
to 5 percentage points and should reflect typical market rates.
2. Interest Abatement
Additional Causes for Abatement
The JCT staff recommends that the IRS be granted the
authority to abate interest: (1) where necessary to avoid gross
injustice; (2) for periods attributable to any unreasonable IRS
error or delay, whether or not related to managerial or
ministerial acts; (3) in situations where the taxpayer is
repaying an excessive refund based on IRS calculations, without
regard to the size of the refund; and, (4) to the extent the
interest is attributable to taxpayer reliance on a written
statement of the IRS. Treasury agrees to abatement of interest
when the taxpayer has reasonably relied on erroneous written
advice from the IRS, but does not recommend further legislative
expansion of abatement of interest, arguing that current law
provides sufficient relief. The National Taxpayer Advocate
recommends abatement when the taxpayer is experiencing
significant hardship.
We support the recommendations of the JCT staff and the
National Taxpayer Advocate and strongly encourage their
adoption. Further, because the IRS has been reluctant in the
past to grant relief in this area, we request that the terms
``gross injustice,'' ``unreasonable'' and ``significant
hardship'' be adequately defined to provide the IRS with clear
standards for implementation.
Application of Abatement Attributable to Errors and Delays to
Nondeficiency Federal Taxes
The current law provision allowing abatement based on
errors or delays by the IRS is limited to interest on income,
estate, gift, generation skipping, and certain excise taxes.
The National Taxpayer Advocate recommends that the abatement
provision be expanded to apply to interest on employment taxes,
the remainder of excise taxes, and certain other taxes. We
agree with that recommendation.
3. Suspension of Interest Where IRS Fails to Contact Taxpayer
Neither Treasury nor the JCT staff make any recommendations
with regard to the interest suspension provision, enacted as
part of the Internal Revenue Service Restructuring and Reform
Act of 1998, that suspends the accrual of deficiency interest
for individual taxpayers in all cases where the IRS fails to
notify the taxpayer within 18 months (1 year beginning in
2004), specifically stating the taxpayer's liability and the
basis for that liability. Under use of money principles,
interest is charged solely as compensation for the use of
another's money. While there may be some situations in which
use of money principles should give way to more compelling
objectives, such as in the abatement context, we believe such
an automatic suspension provision is an unnecessary feature for
a single-rate interest regime with broad interest abatement
authorities. An expanded interest abatement provision should
provide adequate relief for those taxpayers subjected to
excessive interest charges. We, therefore, recommend that this
provision be repealed and that any resulting savings to the
government be applied to lowering the proposed single-rate
amount.
4. Interest Netting
Treasury argues that, given the recent enactment of global
interest netting, it is premature to adjust interest rates to
eliminate all interest differentials. On the other hand, the
JCT staff notes that establishing a single rate of interest
will simplify tax administration and ``limit'' the need for
interest netting on a going-forward basis. We believe that
restoring interest rate harmony will mitigate (but not
eliminate) the need for interest netting in most cases, because
the rate at which interest is paid by a taxpayer to the IRS
with respect to any underpayment of tax will be the same rate
paid by the IRS to a taxpayer who overpays a tax liability.
Unfortunately, the Internal Revenue Code contains several
special rules providing for interest-free periods whereby
taxpayers and the government are given grace periods to take
certain actions without accruing additional interest charges.
For example, the government is given 45 days to process refund
claims and taxpayers are afforded 21 calendar days to pay
demand notices (10 business days if the amount exceeds
$100,000). Thus, even with the single-rate interest regime
advocated by JCT staff, there would continue to be some
situations where taxpayers could be charged interest on periods
of underpayment that run concurrently with a non-interest
bearing overpayment period for the taxpayer.
We support JCT's proposed single rate regime but believe
that interest netting still would be appropriate in some
circumstances, to ensure that taxpayers are not charged
interest on amounts where no true liability actually exists.
Extending interest netting to interest-free periods would be
consistent with use of money principles and would not harm the
government since during these periods of time, neither the
taxpayer nor the government are actually indebted to one
another. In our judgment, taxpayers do not object to interest-
free periods; they recognize the importance of administrative
convenience, to allow the government sufficient time to process
claims for refund. Taxpayers, however, do resent the imposition
of interest on equivalent outstanding amounts under the pretext
that a true liability exists where none does. Absent netting,
the problem will become more acute if the interest rates are
equalized at a higher level, as the JCT staff is proposing.
The JCT report states that limiting the availability of
netting to situations in which the taxpayer both owes and is
owed interest for the same period preserves the integrity of
the rule requiring the suspension of interest where the IRS
fails to contact an individual taxpayer. The JCT staff seems to
be saying that taxpayers should be required to pay interest
during some periods of mutual indebtedness when they clearly
are not indebted to their government in order to preserve the
concept of suspending interest for taxpayers who have
admittedly underpaid their taxes. Logic dictates that taxpayers
who owe tax should pay interest and those who owe no tax should
not pay interest.
In summary, we believe that a new single-rate interest
regime should contain an interest netting component whereby
taxpayers can identify periods of mutual indebtedness involving
interest-free periods and request the IRS to have their
interest charges recalculated in accordance with procedures
similar to those set forth in Rev. Proc. 99-19.
5. Interest and Look-Back Rules
The JCT staff recommends that the single interest rate also
apply to the Code sections that reference the underpayment or
overpayment rate under present law. The Treasury report does
not address this issue. There are several provisions that allow
taxpayers to re-determine their tax liability based on facts
determined after the filing date of the return without
requiring an amended return to be filed--the so-called ``look-
back'' provisions. As we indicated above, we believe that a
single interest rate should be applicable to the underpayments
and overpayments of all taxpayers, but question the amount of
the rate increase proposed by JCT. We are concerned that, in
the context of these sections, under JCT staff's proposed rate
structure, most taxpayers would face a significant increase in
the amount of interest.
6. Exclusion of Individual Overpayment Interest from Income/Denial of
Deduction
In an attempt to equalize rates on an after-tax basis for
individual taxpayers and corporations, the JCT staff recommends
that overpayment interest paid by the IRS to individuals be
excludable from income. While acknowledging that the same rate
and same tax treatment with regard to deficiency interest would
provide equivalent effective interest rates for individual and
corporate taxpayers, Treasury does not propose an exclusion for
interest and believes a deduction for deficiency interest for
individuals is not warranted.
While JCT's recommendation is one way to provide equivalent
effective interest rates on underpayments and overpayments for
individuals, the proposal is incomplete because it fails to
clarify the deductibility of deficiency interest attributable
to trade or business or investment activities of a non-
corporate taxpayer. Section 163(h)(2) provides that, in the
case of a taxpayer other than a corporation, no deduction shall
be allowed for personal interest paid or accrued during the
taxable year. The term ``personal interest'' does not include
interest paid or accrued on indebtedness properly allocable to
a trade or business. Temporary regulations section 1.163-
9T(b)(2)(i)(A) provides, however, that interest relating to
taxes is personal interest regardless of the source of the
income generating the tax liability. This interpretation of the
statute has generated considerable litigation and two different
standards for the deductibility of interest on deficiencies
incurred in a trade or business--a corporation filing a Form
1120 is clearly entitled to deduct deficiency interest while an
individual operating an unincorporated trade or business
reporting income on a Form 1040 return is denied the interest
deduction. We believe section 163(h) should be modified to
allow every taxpayer a deduction for interest attributable to a
deficiency attributable to trade or business activities,
regardless of the form in which the businesses is operated, or
to investment activities.
7. Dispute Reserve Accounts
The JCT staff recommends that taxpayers be allowed to
deposit amounts in a ``dispute reserve account,'' a special
interest-bearing account within the U.S. Treasury. These
accounts are intended to help taxpayers better manage their
exposure to underpayment interest without requiring them to
surrender access to their funds or requiring them to make a
potentially indefinite-term investment in a non-interest
bearing account. The Treasury report does not contain similar
relief.
We have some concerns about how the dispute reserve account
system will operate. For example, will the IRS be permitted to
use the offset provisions against amounts deposited into these
accounts? Nevertheless, we believe the JCT staff's
recommendation blends the good features of several current-law
approaches to avoid deficiency interest charges and merits
serious consideration.
8. Interest-Free Periods
Treasury recommends that, when administratively feasible,
the 45-day rule restricting overpayment interest on refunds
should be applied, in the case of early-filed returns, to the
date the return was received, rather than the last day
prescribed for filing the return. The JCT report does not
recommend any changes with regard to these so-called rules of
convenience.
Under the Code, taxpayers are given a 21-day interest-free
grace period to pay tax liabilities (10 business days if the
underpayment is in excess of $100,000) while the government is
given 45-days to make tax refunds. In addition, overpayment
interest accrues on an overpayment from the later of the due
date of the return or the date the payment is made, until a
date not more than 30 days before the date of the refund check.
Nuances associated with these special rules contribute to
the complexity of interest computations. We believe that in the
context of comprehensive interest reform, consideration should
be given to reviewing and adjusting the application of these
rules. The lengths of the grace periods were established years
ago and may no longer reflect the actual length of time it
takes to complete the assigned task (e.g., transmit data, issue
refund checks, remit payment). On the surface, it seems
patently unfair to give the IRS 45 days from the due date of a
return to process a refund check while allowing some taxpayers
only 10 business days to respond to an IRS bill. We believe
that these rules should be updated, with a view toward
simplification.
9. Application of Compound Interest Only to the Underlying Tax
The National Taxpayer Advocate recommends that compound
interest apply only to the tax liability and that simple
interest apply to penalties and/or additions to tax.
We disagree with that recommendation. Interest computations
already are extremely complex; this proposal would add to that
complexity. Further, such an approach would be inconsistent
with the use of money principles on which interest is based.
10. Limitation on the Total Amount of Interest that Can Accumulate
The National Taxpayer Advocate recommends that the total
amount of interest that can accumulate on a liability should be
limited to 200% of the underlying tax liability.
We disagree with that recommendation as being inconsistent
with the use of money principles on which interest is based.
Standards Applicable to IRS
1. Standards
The JCT staff recommends that standards similar to those
that apply to tax practitioners should be imposed on IRS
employees.
We support the JCT staff's recommendation, but urge that
sanctions be specified to encourage enforcement. As a matter of
fairness and consistency, we recommend that, under current law,
the IRS require revenue agents to have concluded that there is
at least a ``realistic possibility of success'' before
proposing an adjustment against a taxpayer. (If, as is
proposed, the standards for tax return preparers are raised,
the standard for IRS revenue agents should be raised
similarly.) One method of ensuring that a position contained in
a Revenue Agent Report has satisfied the standard could be to
require that each Report be signed, evidencing supervisory
approval, by an individual at the group manager or higher
level, attesting to the fact that the proposed adjustments set
forth therein meet the applicable standard. Implementing a
policy such as this would be consistent with tax administration
principles for the IRS set forth in Rev. Proc. 64-22, 1964-1
C.B. 689. Rev. Proc. 64-22 requires that the Service apply and
administer the law in a reasonable and practical manner, and
that issues only be raised by examining officers when they have
merit, and never arbitrarily or for trading purposes.
2. Awards of Costs and Fees
Section 7430 of the Code currently requires the IRS to pay
the reasonable administrative and litigation expenses of a
taxpayer in certain circumstances if the IRS does not show that
its position was ``substantially justified.'' Such awards are
not available, however, to taxpayers having a net worth above a
certain dollar amount.
We recommend that recovery of such expenses under section
7430 be available to all taxpayers, regardless of their net
worth. The IRS should be held accountable to all taxpayers and
responsible for reimbursing a taxpayer for expenses it unduly
causes the taxpayer to incur.
3. Monitoring and Reporting
The JCT staff recommends that the IRS be required to
publish annually, information regarding payments made under
section 7430 for taxpayers' administrative and litigation
expenses and the administrative issues that resulted in the
making of those payments.
Treasury recommends that, on an ongoing basis, the IRS
undertake review of cases involving awards of attorney's fees
and cases where penalties have not been judicially sustained,
in order to enhance quality review of the administrative
process.
We support the JCT staff's recommendation.
Communications Between IRS and Taxpayers
1. Communications with Individuals
The JCT staff recommends that the IRS place a higher
priority on improving the processes by which the names and
addresses of individual taxpayers are updated in the IRS's
records.
Treasury recommends that on an ongoing basis the IRS
improve the quality of its notices and communications to
taxpayers regarding the basis for penalty and interest
assessments and the abatement procedures. Treasury also
recommends that the IRS institute procedures to reduce the
burdensome nature of the current abatement process.
We support these recommendations.
2. Method of Communicating
The JCT staff recommends consideration by the IRS of the
use of e-mail and fax instead of regular mail for communicating
with taxpayers. The JCT staff also recommends that the IRS
consider proposing legislation to provide for use of an
alternative delivery system where current law requires use of
regular mail.
We support the JCT staff's recommendations.
Conclusion
As stated earlier, we believe there is a need for a
comprehensive review of the penalty and interest provisions in
the Code and reforms to those provisions to ensure they are
appropriately and fairly applied and are designed to accomplish
their purpose. We welcome the opportunity to work with you now
and in the future on such an undertaking.
Chairman Houghton. Thank you very much, Mr. Ely. Mr.
Shewbridge.
STATEMENT OF CHARLES W. SHEWBRIDGE, III, CHIEF TAX EXECUTIVE,
BELLSOUTH CORPORATION, ATLANTA, GEORGIA, AND PRESIDENT, TAX
EXECUTIVES INSTITUTE, INC.
Mr. Shewbridge. Thank you, Mr. Chairman. I am Chief Tax
Executive for BellSouth Corporation in Atlanta, Georgia. I am
here today as President of the Tax Executives Institute, the
preeminent group of in-house tax professionals. Our 5,000
members belong to 52 chapters throughout the United States,
Canada, and Europe and represent the 2800 largest corporations
in North America.
TEI agrees that it is time for an in-depth review of the
Code's interest and penalty provisions. The interest rules
operate in an unfair manner and are difficult to administer. In
many cases, the rules have served as an inappropriate penalty,
such as with the estimated tax penalty, rather than as
compensation for the time value of money. The interest
calculation itself is extremely difficult and leads to errors
by both the government and taxpayers.
In respect of the Code's penalty provisions, TEI believes
that they should be simple, fair, and easy to administer.
Unfortunately, the tax law has moved away from this concept
since the penalty reform effort of 1989. Penalty has been piled
upon penalty as Congress has sought to address particular areas
on a piecemeal basis. We seem to have lost track of the concept
that penalties should be applied only in cases of intentional
noncompliance and not for every error or omission.
TEI believes that a comprehensive review will lead to the
following conclusions: The interest rate differential should be
repealed. The rate of interest on deficiencies and refunds
should equal the applicable Federal rate, plus no more than two
or three percentage points. The estimated tax penalty should be
converted to an interest charge and safe harbors should be
created for all taxpayers, corporate and individual. The Code's
penalty regime should encourage disclosure by taxpayers. A
dispute reserve account system should be established. Finally,
certainty and fairness of application should play a more
prominent role in encouraging compliance than an increase in
penalty rates.
In my remaining time, I want to elaborate on two issues:
the interest rate differential and the standard for the
accuracy-related penalty.
The different interest rates for over and underpayments
have spawned a major complexity: interest netting. In 1998,
Congress established a net interest rate of zero where interest
is payable on equivalent amounts of over and underpayment of
tax. Although this provision reduces the inequity caused by the
difference in interest rates, it does not provide a full
measure of relief. It is also extremely complex to administer.
TEI thus supports the Joint Committee's recommendation to
eliminate the differential. This change would complete the
reform effort Congress undertook 2 years ago.
The Code imposes a hodgepodge of penalties to ensure that a
taxpayer's return is accurate. The standards now contained in
the accuracy-related penalty provisions--more likely than not,
realistic possibility of being sustained, substantial
authority, reasonable basis, and not frivolous--are undeniably
confusing. Taxpayers, practitioners and preparers have been
reduced to assigning mathematical probabilities to each
standard and then deciphering whether a proposed return
position meets the applicable standard. Nevertheless, TEI
believes that harmonization of taxpayer, practitioner, and
preparer standards, as suggested by the Joint Committee and
Treasury Department, is appropriate to encourage the filing of
more accurate returns.
We question, however, whether sufficient attention has been
paid to the effect on tax administration of imposing
significantly higher standards for undisclosed and disclosed
positions. Such an approach may unleash a flood of disclosures
that wastes valuable IRS resources and distracts revenue agents
from issues truly worthy of their scrutiny. Thus, TEI believes
that if a taxpayer has substantial authority, no disclosure
should be necessary to avoid a penalty.
Moreover, we do not believe that a case has been made for
raising the taxpayer standard for disclosed positions from a
reasonable basis to either a realistic possibility of success
or a substantial authority standard. Overwhelming the system
with disclosures will not aid the administration of the law,
and care should be taken that the disclosures that are made are
meaningful and useful.
Finally, Mr. Chairman, even with my 30 years of experience
in the tax field, I find the differences among the various
standards confusing. The higher standards proposed by Joint
Committee and Treasury assume a level of mathematical precision
that does not exist in reality. For example, it will not be
easy to distinguish between substantial authority (a 40 percent
chance) and a realistic possibility of success (which is a 33-
1/3 percent).
Mr. Chairman, we commend you for calling this hearing to
review the Code's interest and penalty provisions. TEI pledges
its support for your efforts to effect meaningful
simplification and reform.
I would be please to respond to your questions.
[The prepared statement follows:]
STATEMENT OF CHARLES W. SHEWBRIDGE, III, CHIEF TAX EXECUTIVE, BELLSOUTH
CORPORATION, ATLANTA, GEORGIA, AND PRESIDENT, TAX EXECUTIVES INSTITUTE,
INC.
Good morning. I am Charles W. Shewbridge, III, Chief Tax
Executive for BellSouth Corporation in Atlanta, Georgia. I
appear before you today as the President of Tax Executives
Institute, the preeminent group of corporate tax professionals
in North America. The Institute is pleased to provide the
following comments on the Internal Revenue Code's interest and
penalty provisions, with particular focus on the
recommendations made in 1999 by the staff of the Joint
Committee on Taxation and the Department of the Treasury. See
Staff of the Joint Committee on Taxation, Study of Present-Law
Penalty and Interest Provisions as Required by section 3801 of
the Internal Revenue Service Restructuring and Reform Act of
1998 (Including Provisions Relating to Corporate Tax Shelters)
(JCS-3-99) (July 22, 1999) (hereinafter cited as the ``Joint
Committee Study''); Office of Tax Policy, U.S. Department of
the Treasury, Report to the Congress on Penalty and Interest
Provisions of the Internal Revenue Code (October 1999)
(hereinafter cited as the ``Treasury Report'').
I. Background
Tax Executives Institute was established in 1944 to serve
the professional needs of in-house tax practitioners. Today,
the Institute has 52 chapters in the United States, Canada, and
Europe. Our more than 5,000 members are accountants, attorneys,
and other business professionals who work for the largest 2,800
companies in the United States and Canada; they are responsible
for conducting the tax affairs of their companies and ensuring
their compliance with the tax laws. TEI members deal with the
tax code in all its complexity, as well as with the Internal
Revenue Service, on almost a daily a basis. Most of the
companies represented by our members are part of the IRS's
Coordinated Examination Program, pursuant to which they are
audited on an ongoing basis. TEI is dedicated to the
development and effective implementation of sound tax policy,
to promoting the uniform and equitable enforcement of the tax
laws, and to reducing the cost and burden of administration and
compliance to the benefit of taxpayers and government alike.
Our background and experience enable us to bring a unique and,
we believe, balanced perspective to the subject of the Internal
Revenue Code's interest and penalty provisions.
TEI has long believed that the Code's interest and penalty
provisions are unduly complex and inequitable. The interest
provisions can operate in an unfair manner and are difficult to
administer, especially when taxpayers have overlapping periods
of under-and overpayments. In many cases, the provisions (such
as with the estimated tax provisions) have served as an
inappropriate penalty, rather than as recompense for the time
value of money.
Moreover, the calculation of interest itself--with its
restricted interest provisions and requirements for compounding
and netting--is inordinately difficult and leads to errors by
both the government and the taxpayer. Almost every TEI member
can recount a protracted tale, if not a horror story, of
convoluted, complicated, and ultimately incorrect interest
calculations. For good reason, taxpayers doubt the IRS's
ability to compute interest accurately, and they frequently
incur significant expense in hiring outside consultants to
review interest charges--often without the benefit of a print-
out of the IRS calculations. We recognize that much of the
cause of the problem lies in the IRS's computer system (which
is in the process of being replaced), but we believe the IRS
can take immediate steps to assist taxpayers now--for example,
by providing copies of interest calculations.\1\
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\1\ Section 6631 of the Code (added by the IRS Restructuring and
Reform Act) requires that individual taxpayers be provided with
interest calculations after December 31, 2000. TEI submits that this
provision should apply to all taxpayers and should be implemented as
soon as possible.
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In respect of the Code's penalty provisions, TEI believes
that they should be simple, fair, and easy to administer.
Unfortunately, the tax law has moved away from this concept in
the last decade where penalty has been piled upon penalty to
target specific areas such as transfer pricing and corporate
tax shelters. Rather than being straightforward, direct, and
effective, penalties have become almost as complicated as the
underlying provisions they seek to enforce. Dangerously, too,
the enactment of new or racheting up of existing penalties
deprives the system of proportionality while representing a
politically expedient way of raising revenues without
increasing ``taxes.''
The tax law seems to have lost track of the concept that
penalties should be applied only in cases of willful (or
volitional) noncompliance, and not for every error or omission.
The current structure does not effectively distinguish between
the two, but instead places taxpayers who unintentionally fail
to meet some requirement in the same category with those who
willfully decide not to comply.
It is clearly time for an in-depth review of the Code's
interest and penalty provisions. TEI commends Chairman Houghton
and the Oversight Subcommittee for scheduling this hearing to
determine the effectiveness of the current interest and penalty
regime and to consider recommendations for reform.\2\ The
Institute believes that such a comprehensive review of the
interest and penalty provisions will invariably lead to the
following conclusions (among others): \3\
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\2\ These comments do not address recent studies and proposals in
respect of corporate tax shelters, which were the topic of a separate
hearing by the full Committee on Ways and Means on November 10, 1999.
Upon request, the Institute would be pleased to provide a copy of that
testimony.
\3\ Both the Joint Committee staff and the Treasury Department make
several recommendations concerning the interest and penalty provisions
as applied to individual taxpayers. Given the composition of its
membership and the business-tax focus of its activities, TEI has not
addressed these recommendations, but suggests that many of them--such
as the Joint Committee staff's recommendation that overpayment interest
be excluded from the income of individual taxpayers--are worthy of
consideration.
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The interest-rate differential should be repealed
in its entirety and the interest charged on under-and
overpayments should be equalized.
The rate of interest on under-and overpayments
should equal the applicable federal rate plus no more than two
or three percentage points.
The estimated tax penalty should be converted to
an interest charge and a safe harbor should be created for all
taxpayers, corporations and individuals.
The Internal Revenue Service's ability to abate
interest should be expanded.
The Code's penalty regime should encourage
disclosure by taxpayers. The standards for imposing penalties
should be harmonized and consistently applied, and there should
be a realization that certainty and fairness of application
play a more prominent role in encouraging compliance than
reflexively increasing penalty rates.
The pension-related penalties should be
consolidated for enforcement purposes under a single government
agency.
A dispute reserve account to suspend the running
of interest while an issue is disputed by the taxpayer and the
IRS should be established.
TEI will be pleased to assist the Oversight Subcommittee in
effecting these changes.
II. Interest Provisions
A. Elimination of the Interest-Rate Differential
Section 6621 of the Code establishes the rate of interest
to be paid on over-and underpayments of tax. The rate on
overpayments of tax by a corporation is the federal short-term
rate plus two percentage points; the underpayment rate is the
federal short-term rate plus three percentage points.\4\
``Large corporate underpayments'' are subject to an interest
equal to the federal short-term rate, plus five percentage
points (the so-called hot interest provision).\5\ Thus, the
rate of interest the government charges corporate taxpayers on
tax deficiencies is higher than the rate of interest the
government pays on refunds.\6\
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\4\ The IRS Restructuring Act eliminated the differential in
respect of individual taxpayers, but not corporations.
\5\ The higher large corporate underpayment interest rate applies
only to periods after the ``applicable date.'' The calculation of the
applicable date differs. If the deficiency procedures apply, the
applicable date is the 30th day following the earlier of the date on
which (a) the first letter of proposed deficiency that allows the
taxpayer an opportunity for administrative review in IRS's Office of
Appeals, or (b) the statutory notice of deficiency is sent by the IRS.
If the deficiency procedures do not apply, the applicable date is 30
days after the date on which the IRS sends the first letter or notice
that notifies the taxpayer of the assessment or proposed assessment.
\6\ Under section 6621(a)(1), the interest rate on corporate tax
overpayments that exceed $10,000 is only AFR plus 0.5 percentage
points, as opposed to AFR plus 2 percentage points. (This provision was
enacted in 1994 as part of the Uruguay Round Agreements Act, Pub. L.
No. 103-465, 108 Stat. 4809, and accordingly is often referred to as
``GATT'' interest.) Thus, the potential difference between the interest
rate for under-and overpayments for corporations is 4.5 percentage
points. Although the GATT interest rate is effective for purposes of
determining interest for periods after December 31, 1994, the IRS has
embraced an unduly narrow interpretation of the statute, applying the
lower rate to overpayment interest accruing before the statute's
effective date. IRS Service Center Advice Memorandum 1998-014 (April
24, 1997). Indeed, the 1997 memorandum represents a change in position
for the IRS, which originally determined that overpayment interest
accrued through December 31, 1994, would not be subject to the lower
GATT rate. The statutory GATT interest provision and the IRS's narrow
interpretation operate to exacerbate the unfairness of the interest-
rate differential.
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The different interest rates for over-and underpayments,
coupled with the differences for large corporations, have
spawned major complexity in the tax law--interest netting. The
situation arises when taxpayers both owe money to and are owed
money by the government (but the debts bear interest at
different rates) and is a common occurrence for large
corporations that may have overpayments and underpayments of
different taxes for several years as the result of multi-year
and overlapping audits. For example, an IRS determination, say
in Year 8, that a taxpayer should have deducted an expense in
Year 1 instead of Year 2 could trigger an adjustment owing to
the interest-rate differential, even though the taxpayer was a
net creditor of the government during the entire period.
In the IRS Restructuring Act, Congress established a net
interest rate of zero where interest is payable on equivalent
amounts of over-and underpayments of tax.\7\ Taxpayers must
affirmatively request and--at least at present--calculate the
adjustments needed to achieve a zero net interest rate.
Although this provision ameliorates the inequity caused by the
difference in interest rates, it does not provide a full
measure of relief. It is also an extremely complex provision to
administer.
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\7\ The provision applies to interest for periods beginning after
July 22, 1998. In addition, the provision applies if: (i) the statute
of limitations has not expired with respect to either the underpayment
or overpayment; (ii) the taxpayer identifies the overlapping periods
for which the zero rate applies; and (iii) the taxpayer requests the
netting before December 31, 1999. In Rev. Proc. 99-43, the IRS
clarified the transition rule by providing that--assuming that both
statutes of limitations were open on July 22, 1998--a taxpayer must
file a claim requesting application of the net rate of zero by December
31, 1999, only if both the applicable statutes will have expired before
that date.
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Tax Executives Institute supports elimination of the
interest-rate differential. When the differential was enacted,
two reasons were given for having different rates for under-and
overpayments: (i) financial institutions do not borrow and lend
money at the same rate, and (ii) the differential between the
tax interest rate and the market rate might cause taxpayers
either to delay paying taxes or to overpay them, depending upon
the rate of interest accruing. H.R. Rep. No. 99-426, 99th
Cong., 1st Sess. 849 (1985) (hereinafter cited as ``1985 House
Report''); S. Rep. No. 99-313, 99th Cong., 2d Sess. 184 (1986)
(hereinafter cited as ``1986 Senate Report''). Contrary to the
views expressed in the Treasury Report (at 121), TEI submits
that these reasons--even if valid in 1986--are no longer
applicable. Taxpayers do not deliberately ``lend'' money to the
government. If such practices ever occurred, they were
effectively put to an end nearly two decades ago by changes to
the manner in which, and the rate at which, interest is
calculated.\8\ Moreover, returning to one rate of interest for
both under-and overpayments will greatly reduce or eliminate
the need for netting, thereby significantly simplifying the law
and freeing up both taxpayer and IRS resources. Finally, the
proposed amendment would address the inequities arising from
the ``same taxpayer'' rule, pursuant to which under-and
overpayments by related entities (such as with foreign sales
corporation and related supplier adjustments) do not result in
an overall increase in tax liabilities, but because of the
different rates on over-and underpayments, interest may be
owed.
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\8\ Before 1982, interest rates on tax overpayments and
underpayments were adjusted only once every two years; now they are
adjusted on a quarterly basis.
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Thus, the Institute believes that the elimination of the
interest-rate differential would complete the reform effort
Congress undertook in 1998. See Joint Committee Study at 73.
Equalizing the rates would ``provide a better mechanism for
achieving the equivalent effective interest rate goal than the
net zero interest rate approach of current law.'' Id. at 76. It
would also make the benefits of the equivalent effective
interest rates available to all taxpayers, not just those
capable of preparing the complicated calculations.
TEI therefore recommends that the interest-rate
differential be eliminated for all taxpayers.
B. Rate of Interest
Equalizing the interest rates on under-and overpayments
raises the issue of the appropriate rate of interest to be
charged. Current law imposes various rates of interest ranging
from the short-term applicable federal rate (AFR) plus 0.5 (for
overpayments) to 5.0 (for underpayments) percentage points. The
Joint Committee study recommends equal rates of AFR plus 5.0
percentage points (Joint Committee Study at 73), whereas the
Treasury study recommends an underpayment rate of AFR plus 2.0
to 5.0 percentage points (and an overpayment rate of AFR plus
2.5 points) (Treasury Report at 8).
A rate of AFR plus 5.0 percentage points (essentially 10
percent in today's market) is equivalent to the ``hot
interest'' rate that applies to large corporate underpayments.
TEI questions whether this high rate is appropriate for all or
even any taxpayers. As the Joint Committee Study confirms (at
76), large corporations are generally able to borrow money at a
much lower rate. For example, a corporate taxpayer with an
``AA'' credit rating can borrow money today in the commercial
paper market at 5.62 percent for 30 days--an amount comparable
to the short-term AFR. The current interest rate system--with
its provisions for above-market interest and ``hot'' interest--
operates essentially as a penalty. We recognize that a blended
rate is necessary for ease of administration. We also recognize
that, from a tax policy standpoint, an argument can be made
that interest rates should be skewed, if anything, to encourage
overpayment.\9\ Nevertheless, we submit the goal should be to
approximate a market rate of interest (which does nothing more
than reflect the time value of money), and respectfully suggest
that a rate of AFR plus 2.0 or 3.0 percent would be closer to
reality.
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\9\ That is to say, if the interest rate is to provide an incentive
either to overpay or to underpay one's taxes, the incentive should be
toward encouraging overpayment.
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C. Abatement of Interest
Under section 6404(e) of the Code, the Treasury Secretary
is granted the discretion to abate the assessment of all or any
part of interest due for any period on (i) a deficiency
attributable in whole or part to any unreasonable error or
delay by an IRS officer or employee acting in an official
capacity when performing a ministerial or managerial act, or
(ii) a tax payment, to the extent that any unreasonable error
or delay in such payment is attributable to an IRS employee or
officer acting in an official capacity being erroneous or
dilatory in performing a ministerial or managerial act. An
error or delay may be taken into account only (i) if no
significant aspect of such error or delay can be attributed to
the taxpayer involved, and (ii) after the IRS has contacted the
taxpayer in writing with respect to such deficiency or payment.
There is also limited authority to abate interest in respect of
erroneous refunds or reliance on erroneous written advice of
IRS personnel.
Both the Joint Committee staff and the Treasury Department
agree that the IRS's authority to abate interest should be
expanded, though Treasury's recommendation is more
circumscribed.\10\ The Joint Committee staff recommends that
the IRS be permitted to abate interest in cases of gross
injustice. Joint Committee Study at 91-92. Although the ``gross
injustice'' standard establishes a high threshold, adoption of
the Joint Committee staff's recommendation would mark the first
time abatement would be permitted on general equitable grounds.
TEI believes that the recommendation should be adopted, but
suggests that the IRS's administration of this standard be
monitored to determine whether the threshold should be lowered.
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\10\ The Treasury Department recommends that the abatement
provision be expanded only in respect of reliance on erroneous written
advice from the IRS. Treasury Report at 137.
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Furthermore, the Joint Committee staff recommends that
abatement occur for periods attributable to any unreasonable
IRS error or delay. Joint Committee Study at 91-92. This
provision thus eliminates the managerial or ministerial acts
requirement, which creates complex factual issues that
themselves can lead to audit disputes and litigation. The
legislative history of the interest-abatement provision
confirms that Congress did not intend the provision to be used
routinely to avoid payment of interest, but rather that the
provision should operate in instances where the denial of
abatement would be widely perceived as grossly unfair. 1985
House Report at 844-45; 1986 Senate Report at 208-09. There may
well be instances where the denial of an abatement request may
be unfair, but the taxpayer fails to meet the standards set
forth in the statute.
TEI therefore supports the Joint Committee staff's
recommendations in respect of the abatement of interest and
suggests that consideration be given to expanding its reach.
D. Dispute Reserve Account
In general, interest on under-and overpayments continues to
accrue during the period that a taxpayer and the IRS dispute a
liability. Under section 6404(g) of the Code, the accrual of
interest on an underpayment is suspended if the IRS fails to
notify an individual taxpayer in a timely manner, but interest
will begin to accrue once the taxpayer is properly notified. No
similar suspension is available for other taxpayers.
Taxpayers that are unable to promptly resolve their
disputes with the IRS face limited choices. The taxpayer can
continue to dispute the amount owed and risk paying a
significant amount of interest, it can pay the disputed amount
and claim a refund, or it can make a deposit in the nature of a
bond.
The Joint Committee staff recommends that taxpayers be
permitted to deposit amounts in a special ``dispute reserve
account'' within the Treasury Department. Joint Committee Study
at 97. Access to the account would be permitted upon notice to
the IRS. According to the study, the account ``would allow
taxpayers to better manage their exposure to underpayment
interest without requiring them to surrender access to their
funds or requiring them to make a potentially indefinite-term
investment in a non-interest bearing account.'' Id. at 99. It
would also preserve the taxpayer's access to the U.S. Tax Court
while encouraging the prepayment of disputed amounts. Interest
paid on the account would be set at a rate that would provide
reasonable compensation to the taxpayer for the use of its
money, but should not encourage the use of dispute reserve
accounts as an alternative to investment in other short-term
instruments. Id. at 100.\11\
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\11\ The Treasury Report does not address this issue.
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The Joint Committee staff's recommendation is a significant
improvement over the cash bond requirement of current law, and
TEI recommends that it be adopted. Moreover, TEI recommends
that interest accrue on amounts deposited in the account at the
rate established for under-and overpayments of tax.
III. Estimated Tax Penalty
A. Penalty in Lieu of Interest
Under section 6655 of the Code, corporate taxpayers are
subject to a penalty if they *fail to estimate their tax
liability and make quarterly deposits equal to either (i) 100
percent of their actual tax liability, or (ii) 100 percent of
their prior year's tax liability. The ``prior year's tax''
option is generally not available to for so-called large
corporations--roughly, corporations whose taxable income is $1
million or more in any of the preceding three years. The
estimated tax penalty is imposed in lieu of an interest charge
on the underpayments of tax.
Because of the lack of a meaningful safe harbor, the large
corporate taxpayer generally faces the following choice:
paying a penalty for underestimating its
liability, or
overpaying its taxes (in order to avoid the
penalty).\12\
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\12\ The estimated tax rules provide an annualization method that
may be employed to avoid any penalties. Determining annualized tax
liability and quarterly estimated payments under section 6655(e),
however, remains far from simple. This process effectively requires
taxpayers to prepare five ``mini'' returns for their estimated tax
payments plus their final return. By reinstating the prior year's
liability safe harbor, Congress could remove the uncertainty associated
with the determination of tax liability from the quarterly estimating
and payment process.
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The second option--which large corporations are generally
required to choose not only by internal business conduct
policies but by the desire to avoid penalties--does not come
without cost. The cost is the effective denial of interest on
the amount of the compelled overpayment by operation of section
6611(e), which provides that interest on an overpayment will
not begin to run until the filing of a claim for refund.\13\
The rules thus act as a ``non-penalty'' penalty for
corporations.
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\13\ The filing of a tax return could constitute a claim for
refund, but most calendar-year large corporations will not file returns
until close to September 15 (the extended due date of their return),
though any outstanding tax would have to be paid no later than March
15. Thus, there could be, at a minimum, a six-month period during which
no interest would accrue on the amount of the overpayment.
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TEI agrees with the recommendation that the estimated tax
penalty be converted to an interest charge at the rate provided
under section 6621 of the Code, which would make the interest
deductible by corporate taxpayers. See Joint Committee Study at
114-15.\14\ The estimated tax penalty is, in reality, a charge
for the time value of money and the law should reflect this
fact. It is simply bad tax policy to disguise an interest
charge as a penalty.
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\14\ But see Treasury Report at 81 (recommending retention of
current law).
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TEI therefore supports the Joint Committee staff's
recommendations. We also agree with its recommendation (at 118-
19) that, in the pursuit of simplification, the interest rates
should be aligned so that, for any given estimated tax
underpayment period, only one interest rate applies, i.e., the
interest applicable on the first day of the quarter in which
the estimated payment due date arises.
B. Safe Harbor
TEI is disappointed that neither the Joint Committee Study
nor the Treasury Report addresses need for an estimated tax
safe harbor for corporate taxpayers. Because they are not
permitted to utilize the prior year's tax rule, large
corporations must base their quarterly deposits on estimates of
their current year's tax liability. Estimating taxes is not an
exact science. The existing task is literally impossible in
light of the complexity of the tax laws, the rapidity with
which they have been changed in recent years, and the fact that
the numerous adjustments to financial income can accurately be
done only annually.
TEI submits that there is no valid tax policy reason for
denying large corporations the availability of the prior year's
tax rule under section 6655. We therefore recommend that a safe
harbor, based on a percentage of the prior year's (or the
average of a group of years') liability, be established for
large corporate taxpayers.
V. Penalties
A. Accuracy-Related Penalties
The Code imposes a hodgepodge of penalties to encourage
taxpayers to file accurate returns. These penalties employ a
variety of standards, ranging from ``more likely than not''
(section 6662(d)(2)B)(i)) and ``reasonable basis'' (section
6662(d)(2)(B)(ii)) for taxpayers, to ``realistic possibility of
being sustained'' (section 6694(c)) and ``not frivolous''
(section 6694(a)) for return preparers. The less stringent
standards are generally applicable for positions that are
disclosed on a return. See Joint Committee Study at 152, Table
7 (``Summary of Existing Standards for Tax Return Positions'').
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment attributable to any of the following: (i)
negligence or disregard of rules or regulations; (ii) a
substantial understatement of income tax; (iii) a substantial
valuation overstatement; (iv) a substantial overstatement of
pension liabilities; or (v) a substantial estate or gift tax
valuation understatement. The accuracy-related penalty was
enacted in 1989 to replace several other penalties, including
the negligence, substantial understatement, and valuation
overstatement penalties. The penalty is generally not imposed
with respect to any portion of the underpayment for which there
is reasonable cause if the taxpayer acted in good faith. I.R.C.
Sec. 6664(c)(1).
For corporations, an understatement for any taxable year is
``substantial'' if it exceeds the greater of $10,000 or 10
percent of the tax required to be shown on the taxpayer's
return. I.R.C. Sec. 6662(d)(1). An exception to the penalty is
provided for items in respect of which there is substantial
authority or adequate disclosure of the taxpayer's
position.\15\
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\15\ Special rules apply in respect of ``tax shelters,'' where the
penalty can be avoided only if the taxpayer establishes that, in
addition to having substantial authority, it reasonably believed that
the treatment claimed was more likely than not the proper treatment of
the item; adequate disclosure has no effect on the application of the
penalty in respect of tax shelters.
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The Code also imposes a two-tiered penalty on tax return
preparers in respect of positions not having a ``realistic
possibility'' of being sustained on the merits. Specifically,
if the position results in an understatement, a penalty will be
imposed unless the preparer takes steps to ensure the
disclosure of the position and the position is ``not
frivolous.'' I.R.C. Sec. 6694 (a) & (c).
The Joint Committee staff and Treasury Department both
recommend that penalty standards be harmonized, though they
approach the issue in different ways. Their reports focus on
two issues:
The appropriate standard imposed on taxpayers and
tax return preparers.
The appropriate standard imposed for disclosed and
undisclosed return positions.
The Joint Committee staff recommends that, for both
taxpayers and preparers, the minimum standard for each
undisclosed position on a tax return be that the taxpayer or
preparer must reasonably believe that the tax treatment is
``more likely than not'' the correct tax treatment under the
Code. Joint Committee Study at 153. For disclosed positions,
the Joint Committee staff would require both substantial
authority and adequate disclosure and would eliminate the
reasonable cause exception of section 6664(c)(1). Joint
Committee Study at 154-155, Table 8 (``Proposed Standards for
Tax Return Positions''). Thus, under the Joint Committee
staff's proposal, the standard in respect of disclosed
positions would move from the disjunctive (substantial
authority or disclosure) to the conjunctive (substantial
authority and disclosure).
In contrast, the Treasury Department would retain the
``substantial authority'' standard for undisclosed positions
and raise the standard for disclosed items to a ``realistic
possibility of success'' for both taxpayers and tax return
preparers. Treasury Report at 108.
The multitude of standards now contained in the Code--more
likely than not, realistic possibility of being sustained,
substantial authority, reasonable basis, not frivolous--is
undeniably confusing and has reduced taxpayers, practitioners,
and preparers to assigning mathematical probabilities to each
standard and then divining (to the extent possible) whether a
proposed return position meets or exceeds the applicable
standard. The clarity suggested by the use of mathematical
probabilities, however, is a false one, for the tax law is
marked by many things, but mathematical precision is rarely one
of them.\16\
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\16\ TEI is also concerned about how meaningful a difference exists
between the two proposed standards. What is the difference between the
Joint Committee staff's recommendation of a ``substantial authority''
standard--which is defined as a 40-percent probability of success--and
the Treasury Departments's ``realistic possibility of success
standard--which is defined as a 33-percent probability? We submit that
it would be almost impossible to analyze a proposed transaction with
such precision. More troublesome, we foresee situations in which a
taxpayer's (or practitioner's) good faith judgment that a position
satisfies the higher (40 percent) standard could be second-guessed by a
revenue agent who concludes, also in good faith, that the possibility
of success was 6.5 percentage points lower.
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These concerns notwithstanding, TEI believes that some
adjustment to and harmonization of taxpayer, practitioner, and
preparer standards may be appropriate to encourage the filing
of more accurate returns. We question, however, whether
sufficient attention has been paid to the effect of raising the
standard in respect of undisclosed positions to ``more likely
than not'' (as the Joint Committee staff suggests). Such an
approach may unleash a torrent of disclosures that consumes
valuable IRS resources and distracts revenue agents from issues
more worthy of their scrutiny. Thus, although we appreciate the
surface appeal of the statement that ``'more likely than not'
is a simple threshold that is easily understood'' (Joint
Committee Study at 153), we are concerned about how an ``at
least probably correct'' standard (id.) will be applied in
practice. As the Joint Committee staff notes, it is unrealistic
to expect taxpayers to file a perfect return (id. at 152), and
TEI is concerned that taxpayers may find themselves facing
penalties where, several years after they grappled with the
vagaries and interstices of the tax law, a revenue agent or
court concludes--with the benefit of hindsight--that the
taxpayer erred in concluding its position was ``at least
probably right.'' (This concern is heightened in light of the
Joint Committee's recommendation that the reasonable cause
exception of current law be repealed.) \17\ If a taxpayer has
substantial authority for a return position--e.g., if a court
decision or regulation supports its position--no disclosure
should be necessary in order to avoid a penalty. See Treasury
Report at 108.\18\
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\17\ It should also be recognized that the person making the
decision whether the taxpayer was ``at least probably right'' (i.e.,
revenue agent, Appeals officer, or court) would not even reach that
question until concluding that the taxpayer was wrong on the merits.
\18\ Given the additional recommendation to increase the amount of
the preparer penalty--from a two-tier penalty of $250 or $1000 per
return to 50 or 100 percent of the fee (Joint Committee Study at 156)--
TEI wonders whether sufficient attention has been focused on the
potential adverse effect of the higher standards.
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Moreover, we do not believe that the case has been made for
raising the standard for disclosed positions in respect of
taxpayers from a reasonable basis to either a realistic
possibility of success standard (as the Treasury proposes) or a
substantial authority standard (as the Joint Committee staff
proposes). Again, the Institute is concerned that raising the
standard would be counterproductive. It may prompt taxpayers,
out of an abundance of caution, to laden down their tax returns
with myriad disclosure forms, thereby greatly diminishing the
value of any particular ``needle'' in the burgeoning
``haystack.'' Overwhelming the system with disclosures will not
aid the administration of the law.\19\
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\19\ The Joint Committee Study (at 156) acknowledges that no
empirical evidence exists on whether or how effectively the IRS uses
the taxpayer disclosures made under current law, and it recommends that
the IRS be required to maintain records on its own usage of taxpayer
disclosures. TEI supports this recommendation and suggests that,
pending the gathering and analysis of information on the effectiveness
of current law, Congress not rush to judgment on the need for more and
better disclosures.
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B. Pension Benefit Penalties
Current law imposes several penalties in respect of the
failure to file the Form 5500 series (the annual return/report
for pension plans). The penalties are imposed by the IRS (under
Code section 6652(e)), the Department of Labor (under DOL Reg.
Sec. 2560.502(c)-2(d)), and the Pension Benefit Guarantee
Corporation (PBGC) (under PBGC Reg. Sec. 4071.3).
The Joint Committee staff recommends the consolidation into
one penalty of the present-law penalties imposed by the
Internal Revenue Code and ERISA for failure to file the Form
5500 series. Joint Committee Study at 161. The penalty that
would result from this consolidation would be no less than the
existing ERISA penalty for failure to file. In addition, the
staff would designate the IRS as the agency responsible for
enforcing the reporting requirements and replace the Labor
Department's voluntary compliance program with a similar
program administered by the IRS. This would reduce from three
to one the number of government agencies authorized to assess,
waive, and reduce penalties for failure to file. Other
penalties imposed for the failure to file certain reporting
forms would also be eliminated. Id. The Treasury Department
also supports consolidation of the penalties, but recommends
that the administration of the penalties rest with the
Department of Labor. Treasury Report at 141.
In TEI's view, consolidating the penalties would be a
marked improvement over current law. It would simplify the Form
5500 series penalty structure, reduce the number of potential
penalties for failure to file, strengthen incentives to comply,
and encourage voluntary compliance by delinquent filers while
retaining the most significant of the present-law penalties for
failure to file. On balance, we favor the Joint Committee
staff's proposal to have the IRS responsible for administration
of the streamlined regime.
C. Administrative Proposals
The Joint Committee staff makes several recommendations
concerning the administration of the penalty provisions. First,
the staff recommends that the IRS improve the supervisory
review of the imposition of penalties as well as their
abatement (or waiver). Joint Committee Study at 169. Improving
the level of review would improve consistency and combat the
perception that penalties are often used as ``bargaining
chips.'' As the Joint Committee staff suggests, another way to
improve supervisory review would be to institute penalty
oversight committees, similar to the one established for
administering the transfer pricing penalty under section
6662(e)(3) of the Code.
TEI believes that these suggestions are sound and
encourages the IRS to consider whether the penalty oversight
committees should be expanded to the review of other penalties,
most especially, accuracy-related penalties.
VI. Miscellaneous Recommendations
A. Standards Applicable to IRS Personnel
The Joint Committee staff makes several recommendations
concerning the administration of the tax law by the IRS,
including a revision of the standards applicable to IRS
personnel under Rev. Proc. 64-22, 1964-1 C.B. 689, which among
other things provides that IRS employees should not adopt a
strained construction of the Code. As the Joint Committee staff
notes, ``the standards of conduct applicable to the IRS are an
important component of taxpayers' perceptions of the relative
fairness of the administration of the tax laws.'' Joint
Committee Study at 167.\20\
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\20\ The Treasury Report is silent on this issue.
---------------------------------------------------------------------------
TEI agrees that the standards to which IRS employees are
held should be clarified. We also agree with the Joint
Committee that some employees may have misconstrued the quoted
language from Rev. Proc. 64-22--which also appears several
places in the Internal Revenue Manual (IRM)--to suggest that a
revenue agent's position need not be reasonable, it just cannot
be strained. As the Joint Committee's report puts it: ``[I]t
may appear that an inappropriately low standard of conduct is
applicable to the IRS.'' Joint Committee Study at 167. Thus,
the Joint Committee staff recommends that the standards be
revised to incorporate a higher standard of behavior by the
IRS, similar to that for practitioners.
TEI agrees that a higher standard of conduct for IRS
personnel is appropriate and recommends adoption of the Joint
Committee staff's recommendation.
B. Failure-to-Deposit Penalty
The Joint Committee staff and Treasury Department make
several recommendations concerning the four-tier failure-to-
deposit penalty under section 6656(b). Although both suggest
that no new legislation be enacted in this area for two years--
in order to give the recent statutory changes time to be
evaluated--the Joint Committee staff adds that the Treasury
Department should consider revising its deposit regulations
concerning events that trigger a change in the deposit schedule
in a later calendar quarter. This would give the IRS an
opportunity to notify the taxpayer of the change in status
before it takes effect. It would also give the depositor time
to recognize its new obligations and adjust its operating
procedures accordingly. Both studies also recommend that the
IRS continue to work with payroll service providers to expedite
resolution of problems where a single error or mishap may
affect multiple taxpayers. Joint Committee Study at 139-140;
Treasury Report at 96.
TEI supports these recommendations, but suggests that
consideration be given to implementing a mechanism to identify
third parties who can provide an oral response to the IRS and
receive information in return--without resorting to the time-
consuming method for obtaining a power of attorney. Based on
reports from our members, TEI understands that at least one
District Office has experimented with including a unique
identifying number on each notice of proposed penalty. If a
caller responds to the notice and provides the name and
employer identification number (EIN) of the taxpayer and the
identifying number, the IRS assumes the caller is authorized to
discuss the matter, eliminating the need for a power of
attorney and providing a swift resolution of any questions. TEI
recommends that such a procedure be implemented.
VII. Conclusion
Tax Executives Institute appreciates this opportunity to present
its views on the interest and penalty provisions of the Internal
Revenue Code. Any questions about the Institute's views should be
directed to either Michael J. Murphy, TEI's Executive Director, or
Timothy J. McCormally, the Institute's General Counsel and Director of
Tax Affairs. Both individuals may be contacted at (202) 638-5601.
Chairman Houghton. Thanks very much, Mr. Shewbridge. I am
going to ask Mr. Coyne to ask the first question.
Mr. Coyne. Thank you, Mr. Chairman. Mr. Pearlman and Mr.
Ely, I wonder if you could respond. We understand that the IRS
audits and collections are at an all-time low. I just would
like to have your two views on that situation.
Mr. Pearlman. Well, we understand the same thing. I think
part of--it is a complicated issue, but I think it is an
extraordinarily important issue. Part of it is attributable to
the tremendous changes that are taking place at the IRS, and I
think my impression is that the modernization project
inevitably was going to result in some reduction in compliance
activities, and hopefully, that is short-term and the
Commissioner has indicated that is a short-term phenomenon and
we expect it will be. Some of it is attributable to budget
constraints and the need to shift personnel from one function
within the Service to another.
Clearly, the Service has heard the message from the
Congress that it needs to improve its quality of taxpayer
service and it appears that they have devoted substantial
resources for doing so, and that has had an effect on
collection and audit. Finally, some of the effect certainly on
the collection side has apparently been the result of the 1998
legislation and the potential liability, personal liability on
IRS employees.
Again, if you listen to the senior management of the
Internal Revenue Service, because of increased improved
training in that regard, they believe that too is a short-term
phenomenon. I think the most important issue, the most serious
issue, is the question of audit coverage. I am more concerned
about audit coverage than I am collection activity. I think the
collection activity issue will sort of settle out. But I
believe that audit coverage is a big issue. I don't know what
the right level of coverage should be. I mean I don't hold the
kind of expertise to know whether the numbers should be 1
percent or 2 percent. But my perception as a practitioner is
that the lower audit coverage has had an effect on compliance,
and I would expect that would continue. I think it is an issue
that this committee really should take a look at, without
having an agenda, but simply to try to get a feel from the
experts, both within the government and outside, as to what is
happening in terms of compliance and how audit resources can
best be deployed to assure the highest level of compliance
without being overbearing.
Mr. Ely. I will echo a lot of what Mr. Pearlman said. I do
agree that the audit rate is historically low. I believe the
rates are below 1 percent, maybe three-quarters of a percent.
However, I think the IRS is taking the right approach, which is
really to not so much focus on the audit coverage, whether it
is 1 percent, a half a percent, 2 percent, I don't think that
is going to make all the difference in the long term. I think
what they should be focusing on, which I think what they are
starting to do is focus on encouraging compliance in different
ways, focusing on education, taxpayer outreach, tax system
modernization, explaining the rules to taxpayers through
identification so that they can comply on their own. I think if
we are going to base our system on the IRS audit rate, I think
it is going to fail. I think what we should do is to encourage
compliant conduct. That is why I believe also the interest and
penalty reform studies that you are doing now are so important,
and should be focused towards that area.
Mr. Coyne. Thank you.
Chairman Houghton. Mr. Portman.
Mr. Portman. Thank you, Mr. Chairman. I appreciate you all
being here. I apologize, we all have different things going on
right now and I couldn't be here for all of your testimony, but
I have seen the summaries of it and I do appreciate your
specific input on interest and penalties, the focus of our
hearing and what this subcommittee is trying to grapple with
and come up with at the end of the day, are some
recommendations for either legislative changes or encouraging
Treasury and the IRS to make administrative changes that we
think they already have the authority to do under existing law.
My question that I would like to focus on if I might is
this differential issue. We studied this and the IRS Commission
came up with some thoughts on it. I am not sure that the
statute is clear on it, to be frank, and what I would like to
do, if I could get input from as many of you as we have time
for on how you have come out on this and really to process how
we should get there.
The Joint Tax Committee study, as you know, proposes
eliminating the differential altogether because it is so
complicated. The underpayment, overpayment rate is a difficult
one for the IRS to deal with. A lot of people who looked at it
from the outside say that the taxpayers usually get it wrong.
Someone said they always get it wrong and the IRS usually gets
it wrong.
My question is should there be a single rate for
overpayments and underpayments and would this be a significant
simplification measure. I will go if I could from Ms. Akin
down.
Ms. Akin. I believe that your statement is right, that
taxpayers can't figure it, the IRS can't figure it, and
everybody does have a problem with it. It should be very
simplified and should be the same rate for overpayment as
underpayment.
Mr. Portman. Ron?
Mr. Pearlman. Mr. Portman, I think you are absolutely
right. I was on the Joint Committee staff in 1989 when the
proposal was adopted, and I remember, I remember the day when I
said to the then chairman of the Senate Finance Committee, this
provision is going to create major problems, and I think there
are two problems. One is a perception problem. People don't
understand it. Even though there is a theoretical basis for the
differential, people simply don't understand it, and the second
problem is that it is inevitably complex, and no matter how
hard people work on interest netting, it is always going to be
complex. It seems to me the right way to deal with a problem
that produces complexity and a perception issue is to get back
to a more rational world, and I think a single rate is the
rational world.
Mr. Portman. Mr. Ely.
Mr. Ely. I would concur. We strongly believe that a single
rate is the appropriate mechanism. Interest is not a penalty,
it is solely for compensation for the use of money. We would,
however, go a little further than the Joint Committee. I think
a very good point that was brought up when you were here
earlier talking with Mr. Mikrut was the issue of periods where
there is a mutuality of indebtedness, where the government owes
you money, you owe the government money. We believe absolutely
that should be taken into account, under the use of money
principles.
Mr. Mikrut brought up an example, and I think if you looked
at an example of where you have a taxpayer with a single tax
year, when a taxpayer, the same scenario where there is a 45-
day rule, they file their return, they seek an overpayment,
they get their money without interest. If that same taxpayer,
it was later determined that taxpayer had a deficiency, under
current law, and the IRS finally acquiesced to this after four
cases, that taxpayer would not owe interest for that period of
time from when the return was filed until they received their
cash. That is really the appropriate approach to look at the
interest, and all we are asking is that same approach be taken
to other years. So we think it is the appropriate result.
Mr. Portman. Mr. Shewbridge.
Mr. Shewbridge. I echo what they are saying. I think the
interest calculation is among the biggest problems that
corporate America has. I hear complaints about it all across
the country and have for many, many years. I think that
simplifying, by establishing one rate makes an awful lot of
sense. We do believe, however, that the rate should be at a
market rate and not at a punitive rate. We look forward to
working with the Subcommittee on trying to establish a rate
that makes sense and something that would greatly simplify the
Code.
Mr. Portman. Thank you again for your testimony. We look
for to working with you as we go forward.
Thank you, Mr. Chairman.
Chairman Houghton. Thank you, Mr. Portman. Is Mr. Weller
here? Mr. Weller, do you have any questions?
Chairman Houghton. I just have one question. Mr.
Shewbridge, in your statement you mentioned the Joint Committee
on Taxation, their study and the recommended change and we sort
of danced around this thing, the creation of a special dispute
reserve account. Do you want to break that down a little bit?
Mr. Shewbridge. Ms. Paull did a good job in her statement
of describing how it would work. Basically, today you can make
a deposit in the nature of a cash bond that cuts off interest
charges for a tax issue that might be in dispute. Under the
proposal, you would pay money into a ``dispute reserve
account,'' which would earn interest. The taxpayer could
withdraw the money during the process if 45 days' notice is
given to the IRS. The balance in the account can be used to pay
the ultimate tax liability, plus interest, when the issue is
finally resolved.
Chairman Houghton. Okay. That is the only question I have.
Do you have any more?
Well, ladies and gentlemen, thank you very much. We
certainly appreciate it.
[Whereupon, at 12 noon, the hearing was adjourned.]
[Submissions for the record follow:]
American Council of Life Insurers
February 10, 2000
A. L. Singleton
Chief of Staff
Committee on Ways and Means
U.S. House of Representatives
1102 Longworth House Office Building
Washington, DC 20515
Re: Hearing on I.R.C. Penalty and Interest Provisions by the
Subcommittee on Oversight of the House Committee on Ways and Means,
January 27, 2000
Dear Mr. Singleton:
I am writing on behalf of the American Council of Life Insurers.
The 435 member companies of the ACLI have 73.2 percent of the life
insurance in force in the United States in legal reserve life and
health insurance companies. Their assets represent 79.4 percent of all
United States life and health insurance companies, 82.2 percent of the
pension business, and 86.9 percent of the long term care insurance
business with such companies. We appreciate the opportunity to present
comments regarding the penalty and interest provisions of the Internal
Revenue Code for inclusion in the hearing record of the Subcommittee.
In our letter responding to the Joint Committee on Taxation's Press
Release 98-02 requesting comments on their Interest and Penalty Study,
we raised a number of points, including one regarding ``global
netting'' of interest on underpayments and overpayments of tax for
overlapping periods. The relevant part of our letter dated February 26,
1999 was as follows:
Global Interest Netting: We note that since 1986, penalty
provisions have been strengthened substantially to discourage
inappropriate behavior. Because of the broad reach of the current
penalty provisions, the time is ripe to equalize the overpayment-
underpayment rates of interest to eliminate ``hot'' interest. The
statutory interest rates should favor neither the Taxpayers nor the
Government. While we understand that this problem was addressed as part
of the IRS Restructuring and Reform Act of 1998 and the enactment of
global interest netting provisions, these provisions are complex and do
not completely resolve the problems caused by the interest rate
differentials. We suggest that consideration be given to equalization
of the interest rates. Absent such an equalization, our member
companies have indicated that guidance is needed on the application of
the global interest netting provisions, especially with respect to
their applicability to pre-1999 tax years.
During 1999, the IRS did issue initial guidance on how to achieve
netting of interest with respect to interest accruing before October 1,
1998 in Rev. Proc. 99-19, 1999-13 I.R.B. 10. Comments submitted by ACLI
and others, led to some modifications that were included in Rev. Proc.
99-43, 1999-47 I.R.B. 579. While this guidance was helpful, and
provided assistance to taxpayers who were approaching the December 31,
1999 statutory deadline for filing claims for relief for interest
accruing before October 1, 1998, it did little to alleviate the ongoing
computational and administrative problems that will face both taxpayers
and the IRS in computing global netting relief for interest accruing
both before and after October 1, 1998. The way to accomplish this is by
eliminating the interest rate differential.
We note that support for a single interest rate was voiced by a
number of witnesses at the Subcommittee's January 27, 2000 Hearing,
including Lindy Paull, Chief of Staff of the Joint Committee on
Taxation, IRS National Taxpayer Advocate Val Oveson, Charles W.
Shrewbridge, president of the Tax Executives Institute, Mark Ely,
representing the Tax Division of the American Institute of Certified
Public Accountants, and Ronald Pearlman, chairman of American Bar
Association's Section of Taxation task force on corporate tax shelters.
The points they raised were similar to those we have given. We
therefore reiterate our request that consideration be given to
correcting the problem by eliminating the rate differential
legislatively and establishing a uniform rate for underpayments and
overpayments to be applicable to all taxpayers and to the government.
Sincerely,
Mark A. Canter
American Council of Life Insurance
February 26, 1999
Lindy L. Paull, Esquire
Chief of Staff
Joint Committee on Taxation
1015 Longworth House Office Building
Washington, D.C. 20515
Re: Joint Committee on Taxation Press Release 98-02 Interest and
Penalty Study
Dear Ms. Paull:
We are writing on behalf of the American Council of Life Insurance
in response to JCT Press Release 98-02 which indicates that comments
are being sought from the public on a number of issues relating to the
administration and implementation by the Internal Revenue Service (the
``Service'') of the interest and penalty provisions of the Internal
Revenue Code. The 493 member companies of the American Council of Life
Insurance have 77.3 percent of the life insurance in force in the
United States in legal reserve life insurance companies. Their assets
represent 82.3 percent of all United States life and health insurance
companies and 83.7 percent of the pension business with such companies.
In reviewing the issues noted in the press release, our members
would like to submit the following comments.
Penalties Related to Information Returns: Our member companies file
a substantial number of information returns, including Forms 1099-INT,
1099-R, 1099-LTC, and 1099-MISC. In filing these returns, the companies
make extensive efforts to obtain the correct name and matching taxpayer
identification number (TIN) and to otherwise comply with reporting and
withholding obligations. At times, however, the name and TIN do not
match, resulting in an assessed penalty to the company filing the
information return. While assessed penalties can be and generally are
waived upon a showing of reasonable cause by the Taxpayer filing the
information returns, the waiver process is costly and time consuming
for both the Taxpayers and for the Service.
Currently, we understand that the Service has a policy of not
assessing a proposed penalty if a company is in significant compliance
with the information reporting requirements. Based on our member
companies' experiences, this significant compliance standard is
considered to be met as long as 99.5% of the returns are correct. Thus,
there is an informal ``safe harbor'' of .5%.
While we appreciate the Service's need for correct information
returns, we believe that this standard is excessively stringent.
There have been legislative proposals in recent years to formalize
and increase such a ``safe harbor.'' We suggest that the Service issue
guidance providing for a formal safe harbor of 5% so that as long as
95% of a company's information returns are correct, no penalty would be
assessed. Increasing the threshold will not discourage any company from
undertaking reasonable efforts to obtain the correct name and TIN or
otherwise meet its reporting and withholding obligations. It will ease
the burden to Taxpayers and the Service in applying for and processing
waivers of proposed penalties.
Based on substantial experience in complying with reporting and
withholding requirements, our member companies believe that there
should be a presumption that financial intermediary payors (information
return filers) have ``reasonable cause'' for errors made in information
reporting. Based on the large number of information returns filed by
financial intermediaries, inadvertent errors are inevitable and it
should be presumed that they are not intentional. Companies filing
information returns spend substantial amounts to establish and maintain
systems and procedures to correctly report and withhold. The reporting
and withholding by financial intermediaries assist the government in
the orderly collection of tax revenue. Information reporting and
withholding by financial intermediary payors should be viewed as a
partnership enterprise between the government and the payors. Penalties
for failure to fulfill reporting and withholding obligations should
only be assessed in the event that a payor has clearly failed to
exercise reasonable cause.
TIN Validation Program: Our member companies responsible for filing
information returns obtain the name and TIN from their policyholders
and payees. Currently, they have no method of validating that the name
and TIN provided are correct prior to the filing of an information
return. If there is an error, the Service advises them after the
returns have been filed. The notice of an incorrect name/TIN is often
accompanied by a proposed penalty notice for filing an incorrect
information return. In many cases, the Service does not advise the
Company of an error for a number of years after the return has been
filed. In the case of returns filed annually, the company may have
filed multiple information returns with an incorrect name or TIN by the
time it is notified of the error.
Were companies able to check whether the name/TINs were correct
prior to filing their information returns, they would better be able to
contact the affected policyholders or payees to obtain the correct
information. In a two-year pilot application, the Service permitted
some name and TIN verification. It is our understanding that
information filers were in favor of this program and have requested
that the Service institute a broad-based name/TIN matching system. We
suggest that a name/TIN verification program for information return
filers be instituted to reduce the number of incorrect information
returns. This would result in a saving of resources for both the
Service and information reporters.
Changes in Information Reporting and Withholding Obligations: As a
general matter, our member companies are concerned that the substantial
additional computer systems and administrative costs imposed on them as
payors are not adequately considered when there are changes in
withholding and information reporting obligations. In a real sense,
these additional costs are a ``tax'' on payors; ultimately, this tax is
taken into account by companies in determining the amounts that they
can pay to policyholders. In this regard, we urge that Congress, the
Department of the Treasury and the Internal Revenue Service coordinate
with the payor community and seriously consider the administrative
costs imposed on payors prior to revising or adding to our reporting
and withholding responsibilities.
IRS Communication with Taxpayers: Our members report that certain
communications, including penalty notices, from the Service lack
adequate explanation as to the nature of the issue raised by the
Service and the actions that may be taken by the Taxpayer. Taxpayers
have indicated that when they contact the Service for additional
information, the contact person noted on the communication often has no
further information than that provided in the original communication
and is unable to assist the Taxpayer in resolving the issues raised by
the communication. For example, certain penalty notices for incorrect
information returns have been issued without identifying the reportedly
erroneous return; when the Taxpayer contacts the Service for more
information, the Service has been unable to identify the information
return to which the penalty relates. In the end, the Taxpayer cannot
respond to the proposed penalty notice. There have also been instances
in which a Taxpayer believes that an issue has been resolved based on a
telephone conversation with a Service representative, only to find
later that not only does the issue remain unresolved, but that the
Service records do not reflect the conversation with the Taxpayer.
We suggest that the Service provide background documentation in all
communications to a Taxpayer in order to explain and support the issue
raised. In addition, we suggest that the Service provide the contact
name of the person who initiated the communication and who is familiar
with the issues raised therein. In addition, Taxpayers who contact the
Service with respect to a communication should be able to affirmatively
rely on the representations made by the Service representative during
this contact. As to situations in which the Taxpayer has contacted the
Service concerning an undocumented communication, the Service should
not assess penalties or interest during the time that the Taxpayer is
working to obtain information necessary to resolve the issue.
Changes of Address: Several of our member companies have
experienced situations in which the Service has changed the Taxpayer's
name or address when the Taxpayer has not requested that such a change
be made. For example, a corporation provides its address on Form 1120;
subsequently, a communication is sent to the Service concerning the
Taxpayer, either from a division of the Taxpayer at a different
address, or from an outside representative. Taxpayers have found that
the Service has changed the address of the Taxpayer in its records to
that of the correspondent, with no instruction to do so. Once the
address is changed, there have been cases in which the Service has sent
future correspondence on unrelated matters to the new, incorrect,
addresses. This incorrect mailing often delays Taxpayers' responses to
Service correspondence. In other situations, Taxpayers have filed
consolidated returns in the name of the corporate parent with the
proper taxpayer identification number; subsequently, a communication is
made to the Service concerning the return which notes the name of a
subsidiary of the parent, with the parent's taxpayer identification
number for reference. Taxpayers in this situation have found that the
Service has changed the name of the corporate parent in its records to
that of the subsidiary, again, without any instruction to do so.
In order to alleviate these inadvertent changes of name and
address, we suggest that the Service be permitted to change its records
of a Corporate Taxpayer's name or address only in one of three
situations: (1) filing of a Form 1120 with a new name or address, (2)
specific request on a Form 8822 or similar letter from the Corporate
Taxpayer, or (3) the Service otherwise has actual knowledge of a change
in name or address of the Corporate Taxpayer and advises the Taxpayer
that the Services records are being changed.
Uniform Taxpayer Contacts: Our members report that, in some cases,
the Service sends communications to various departments within the same
corporation. Taxpayers have difficulty in timely responding to these
communications when they are mailed to different locations or
departments. In addition, the Service may not be aware in each
situation as to the specific department within a corporation where any
given correspondence should be sent and may select an incorrect
department, thus delaying the Taxpayer's response.
As a means to centralize communications between the Service and
Taxpayers, we suggest that Taxpayers be offered the ability to
designate a corresponding officer within the company to receive either
all of the Service's communications to the Taxpayer or all of a certain
type of communications (such as all employment tax matters). Once the
Taxpayer had made this election to designate a corresponding officer,
the Service would be required to send all communications to this
corresponding officer. There may be situations in which certain
communications were sent to counsel for the Taxpayer pursuant to a
power of attorney; once a designation is made, a copy of the original
communication should also be sent to this corresponding officer. This
designation could be made annually on the Form 1120 or Form 851,
Affiliations Schedule. If a designation was made, the Service could be
assured that its communications would be forwarded to the proper party.
Service Transfers of Tax Payments: Our member companies have
indicated that the Service has, without their consent and often without
notice, transferred funds between amounts paid to satisfy corporate
income tax (Form 1120) obligations and those deposited with a Form 941,
Form 945, or Form 1042 to satisfy income and employment tax
obligations. That is, a Taxpayer who has made a Form 941 deposit may
find that the Service has transferred the funds to the Taxpayer's 1120
account, with the result that there are insufficient funds in the Form
941 account. Insufficient funds in a Form 941 account can result in a
penalty for failure to make adequate deposits.
We suggest that the Service be prohibited from transferring funds
between different Taxpayer accounts absent specific consent by the
Taxpayer. This prohibition will avoid the assessment of improper
penalties for failure to make adequate deposits when in fact the
deposits were timely made, but the funds were transferred by the
Service to a different account. In the event that a prohibition is not
feasible, we would suggest that, at a minimum, the Service be required
to provide advance notice when funds are to be transferred among
accounts. If amounts are transferred without consent or advance notice,
the Service should be prohibited from assessing any penalties or
interest which may arise due to a deficiency in any account from which
funds were transferred.
Global Interest Netting: We note that since 1986, penalty
provisions have been strengthened substantially to discourage
inappropriate behavior. Because of the broad reach of the current
penalty provisions, the time is ripe to equalize the overpayment-
underpayment rates of interest to eliminate ``hot'' interest. The
statutory interest rates should favor neither the Taxpayers nor the
Government. While we understand that this problem was addressed as part
of the IRS Restructuring and Reform Act of 1998 and the enactment of
global interest netting provisions, these provisions are complex and do
not completely resolve the problems caused by the interest rate
differentials. We suggest that consideration be given to equalization
of the interest rates. Absent such as equalization, our member
companies have indicated that guidance is needed on the application of
the global interest netting provisions, especially with respect to
their applicability to pre-1999 tax years.
Disclosure and Penalties: Currently, Taxpayers are encouraged to
disclose on their tax return items or positions that are not otherwise
adequately disclosed on a tax return. Under section 6662(d)(2)(B) of
the Code, if this disclosure is made, the Taxpayer may avoid the
imposition of certain accuracy-related penalties. Disclosure does not
reduce penalties, however, for items which are defined as ``tax
shelters.'' A tax shelter is broadly defined as ``(I) a partnership or
other entity, (II) any investment plan or arrangement, or (III) any
other plan or arrangement, if a significant purpose of such
partnership, entity, plan or arrangement is the avoidance or evasion of
Federal income tax.''
It should be clarified that this broad definition of tax shelter
does not include tax planning which has as its result the reduction of
Federal income tax. While Taxpayers may not evade tax, they are
certainly able to arrange their affairs with the result that their tax
burden is lower. Guidance is needed as to the distinction between
whether a position is a result of tax planning or whether it is a
result of a tax shelter transaction. In addition, for taxpayers who
separately disclose positions under section 6662(d)(2)(B), there should
be a presumption that the position taken is not taken to substantially
understate taxes and should not be subject to penalties. This
presumption will encourage Taxpayers to disclose their tax planning and
will facilitate the Service's auditing of these returns.
Penalty Modification: Our members have reported varying experiences
with respect to the ability of Service examining agents to adjust
certain penalties during the examination process. In some districts,
examining agents have indicated that they can modify penalties; in
others, examining agents report that they are unable to do so. The
ability to modify a penalty should be available at all levels of the
administrative process. There are situations where an assessment could
be accepted by a Taxpayer were penalties modified at the examination
level. Often, when the penalties are not modified, the Taxpayer
requests that the case be transferred to the Appeals Division of the
Service. At this higher level, the penalties may be and often are
modified, with the result of acceptance by the Taxpayer of an
adjustment to the return. Were the ability to modify penalties
available at the examination level, certain cases would not need to be
referred to Appeals process. Thus, disputes could be resolved with use
of fewer resources both by the Service and by the Taxpayers.
Estimated Tax Penalties: Taxpayers are subject to penalties for
failure to pay the proper amount of estimated taxes. Under the current
penalty structure, there is no exception to this penalty for
underpayments which are due to erroneous estimates of investment return
when that error is caused by market volatility. For example, a
Taxpayer's capital gains will fluctuate each year depending on interest
rates, asset performance and other market conditions. While Taxpayers
make their best estimates of what their ultimate investment income will
be and appropriately pay estimated taxes on this good faith estimate,
in some years, this estimate will be different from the actual amount
of income. As result of this discrepancy between the amount which the
Taxpayer believed should be paid as estimated tax and the ultimate tax
liability, Taxpayers may become subject to the penalty for underpayment
of estimate taxes. We suggest that the penalty rules provide for an
exception to the application of the underpayment penalty when the
underpayment of estimated tax is due to unanticipated income as a
result of market fluctuations.
In summary, the member companies of the American Council of Life
Insurance support the review of the administration and implementation
of the penalty and interest provisions of the Internal Revenue Code.
Our member companies, both as corporate Taxpayers as well as
information reporters, would like to work with you toward efforts to
simplify penalty and interest administration and to reduce Taxpayer
burdens. Thank you for your attention to these issues.
Sincerely,
Jeanne E. Hoenicke
Laurie D. Lewis
American Council of Life Insurance
May 14, 1999
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044
Attn: CC:DOM:CORP:R (IT&A, Branch 1) Room 5228
Re: Comments Concerning Rev. Proc. 99-19--Interest Netting
Dear Sir or Madam:
I am enclosing comments on the above noted Revenue Procedure on
behalf of the member companies of the American Council of Life
Insurance in response to your request for comments in the Revenue
Procedure. The 493 ACLI member companies have over 77 percent of the
life insurance in force in the United States in legal reserve life and
health insurance companies and assets representing 82.3 percent of all
United States life and health insurance companies.
We appreciate the flexibility you have shown in soliciting comments
on these difficult issues and providing initial guidance in a timely
manner to enable meaningful dialogue. We understand that more
comprehensive guidance will be forthcoming regarding application of
these rules to interest accruing for periods beginning after July 22,
1998, and look forward to working with you on these as well. If there
are any questions regarding any matter raised herein, or if further
information is requested, please contact me. Thank you again for your
assistance.
Sincerely,
Mark A. Canter
encl.
Comments Concerning Rev. Proc. 99-19
Executive Summary
On March 16, 1999, the Internal Revenue Service published
Rev. Proc. 99-19 providing guidance regarding application of
section 6621(d) of the Internal Revenue Code. Section 6621(d)
was enacted by section 3301 of the Internal Revenue
Restructuring and Reform Act of 1998 (RRA), Pub. L. No. 105-
206, 112 Stat. 741, and was amended by section 4002(d) of the
Tax and Trade Relief Extension Act of 1998, Pub. L. No. 105-
277, 112 Stat. 2681. It provides for a net interest rate of
zero for overlapping tax underpayments and tax overpayments.
Rev. Proc. 99-19 focuses on the procedural steps that must be
taken for taxpayers to utilize the net interest rate of zero
for periods beginning before July 22, 1998 (i.e., interest
accruing before October 1, 1998). The following comments,
prepared in response to the I.R.S. request for comments in Rev.
Proc. 99-19, point out the following five areas of concern:
1. The procedure should allow for generic descriptions of
overlapping tax underpayments and tax overpayments on Form 843,
as in many instances not all of the information specified will
be available by December 31, 1999.
2. The procedure should make clear that any tax overpayment
that is not completely utilized for purposes of applying the
zero net interest rate for a given tax year should be available
in the event of a subsequently uncovered tax underpayment for
the same year.
3. The procedure should allow for offsetting of liabilities
for periods of overlapping refunds and deficiencies, i.e., the
``credit/offset approach.''
4. The procedure should clarify the application of the
interest netting rules for companies that are members of
affiliated groups.
5. The procedure for furnishing a written statement in
connection with returns of the taxpayer that are under
consideration by any office of the Service provided in section
4.06 of the Revenue Ruling should be expanded.
1. Generic descriptions should be allowed for completing Form
843.
Many of our member companies are Coordinated Examination
Program (``CEP'') taxpayers whose returns are subject to
continuous review by the Service. At any given point in time a
number of tax years may be open, and extensions of the statute
of limitations period are routinely executed. In addition to
federal income tax returns, our members also file excise tax
returns, payroll tax returns and, in connection with the
products they sell, information and withholding reports, all of
which may be subject to examination and adjustment. It is
probable that there may be instances where examinations that
may cause adjustments to pre-October 1, 1998 periods will not
have commenced as of December 31, 1999. Legislative history of
the RRA makes clear that ``the Secretary will implement the
most comprehensive netting procedures that are consistent with
sound administrative practice . . . ``. S. Rep. No. 105-174
(1998). The RRA itself requires that by December 31, 1999,
taxpayers make a request to the Secretary to apply the zero net
interest provisions of Code section 6621(d) to the pre-October
1, 1998 periods. Regarding identification of covered payments,
the RRA requires that the taxpayer: ``reasonably identifies and
establishes periods of such tax overpayments and under-payments
for which the zero rate applies . . . `` RRA section
3301(c)(2). Given that (i) payments that are intended to
receive the benefit of this provision may not be evident or
have manifested to the taxpayer as to either the amount or even
the nature of the tax, i.e., income, excise, payroll, etc., and
(ii) the statute clearly requires some filing to be made by
December 31, 1999, ``reasonable'' identification of the
payments and periods involved for as yet unknown amounts can be
accomplished only through a generic description such as
``payments related to all open tax payment periods as of
December 31, 1999, for interest payable for periods prior to
October 1, 1998.''
2. The procedure should make clear that overpayments not
completely utilized should be available in the event of a
subsequently uncovered Tax Underpayment for the same year.
The Revenue Procedure notes that the Conference Report
accompanying the RRA indicates that in calculating the net
interest rate of zero without regard to whether the overpayment
or underpayment is currently outstanding, each overpayment or
underpayment should be considered only once in determining
whether equivalent amounts of overpayment and underpayment
overlap for a particular period. Given the wide variety of tax
payments that can be attributable to a given period, and
differing examination schedules that may be applicable to the
same period of time, but for different returns, it is possible
that a number of separate underpayments for a particular
reporting period may be assessed at different times. If the
amount of an underpayment that is applied against an
overpayment for the same period is less than the overpayment,
the excess should be available for any subsequent underpayment
assessment for the same period. For example, if there is an
overpayment of income tax of $200,000 that accrued interest for
calendar year 1996, and underpayments of income tax or any
other type of tax of $100,000 were subsequently assessed and
accrued interest in both 1997 and 1998, the 1996 overpayment
should first be offset against the $100,000 underpayment in
1997, with the remaining $100,000 being available to offset the
1998 underpayment (assuming applicable statutes of limitation
are still open). Guidance should be provided clarifying this
treatment.
3. Rather than calculating deficiency interest and refund
interest for overlapping periods at the same rate, the credit/
offset approach should be used.
Implementing the provisions of Code section 6621(d) by
calculating deficiency interest on an underpayment and then
calculating refund interest at the same rate for matching
overpayments for the same time periods would create needless
extra work for both the IRS and the taxpayer. In addition,
there may be situations in which interest paid to the taxpayer
will not be completely offset by interest deductible by the
taxpayer due to circumstances such as sourcing rules, i.e.,
interest received on a refund will be U.S. source income, while
interest paid on a deficiency may have to be allocated to
foreign sources subject to limitation on deductibility. The
alternative method for applying a net interest rate of zero is
the ``credit/offset approach.'' Where interest is both payable
from and allowable to a taxpayer for the same period, the IRS
should offset the liabilities rather than processing them
separately and netting the interest to zero. Thus, for the same
period, no overpayment or underpayment would be outstanding,
rather than creating both an overpayment and an underpayment
running at the same interest rate.
4. Additional guidance should be provided for companies that
are members of affiliated groups.
Section 6621(d) provides for netting of interest for
overpayments and underpayments of all categories of federal
taxes, not just income taxes. In many instances, tax returns
for employment or excise taxes will be filed under the Taxpayer
Identification Number (TIN) of a subsidiary company, rather
than under the TIN of the parent company of a group of
affiliated companies. The decision by Congress to expand the
netting regime to taxes other than income taxes implicitly
recognizes that netting should be available even where the
returns involved may not all be filed under the same TIN.
Guidance should be provided and systems created to implement
these expanded offset possibilities.
In addition, there will be situations in which the
affiliated group filing an interest netting request under the
Revenue Procedure will be different from that in existence at
the time the offsetting overpayment and underpayment interest
accrued. In connection with corporate reorganizations and
acquisitions, there may be circumstances in which affiliated
corporations join, leave or move in the group's corporate
hierarchy. The Revenue Procedure should make clear that
interest netting should be applied in a manner that allows
underpayments and overpayments made by any member of the
affiliated group to be available to offset overpayments or
underpayments made by any other member company of the
affiliated group for the same time period.
5. Clarify special procedure under section 4.06 of the revenue
procedure.
Section 4.06 provides for special procedures (including no
Form 843 submission and abbreviated information filing
requirements) where global netting relief is requested by ``a
taxpayer in connection with a return (or returns) of the
taxpayer under consideration by any office of the Service.''
Our members believe section 4.06 should be amended to clarify
that the term ``under consideration by any office of the
Service'' covers post-IRS Appellate Division consideration,
including years in litigation regardless of the judicial forum.
The justification for allowing abbreviated procedures pursuant
to section 4.06 for years under IRS review applies equally to
years in litigation.
Furthermore, taxpayers eligible to file under section 4.06
for at least one tax year (or set of years) should be permitted
to file one statement under section 4.06 covering all taxable
years (including years not yet under audit) for which filings
must be made by December 31, 1999 under Rev. Proc. 99-19. This
approach would greatly reduce the incidence of multiple
submissions by a single taxpayer, thereby lessening the burden
on both taxpayers and the Service and making the process much
less confusing to all parties. A single submission under
section 4.06 covering years not yet under audit is appropriate
because taxpayers will have even less specific information
about netting opportunities for years not yet under audit than
they have for years now covered by section 4.06.
Moreover, section 4.06 should be modified to clarify that
identification of refunds and payments required by section
4.06(3) need not be specific; rather, the provision would be
satisfied through a generic description such as ``payments
related to all open tax payment periods as of December 31,
1999, and refunds on which interest is payable for periods
prior to October 1, 1998.'' Examples illustrating this concept
would be helpful.
Finally, section 4.06 should be modified to clearly note
the place where the section 4.06 submission must be filed.
Similar information is now provided under section 4.02 for Form
843 filings. This will assure that coordination occurs with
respect to all possible examinations and returns for which a
section 4.06 filing must be made by December 31, 1999. Our
members believe that all section 4.06 statements should be
filed with the District Office where the taxpayer most recently
filed its federal income tax return and that such filing will
be deemed adequate notice to the National Office and any other
District Office of the Service that may be examining any
returns of the taxpayer.
Summary
Based upon the above, we urge the Internal Revenue Service
to modify the guidance provided by Rev. Proc. 99-19 so that (i)
generic descriptions of the payments and periods covered are
acceptable for the Form 843 filing due by December 31, 1999;
(ii) it is clear that the excess of overpayments not fully
utilized are available for purposes of calculating the net
interest rate of zero for subsequent underpayment amounts
related to an overlapping period; (iii) zero net interest is
implemented by the credit/offset approach; (iv) issues
involving companies that are members of affiliated groups are
addressed; and (v) greater details are given for the filing
procedures provided in section 4.06 of the Revenue Procedure
regarding written statements of taxpayers subject to
examination by the Service.
STATEMENT OF JAMES R. BURKLE, VICE PRESIDENT, CORPORATE TAX, CERIDIAN
CORPORATION, MINNEAPOLIS, MN
Mr. Chairman, thank you for the opportunity to provide
comments on the penalty provisions of the Internal Revenue Code
(IRC) and on the recommendations for improvement made by the
Joint Committee on Taxation (JCT) and the US Treasury.
Ceridian Corporation, headquartered in Minneapolis,
Minnesota, is a leading information services company that
provides outsourced payroll processing, tax filing services,
and integrated human resource management systems to
predominantly large and mid-sized businesses. Ceridian's Tax
Service is a high volume automated bulk filer serving
approximately 60,000 employers. Ceridian collects and deposits
$98 billion in employment taxes annually, files in excess of
800,000 quarterly tax returns with the IRS and 6,000 other tax
agencies, and processes more than 2.6 billion electronic
payroll tax transactions on behalf of clients. Ceridian has
over 20 years of tax filing experience.
Ceridian's payroll and tax filing service, including the
depositing of employment taxes, is comprised of many processes
and procedures, all of which are designed to insure the
accurate and timely filing and depositing of all federal and
state tax liabilities, and are continually updated in order to
fulfill the ever-changing needs of our client base and meet
reporting requirements. The timely depositing of tax
liabilities to the Internal Revenue Service (IRS) on behalf of
clients ranks as Ceridian's highest priority.
Ceridian was pleased to submit a statement to the JCT and
US Treasury when they invited comments from interested parties
for their studies on tax penalty administration. As stated in
those comments, we believe that the current administration of
the tax penalty system is inadequate and unfairly treats
taxpayers that are and want to be compliant with the system.
The IRS penalty handbook in Part XX of the Internal Revenue
Manual states that ``penalties are used to enhance voluntary
compliance.'' (IRM (20)121). But the system has failed to
uphold this basic tenet by administering penalties arbitrarily,
and by putting the burden on the taxpayer to prove good faith
compliance. The penalty system for employers needs improvement
in the following three areas:
1. Current administration of the penalty system fails to
distinguish between employers that want to comply and those
that are deliberately non-compliant.
2. The penalty provisions of the IRC are not uniformly
applied. While the IRS national office may advocate one policy
and set of goals, the IRS field offices generally do not follow
that stated policy, resulting in delays and inconsistent
policies based on local rulings.
3. The size of the penalty is often not proportionate to
the offense.
1. A fair and effective penalty system should take into
account tax deposit history
Mr. Chairman, in your opening statement at the January 27,
2000, hearing you said, ``penalties and interest can be quite
severe, even debilitatinga. . .we must minimize the number of
taxpayers who are caught in the penalty system, not because
they were cheating, but because they were mistaken.'' We agree.
The Code's penalty and interest provisions are intended to
deter noncompliance and prevent tax avoidance and fraud. But
today the provisions are applied without regard to the taxpayer
or type of error.
Taxpayers that fail to make deposits out of willful
neglect, have a truly egregious compliance history and
demonstrate a pattern of noncompliance, should be penalized
severely. But the system fails to distinguish between taxpayers
that won't comply, and taxpayers that want to comply or have
economic difficulty doing so.
Taxpayers that make every effort to comply can be severely
penalized for inadvertent, human errors or tax system problems.
For example, as a result of human error, Ceridian transmitted a
client's payroll using an incorrect client ID number, resulting
in tax deposits being misapplied. Ceridian corrected the error
and immediately implemented procedures to ensure that a similar
error does not recur. But Ceridian did not have visibility of
the error until after the deposit was made and penalty and
interest already were assessed. Despite a history of compliance
and having reasonable cause for the late deposit, the taxpayer
and Ceridian had to go through extraordinary efforts to prove
good faith compliance. Penalties are automatically assessed
regardless of the type of error, putting the burden on the
taxpayer to prove good faith compliance.
A particular concern of bulk filers and large employers is
that penalties are unnecessarily punitive on taxpayers that
process a large number of transactions annually and incur one
or two errors as opposed to taxpayers with very few
transactions that incur the same number of errors. The result
is that taxpayers with high compliance rates are penalized as
severely as those with high error rates. An important
indication of a taxpayer's willingness or unwillingness to
comply--the taxpayer's record of compliance--is not taken into
consideration by the IRS when assessing penalties.
The seemingly unfair treatment of taxpayers that have a
history of demonstrated compliant behavior directly undermines
what is the stated goal of a voluntary tax system, encouraging
taxpayer compliance.
Recommendation: In a voluntary tax system, the taxpayer's prior
actions and conduct should weigh heavily in determining the
assessment of any penalty and interest. Otherwise, human or
technical error is penalized to the same degree as willful
noncompliance. The type of reporting should also be taken into
account. A bulk filer with a client base in the thousands has
voluntary compliance as its implied, if not stated goal. An
assessment of a Failure to Deposit Penalty for such an entity
because of human error, for example, does little to encourage
voluntary compliance and much to prove the system's
arbitrariness. An analysis of past behavior is the best, and at
times, the only way to gauge the ``intent'' of the taxpayer and
identify the members of the non-compliant group. Targeting
taxpayers that are willfully non-compliant would improve
administrative efficiencies and establish ``the fairness of the
tax system by justly penalizing the non-compliant taxpayer,''
as stated in the IRM XX-Penalty Handbook.
2. Penalty provisions should be applied uniformly to encourage
greater compliance
The Joint Committee on Taxation acknowledged in their study
that penalty assessment and abatement is not uniform across the
IRS. The IRS national office's policies for encouraging
voluntary compliance by the taxpayer often are not the policies
of the IRS field offices. Uniform application of penalty and
interest provisions across all levels of the IRS (including IRS
service centers and district offices) as is intended in the
Code and under the IRM XX-Penalty Handbook, would produce more
efficient and effective administration of the tax system. It
also would improve the perception of fairness in the tax system
and encourage greater compliance. The reality is that the
penalty provisions are not being uniformly implemented or
administered.
For example, past experiences of large employers and bulk
filers have been that each IRS service center would interpret
the facts in similar penalty abatement requests differently,
resulting in abatement in one case and upholding the assessment
in another. The unintended result is service center
``shopping'' by large employers and bulk filers. Also, as a
bulk filer, it has not been unusual for penalty and interest
abatements issued by the service center with jurisdiction over
the client taxpayer to be rescinded by another service center.
The tax system is undermined when the national office's stated
policies and goals are not followed by IRS offices in the field
that have direct contact with taxpayers. If the penalty and
interest provisions were applied uniformly, the administration
of the tax system would be more effective and fair as intended
by the IRS.
Recommendation: The issue of uniformity is important to the
integrity of the tax system. The JCT recommends that the IRS
improve its supervisory review of penalty imposition and
abatement and establish oversight committees for specific
penalties--similar to the Transfer Pricing Penalty Oversight
Committee. Ceridian agrees that supervisory review emphasizing
consistent policies between the national and field offices
could achieve more effective administration of penalties and
abatement.
Ceridian also recommends establishing a single point of
contact within the IRS to oversee penalty issues for the large
number of employers represented by bulk filers. The JCT and US
Treasury recognize that the IRS' case-by-case procedure for
handling penalties is not efficient for bulk filers and their
clients, or the IRS, when one software change can cause
penalties to be imposed on hundreds or thousands of taxpayers
across every state. The US Treasury recommends working with
bulk filers to develop a ``proxy'' penalty that would alleviate
the problem of dealing with many taxpayers individually on the
same inadvertent error. The JCT recommends that the IRS work
with bulk filers ``to expedite resolution of problems where a
single error or mishap may impact multiple taxpayers.''
Ceridian suggests that resolution of these problems can be
expedited by designating a national point of contact for bulk
filers.
"One point of contact'' already is being implemented for
taxpayers under IRS' reorganization of its 33 district offices
and 10 service centers into 4 operating divisions. Each
division will have responsibility for specific taxpayer groups
from pre-filing to post-filing. Many bulk filers, however, will
have clients in more than one division with no identified point
of contact for specific issues pertaining to these taxpayers. A
single, national point of contact would simplify the tax
payment and filing process and reduce the compliance burden on
both the taxpayer and the IRS.
3. The size of the penalty should be proportionate to the
offense
The perceived fairness of the tax system is diminished by
the amount of penalty and interest that can be assessed because
of one inadvertent, human mistake or technical error. The tax
system not only puts the burden squarely on the taxpayer to
prove good faith compliance, but it could cost the taxpayer
excessive penalties.
A good example is the Failure to Deposit penalty for
failing to use the correct deposit method, especially with
regard to the Electronic Federal Tax Payment System (EFTPS).
Employers are automatically penalized 10 percent per tax
deposit if payments are not made through EFTPS--even if tax
liabilities are paid on time and the taxpayer has an otherwise
unblemished deposit record. The amount of the penalty often is
many times greater than the actual loss of revenue to the IRS
and is disproportionate to the offense. The IRS and Congress
have taken action to waive the 10 percent penalty for some
employers, but the waiver does not address the unnecessary
severity of the penalty.
It also does not address the issue that a taxpayer should
never be penalized in instances where their payments are on
deposit with the IRS or its depository on or before the tax due
date. The fact that payment has been deposited should be taken
into account before assessing penalties. The imposition of a
penalty in such an instance is wholly inappropriate and not
proportionate to the error.
Recommendation: Ceridian agrees with the US Treasury's
recommendation to reduce the 10 percent deposit penalty to 2
percent because the severity of this penalty often exceeds the
taxpayer error. However, reducing the penalty amount does not
address the issue of fairness. An honest mistake by a taxpayer
with a history of compliance would still be penalized to the
same degree as a willfully non-compliant taxpayer. A taxpayer's
compliance record should be taken into account in administering
penalties. Ceridian also agrees with the JCT's recommendation
to revise deposit regulations so that taxpayers whose deposit
schedules change are notified by the IRS of the change in
status before it takes effect. Employers may not realize that
their deposit schedule has changed until they receive a penalty
notice months later and start incurring penalties.
Conclusion
The JCT and US Treasury studies were important undertakings that
should prompt needed change. The vast majority of taxpayers want to
comply and should be assisted and encouraged to do so. As Commissioner
Rossotti has stated numerous times, the IRS is working to encourage
compliance by providing clearer communications, marketing the benefits
of electronic payment and offering improved taxpayer service and
education.
This is a tremendous step in the right direction. But the current
administration of tax penalties does little to instill confidence in
the tax system and fails to effectively target and reduce severe
noncompliance. The penalty system has become arbitrary where taxpayers
in different parts of the country may receive different treatment in
similar situations. The arbitrariness extends to the actual amount of
the penalty where excessive penalties can be automatically assessed
without regard to the reason for the error or the taxpayer's deposit
history. Resources should be focused more effectively. Uniform goals
across all levels of the IRS and targeting efforts toward deterring
noncompliance among willfully non-compliant taxpayers will produce a
more efficient and equitable system.
Thank you, again, for the opportunity to comment on the penalty
provisions of the Internal Revenue Code and the studies completed by
the JCT and the US Treasury.
STATEMENT OF COALITION FOR THE FAIR TAXATION OF BUSINESS TRANSACTIONS
\1\
The Coalition for the Fair Taxation of Business
Transactions (the ``Coalition'') is composed of U.S. companies
representing a broad cross-section of industries. The Coalition
is opposed to the broad-based ``corporate tax shelter''
provisions in the Administration's budget because of their
detrimental impact on legitimate business transactions. The
Coalition is particularly concerned with the broad delegation
of authority provided to IRS agents under these proposals,
which would reverse some of the reforms of the IRS
Restructuring Act, passed just last year.
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\1\ This testimony was prepared by Arthur Andersen on behalf of the
Coalition for Fair Taxation of Business Transactions.
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Pursuant to section 3801 of the Internal Revenue Service
Restructuring and Reform Act of 1998, the Department of
Treasury, on October 25, 1999, issued a report \2\ on the
penalty and interest provisions of the Code. The Joint
Committee on Taxation (``JCT''), on July 22, 1999, released a
study \3\ of present-law penalty and interest provisions. Both
studies include recommendations regarding penalty and interest
provisions in the Code. Many of the recommendations in the
studies are directed at rules for individuals, the Coalition
will focus its comments on those recommendations we believe
will have an impact on corporate taxpayers.
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\2\ Department of the Treasury, Report to Congress on Penalty and
Interest Provisions of the Internal Revenue Code, October 1999
3 Joint Committee on Taxation, Study of Present-Law Penalty and
Interest Provisions as Required by Section 3801 of the Internal Revenue
Service Restructuring and Reform Act of 1998 (Including Provisions
Relating to Corporate Tax Shelters) (JCS-3-99), July 22, 1999.
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I. Accuracy-related Penalty
The American scheme of income taxation is based on the
fundamental premise of ``self-assessment'' by taxpayers of
their tax liability.\4\ It is clear that the existing tax
system could not function properly if the majority of taxpayers
did not report the correct amount of tax without the
government's prior determination of the tax liability.
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\4\Commissioner v. Lane Wells Co., 321 U.S. 219 (1944).
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To encourage taxpayers to comply with this self-assessment
system of taxation, the Internal Revenue Code (``Code'')
contains provisions to punish taxpayers and return preparers
that fail to comply with minimum tax return reporting
standards.\5\ For taxpayers, return positions must meet the
``reasonable basis'' standard to avoid penalties. For return
preparers, the minimum standards to avoid penalties for
undisclosed return positions is the ``realistic possibility of
success on the merits'' standard and the ``not frivolous''
standard for disclosed positions.
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\5\ See I.R.C. Sec. Sec. 6662 and 6694.
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JCT and Treasury each recommend raising the minimum
standards that must be met in order for taxpayers and return
preparers to avoid the impositions of penalties. We believe
these recommendations would raise the minimum standards to
unjustifiable levels. It is unrealistic to expect taxpayers to
file ``perfect'' returns, on which every item is unquestionably
correct. Federal tax law is complex, ambiguous and constantly
evolving. The determination of a taxpayer's correct amount of
tax is often not clear-cut. The recommendations to raise the
minimum accuracy standards to avoid the accuracy-related
penalty and return preparer penalties are too harsh and are not
justified.
A. Joint Committee and Treasury Proposals
JCT recommends that for both taxpayers and return preparers
the minimum standard for each undisclosed position on a tax
return is that the taxpayer or preparer must reasonably believe
that the tax treatment is ``more likely than not'' the correct
tax treatment. This standard requires a greater than 50 percent
likelihood that all undisclosed positions would be sustained if
challenged. For adequately disclosed positions, JCT recommends
the minimum standard be substantial authority. JCT also
recommends repeal of the reasonable cause exception for the
substantial understatement penalty.
Treasury recommends that for both taxpayers and return
preparers the minimum accuracy standard for undisclosed
positions be the substantial authority standard. For positions
disclosed in a tax return, Treasury recommends that the minimum
accuracy standard be the realistic possibility of success on
the merit standards.
B. Analysis
As justification for raising the minimum reporting standard
for undisclosed positions on a tax return to a ``more likely
than not standard,'' JCT argues that a tax return is signed
under penalties of perjury, which implies a high standard of
diligence in determining the positions taken on a return. JCT
believes this requires a minimum reporting standard that an
undisclosed return position satisfy a ``more likely than not''
reporting standard.
The accuracy-related penalties are designed to reinforce a
taxpayer's self-assessment obligation. The current accuracy-
related penalty and reporting standards, which require
substantial authority for an undisclosed return position and
reasonable basis for a disclosed return position, already
provide a powerful incentive for corporate taxpayers to closely
review and analyze positions taken on their tax returns.
A basic premise of our tax system is that a taxpayer is
entitled to contest a dispute with the Internal Revenue Service
in the United States Tax Court prior to payment of the tax
liability in dispute. This ability is critical in certain
situations where IRS agents aggressively assert a position that
cannot be justified based on a careful analysis of the tax law
in the area.\6\ Taxpayers are not required to possess certainty
of the correctness of a position in order to advance that
position on the return. Given the complexity of the tax system,
it is unreasonable to expect every position on every return to
be unquestionably correct. A standard that requires a taxpayer
to possess a ``more likely than not'' certainty of the position
advanced on the return effectively prevents a taxpayer from
advancing a position and litigating it in the prepayment forum
of the Tax Court because of the probable imposition of a
penalty if the taxpayer does not prevail. Accordingly, the
reporting standards recommended by JCT and Treasury would, as a
practical matter, require a taxpayer to self-assess a tax
liability according to the government's position on a tax
issue, pay the tax, and pursue relief by filing a refund suit.
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\6\ For example, since the Supreme Court decision in Indopco, Inc.
v. Commissioner, 503 U.S. 79 (1992) (requiring expenditures that give
rise to more than incidental future benefits to be capitalized rather
than expensed) IRS agents aggressively try to require taxpayers to
capitalize expenditures with taxpayers ultimately prevailing in court.
See RJR Nabisco v. Commissioner, T.C. Memo 1998-252.
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The recommendation of JCT is further flawed because the
more likely than not standard applies to both the substantial
understatement penalty and the negligence penalty. The effect
of the JCT proposal is to create one accuracy-related penalty
that requires a stricter reporting standard than the
substantial understatement, while no longer requiring the
existence of a substantial understatement of tax for the
penalty to apply. As a result of this proposed reporting
standard, any mistake, whether intentional or inadvertent,
results in the automatic imposition of an accuracy-related
penalty. Treasury's recommendation is subject to the same
criticism. By raising the minimum reporting standard, the
substantial understatement penalty subsumes the negligence
penalty and reverses the long-standing policy of requiring a
higher reporting standard for taxpayers with substantial
understatements.
For return positions disclosed by taxpayers, JCT recommends
that the minimum standard for the disclosed return position be
substantial authority. This minimum standard applies to the
negligence penalty and the substantial understatement penalty.
JCT also recommends the repeal of the reasonable cause
exception to the substantial understatement penalty. Treasury
recommends the minimum reporting standard to avoid these
penalties for disclosed positions be the realistic possibility
of success on the merits standard. Raising the minimum
reporting standard for disclosed return positions is
unjustified for three reasons. First, the recommended standards
eliminate the long-standing policy of distinguishing between
any understatement of tax and a substantial understatement of
tax. Second, the recommended standards are so high that they
are likely to have the effect of taxpayers disclosing less.
This is because if uncertain of a position, a taxpayer may be
more likely to take the chance the Internal Revenue Service
will not audit the return rather than disclose the position on
the tax return. Third, under each of the recommendations, the
substantial understatement subsumes the negligence penalty.
II. Estimated Tax Penalty
If a corporation fails to make timely estimated tax
payments, then a penalty is imposed under section 6655. The
penalty imposed under section 6655 is determined by applying
the underpayment interest rate to the amount of the
underpayment for the period of the underpayment. Although
Treasury recognizes that this sanction has attributes of
interest and of a penalty, it recommends that the current-law
sanction remain a penalty.
We believe this sanction is more appropriately treated as
an interest charge rather than a penalty. As JCT recognized in
its penalty study, the conversion of the corporate estimated
tax penalty (and individual estimated tax penalty) into
interest charges more closely conforms the title and
descriptions of these provisions to their effect. These
penalties are computed as an interest charge, therefore,
conforming their titles to the substance of their function will
improve taxpayers' perceptions of the fairness of the tax
systems. Because these sanctions are essentially a time value
of money computation, which is not punitive in nature but
rather compensatory, calling them penalties makes the offense
of underpaying estimated taxes seem greater than it is and
wrongfully denies an appropriate deduction to business
entities.
For the reasons stated above, we recommend following the
JCT recommendation to convert the existing penalty for failure
to pay estimated tax into an interest provision.
III. Interest
Under current law, there is an interest rate differential
between the interest the government pays on large corporate
overpayments of tax and what it charges on large corporate
underpayments of tax. Treasury recommends in its penalty study
to retain this interest rate differential. JCT recommends that
this interest rate differential be repealed. We agree with the
JCT recommendation for the reasons set forth in their study.
JCT recommends providing one interest rate for both
individuals and corporations applicable to both underpayments
and overpayments. Accordingly, JCT recommends eliminating the
so-called ``hot interest'' provision that applies a higher rate
of interest to certain corporate underpayments, as well as the
special rule that applies a lower interest rate to certain
corporate overpayments. This proposal also limits the need for
interest netting for corporations, a very complex burden for
both taxpayers and the Service.
As recognized by JCT, the recommended changes to the
interest rate provisions would complete the policy begun by the
IRS Reform Act of providing equivalent effective interest rates
on underpayments and overpayments. The recommended changes to
the interest rate provision would, on a prospective basis,
provide a better mechanism for achieving the equivalent
effective interest rate goal than the net zero interest rate
approach of present law. This is because the proposed changes
would, at least on a prospective basis, automatically achieve
the desired result. On the other hand, the implementation of
the net zero interest rate under present law requires taxpayers
to identify the appropriate periods to which the net zero rate
should apply and the recalculate interest for those periods.
The recommended changes would make the benefits of equivalent
effective interest rates available to all taxpayers on a
prospective basis, not only to those taxpayers capable of
preparing complex net zero rate calculations.
Statement of Mark M. Ely, Harry L. Gutman, David L. Veeder, Dallas, TX,
and R. David Miller, Tampa, FL, KPMG Interest Netting Coalition
We are writing on behalf of the KPMG Interest Netting
Coalition in support of the recommendation of the Joint
Committee on Taxation (the ``Joint Committee'') to impose a
single statutory rate of interest on corporate tax
underpayments and overpayments.\1\
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1 In JCT Interest and Penalty Study, JCS-3-99, July 22, 1999, page
3.
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Under current law, a higher rate of statutory interest is
imposed on corporate tax underpayments than on corporate tax
overpayments. Charging a higher interest rate on corporate tax
underpayments is equivalent to subjecting corporate taxpayers
to a penalty equal to the interest differential. There is no
policy basis for assessing a different figure for the time
value of money depending upon whether the debtor is the federal
government or a corporate enterprise. Imposing a single rate of
interest on overpayments and underpayments would eliminate this
unjustified differential.
Imposition of a single statutory rate of interest on
overpayments and underpayments also has the advantage of being
easier to administer than the current global interest netting
rule. The global interest netting rule often requires a
taxpayer to produce complex calculations to demonstrate periods
of overlap and the amounts of overpayments and underpayments
eligible for netting. Imposing a single rate of interest, by
contrast, would generally have the effect of accomplishing
``interest netting'' automatically.
Finally, imposing a single rate of interest has the
advantage of rendering moot several difficult interpretive
questions raised by the global interest netting rule enacted
last year as part of the IRS Restructuring and Reform Act, as
more fully explained below.
The global interest netting rule generally provides that a
taxpayer is entitled to a net interest rate of zero for
equivalent tax overpayments and underpayments during applicable
periods of overlap. Questions have been raised as to whether
the global interest netting rule applies where one taxpayer has
an underpayment and a related taxpayer has an overpayment. As
explained by the Joint Committee:
The zero net interest rate only applies where interest is
payable by and allowable to the same taxpayer. The zero net
interest rate does not apply where interest is payable by one
taxpayer and allowable to a related taxpayer. However, if the
related taxpayers joined in a consolidated return for the
underpayment and overpayment years, they are presumably treated
as a single taxpayer and may apply the zero net interest rate.
[However,] [c]ertain taxpayers are prevented by the Code
from joining in a consolidated return even though one taxpayer
is the wholly owned subsidiary of the other. . .
For example, a wholly owned foreign sales corporation (FSC)
is prohibited from joining in a consolidated return with its
parent. A United States parent will typically transfer property
that will be exported to its FSC at one price, and the FSC will
sell the property to the foreign purchaser at a higher price.
The FSC is allowed to exclude a portion (15/23) of its net
income from Federal income tax, creating an incentive for the
transfer from the parent to the FSC to take place at as low a
price as possible. If the IRS successfully challenges the
transfer price as tax law, the parent will be required to
increase its income and a correlative adjustment will be made
to the FSC decreasing its income by the same amount. This will
generally result in an underpayment by the parent and an
overpayment arising from the same adjustment. Interest payable
on the underpayment may be accrued at a rate as high as short-
term AFR plus 5 percentage points, while the interest on the
overpayment is allowable at a rate as low as short-term AFR
plus one-half percentage point.\2\
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2 JCT Interest and Penalty Study, p. 95.
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If the tax law imposed a single statutory rate of interest
on tax overpayments and tax underpayments, the difficult
interpretive questions raised where interest is owed by one
taxpayer and interest is payable to a related taxpayer would be
eliminated.
Despite our general agreement with the recommendation of
the Joint Committee to impose a single statutory rate of
interest, the proposal does not resolve a situation in which a
taxpayer has an outstanding overpayment and underpayment during
an overlapping period and interest is either not allowable on
the underpayment or not payable on the overpayment.
For instance, the Internal Revenue Code provides that if
the IRS processes a request for a refund within 45 days no
interest may be paid on the overpayment. Interest only runs if
the overpayment is not refunded within the 45-day grace period.
Likewise, interest is not imposed on an ``addition to tax'' if
it is paid within 21 business days of the date the IRS issues a
``notice and demand'' -or request for payment (10 business days
if the amount of the penalty is at least $100,000). Despite
these legislative grace periods, in each case there is still an
outstanding tax overpayment or underpayment, and under ``use of
money'' principles, interest should be accruing. We would
recommend that the global interest netting rule be expanded to
apply during these grace periods when there are overlapping
overpayments and underpayments, regardless of the fact that,
under the Internal Revenue Code, interest is not paid.
For example, if the taxpayer claimed a refund and the IRS
made the refund on the 45th day (and, therefore, includes no
interest), by operation of the global interest netting rule, no
interest should accrue during those 45 days on an underpayment
of the taxpayer up to the amount of the refund. This approach
would take account of the mutuality of indebtedness between the
taxpayer and the government during the period of overlapping
overpayments and underpayments.
Members of the KPMG Interest Netting Coalition include:
Allstate Insurance Company
California Federal Bank
Comdisco
Costco Wholesale Corporation
DaimlerChrysler Corporation
Federated Department Stores
Gillette Company
Household International (Beneficial)
HSBC Bank USA
Norfolk Southern Corporation
Royal & SunAlliance
Sears, Roebuck and Company
Wells Fargo & Company
Willamette Industries, Inc.
STATEMENT OF PROFIT SHARING/401(K) COUNCIL OF AMERICA
This statement for the record is submitted on behalf of the
Profit Sharing/401(k) Council of America. The Council would
like to take this opportunity to provide the following comments
on the Internal Revenue Code interest and penalty provisions
with particular focus on areas that were not touched on by the
Treasury and the Joint Committee on Taxation reports except for
three ERISA related penalties that apply to failure to file in
a timely manner certain required reports.
The Profit Sharing/401(k) Council of America for over half
a century has represented employers who sponsor defined
contribution plans including profit sharing and 401(k) plans.
There are 2,500 members whose plans cover approximately 4
million participant-employees. The Council played a major role
in urging the enactment of 401(k) plans which are now the
predominant form of retirement vehicles in the nation. The
Council is the foremost advocate for employers and their
employees who participate in 401(k) plans.
Consolidation of failure to file and/or late filing fees
Title I (DOL), Title II (IRC), and Title IV (PBGC) of ERISA
each contain provisions for imposing penalties for failure to
file or late filing of Form 5500 and related attachments. The
penalties imposed by each agency are different. IRC rules
permit abatement of penalties, but not reduction, if a taxpayer
can show reasonable cause for the delay. However, the rules for
DOL and PBGC permit the penalties to be reduced or waived. Both
the Treasury and Joint Committee recommend that these penalties
be consolidated and administered by a single agency. However,
the Treasury report recommends this duty be assigned to DOL,
while the Joint Committee report recommends the duty be
assigned to the IRS. The Council whole-heartedly endorses the
recommendations to consolidate the penalties but expresses no
view as to which agency should administer these penalties.
However, in the event either agency declares an amnesty for
plan administrators who failed to file (or are deemed to be
late filers) of Forms 5500, it should be initiated jointly and
administered by one agency.
Excise Taxes Which Operate as Penalties
In addition to certain other penalty provisions found in
Title I and Title II of ERISA, there are many excise taxes
found in the Internal Revenue Code which are part of Title II
and which are levied, where appropriate, by the Internal
Revenue Service. These excise taxes should be reviewed to
determine if they should be repealed or modified. These excise
tax provisions are set forth under Subtitle D-Miscellaneous
Excise Taxes, Chapter 43, IRC. Some of the excises under this
Chapter apply to sponsors of defined benefit plans, others are
imposed on employer sponsored group health plans and on medical
savings accounts. The Council does not intend to discuss or
make recommendations regarding these latter types of excise
taxes.
Sec. 4972-Tax on Nondeductible Contributions to Qualified Plans
Section 404 limits the total amount of annual employer
contributions to sponsored qualified plans to 15% of covered
compensation. If this limit is exceeded, the excess
contributions are not deductible. But in addition, a 10% excise
tax is imposed on the excess amount. It should be sufficient
that the excess contributions are not tax deductible. The
Council recommends that this excise tax be repealed. Better
still, the limit on employer contributions, while it served a
purpose in the past, currently serves no viable purpose under
present ERISA rules. The present nondiscrimination rules and
various other limits imposed on the amount an employer and the
employee can receive in benefits or be allocated to the latter
account in the qualified plan are more than adequate. In fact,
the 404 limitation frequently results in less benefits to
employee-participants as employers strive to stay within the
15% limit in order to keep from paying the 10% excise tax.
Section 4974-Tax on Under Payout of Required Minimum
Distributions
The IRC generally requires that when a participant attains
the age of 70 that each year distributions must be made that
are equal to the amount of his account divided buy his or her
life expectancy. The excise tax is equal to 50% of the
underpayment of the required minimum distribution each year.
Distributions are not required for those age 70 as long as they
continue to be employed by the plan sponsor. However, this
exception does not apply if the participant is a 5% shareholder
in the employer-sponsor.
This requirement was placed in ERISA at a time when a
decedent interest in his qualified retirement plan was exempt
from estate tax. That estate tax exemption has been repealed.
The Council has several recommendations to make with respect to
this excise tax. First, it be should be repealed. As the life
expectancy has dramatically increased and is likely to continue
increasing for some time yet, more people are concerned with
conserving their pension assets to make sure they have enough
to live on over their lifetime. More of them take full or part-
time jobs when they retire from their career occupations. As
retirees are generally healthier they tend to be more active
and often seek post-career employment.
The exception for workers who continue working past age 70
is a good one, but there is no reason why a 5% or more
stockholder-employee should not qualify for the same exception.
As an alternative to repeal, this excise tax is far too
high and should be substantially reduced. Furthermore, the
excise tax falls on the participant who is not likely to have
made the clerical error that caused the underpayment and, and
if it occurs, may not realize that fact. Admittedly, the
section does provide for waiver of the tax if the shortfall is
due to reasonable error and steps are taken to remedy the
situation.
The Council further recommends that some part of the
retiree account balance be exempted from the minimum
distribution requirements so that the participant has a safety
net if he is in danger of depleting his account. Furthermore,
there are complaints that the Service is not employing the most
current mortality tables when calculating life expectancies of
retirees.
Section 4975-Tax on Prohibited Transactions
This section of the Internal Revenue Code provides for the
imposition of an excise tax if the fiduciary or other
disqualified persons enters into transactions or provides
services with a qualified plan in one of a series of
transactions specified in the section that may constitute a
conflict of interest and hence a breach of fiduciary
responsibility. The prohibited transaction rules in the IRC
call for a 15% excise tax to be imposed on the amount involved
in the prohibited transaction. If the transaction is not undone
within a reasonable period after the first tier tax is imposed,
then a second tier tax of 100% of the amount involved in the
transaction is imposed. Title I of ERISA also contains similar
provisions (ERISA sec. 406) but do not impose a flat penalty,
so the DOL can impose a penalty, presumably adjusted to the
facts and circumstances, but not in excess of 5%, or 100%, if
the transaction is not undone. (See ERISA Sec. 502(i). Under
Title III of ERISA the Service is required to notify the DOL
when it intends to impose this excise tax. Likewise, the DOL
must notify the Service if it believes a prohibited transaction
has occurred. Additionally, ERISA Sec. 502(l) provides that the
DOL can impose penalties for breaches of fiduciary
responsibilities. After consultation between IRS and DOL, the
IRS may waive imposition of this excise tax. To the Council
knowledge the Service has seldom, if ever, waived these excise
taxes (first and second tier taxes) upon a recommendation of
DOL. The fact is, this excise tax is a trap that many small and
mid-size business plan sponsors inadvertently violate. The
Council recommends that a more modest penalty be imposed that
fits the violation. In addition, the requirement that the
transaction be undone, in many instances, may work to the
disadvantage of the qualified plan. The penalties imposed by
DOL for breaches of fiduciary duty should be the pattern for
the Service to follow and the current arbitrary and inflexible
excise taxes should be repealed. Sponsors, who with the best of
intentions, are often hit with one or both of the PT excise
taxes may be discouraged from continuing to maintain their
private retirement plans. Breaches of fiduciary duties should
not go unpunished, but the size of the penalty should depend on
whether the transaction was for the purpose of benefiting the
plan and whether, indeed, the plan did benefit from the
transaction.
The Council recommends that the excise tax be repealed and,
in its place, a discretionary penalty based on intention and
the degree of detriment to the plan participants, as provided
in Title I, be imposed. Barring this, the amount of the
inflexible flat excise taxes should be sharply reduced.