[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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \10\ Commissioner of Internal Revenue v. Lane Wells Co., 321 U.S. 
219, 223 (1944).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \11\ Treas. Reg. sec. 1.6662-4(d)(2).
---------------------------------------------------------------------------
    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 
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------

                             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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \11\ The Treasury Report does not address this issue.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \14\ But see Treasury Report at 81 (recommending retention of 
current law).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.

---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \1\ This testimony was prepared by Arthur Andersen on behalf of the 
Coalition for Fair Taxation of Business Transactions.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \5\ See I.R.C. Sec. Sec. 6662 and 6694.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    1 In JCT Interest and Penalty Study, JCS-3-99, July 22, 1999, page 
3.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    2 JCT Interest and Penalty Study, p. 95.
---------------------------------------------------------------------------
    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.
