Comments on the penalty and interest study.

• Position: Tax Executives Institute comments

April 21, 1999

On April 21, 1999, Tax Executives Institute submitted the following comments to the Joint Committee on Taxation and Internal Revenue Service regarding penalty and interest issues in conjunction with a study required by section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998. TEI's comments were prepared under the aegis of its IRS Administrative Affairs Committee, whose chair is Stephen W. Boocock of Allegheny Teledyne, Inc. Contributing substantially to the Institute's submission were Ben J. Clayton of Philips Petroleum Co., Douglas C. Durham of Allegheny Teledyne, Inc., John S. Estes of Fort James Corporation, Sheldon A. Kimel of Brunswick Corporation, Michael J. Nesbitt of Paychex, Inc., and Terilea J. Wielenga of QAD Inc.

On December 23, 1998, the Joint Committee on Taxation staff and the Internal Revenue Service requested comments on penalty and interest issues in conjunction with a study required by section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. No. 105-206, 112 STAT. 782. The IRS's request (Notice 99-4) was published in the January 19, 1999, issue of the INTERNAL REVENUE BULLETIN (1999-3 I.R.B. 9). The Joint Committee's request was in the form of a letter to TEI.

1. Background

   Tax Executives Institute is the preeminent association of business tax executives in North America. Our approximately 5,000 members represent 2,800 of the leading corporations through 52 chapters in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and 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. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and that taxpayers can comply with in a cost-efficient manner.

   Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the Internal Revenue Service and provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the penalty and interest provisions of the Internal Revenue Code.

   In their requests, the Joint Committee staff and the IRS ask for comments on penalty and interest issues, as well as specific recommendations on ways to (i) simplify the current penalty and interest regimes; (ii) make tax administration more efficient; (iii) reduce inequities and burdens on taxpayers; and (iv) deter noncompliance, tax avoidance, and fraud. Comments were specifically requested on 13 penalty and interest issues, including --

   * Whether the provisions encourage voluntary compliance;

   * Whether the provisions permit taxpayers to generate overpayments or underpayments so that they may take advantage of disparities between commercial borrowing rates and the rates imposed by section 6621;

   * Whether IRS communications provide an adequate explanation of why penalties and interest were imposed; and

   * Whether the IRS's authority to waive penalties or abate interest should be modified.

   TEI is pleased to respond to these requests.

2. Penalties

   1. Overview

      Ten years ago, Congress completed a major overhaul of the penalty provisions of the Code. The resulting legislation, styled the Improved Penalty and Compliance Tax Act, aimed to revise and streamline several penalty provisions. Congress made the changes because it concluded that --

      [T]he number of different penalties that relate to accuracy of a tax return, as well as the potential for overlapping among many of these penalties, causes confusion among taxpayers and leads to difficulties in administering these penalties by the IRS. Consequently, the [House Ways and Means] committee has revised these penalties and consolidated them. The committee believes that its changes will significantly improve the fairness, comprehensibility, and administrability of these provisions. H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1388 (1989).

      A decade later, we face the same Sissyphean task -- reforming the Code's penalty provisions. Rather than learning from the past -- that penalties should be simple, fair, and easy to administer -- Congress, sometimes at the IRS's and Treasury Department's urgings, has piled penalty upon penalty, targeting specific areas such as transfer pricing and corporate tax shelters in perhaps well-intentioned, but mishandled efforts to encourage compliance. Rather than being simple, 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."

      Tax Executives Institute believes that in order to achieve a penalty framework that is comparatively fair, simple, and easy to administer, the first step is to affirm the proper role of penalties in the tax system. The issue is not whether taxes or interest are due and owing. Rather, the focus is only whether a penalty should be imposed owing to a taxpayer's failure or inability to report the correct tax liability or file an accurate information return. TEI believes that four principles should drive the establishment of an effective and fair penalty regime that encourages voluntary compliance.

      First and foremost, penalties should be used to punish intentional or negligent noncompliance -- essentially purposeful acts -- not inadvertent errors or omissions. The current structure does not effectively distinguish between the two, putting taxpayers who unintentionally fail to meet some requirement in the same category with those who willfully decide not to comply. The taxpayer's history of compliance with the tax laws should therefore be considered in determining whether to impose a penalty.

      Next, each penalty should be capable of being abated within the IRS subject to a reasonable cause standard. In other words, there should be no automatic, strict liability, or mechanically imposed penalties. Penalties -- such as those for the failure to pay estimated tax penalties under sections 6654 (individuals) and 6655 (corporations), to comply with the reporting requirements under sections 6038A and 6038C (relating to foreign corporations), or to comply with the transfer pricing documentation rules under section 6662(e) -- should be revised to include a reasonable cause exception. The IRS should also be given the discretion to waive any penalty in appropriate circumstances. In addition to considering the taxpayer's history of compliance in determining whether a penalty should be imposed, the IRS should weigh the effect of the lack of guidance on an issue and the taxpayer's size and sophistication.

      Third, penalties should encourage disclosure. As a general matter, no penalty should be asserted where the taxpayer has fully disclosed the item or transaction. Some penalties -- such as the corporate tax shelter penalty of section 6662(d)(2)(C)(iii) -- actually discourage disclosure of return positions. These provisions should effect a waiver of the penalty where the position is fully disclosed. In addition, more provisions such as the "qualified amended return" rule set forth in Treas. Reg. [sections] 1.6664-2(c)(3) -- providing that errors detected and corrected before the IRS contacts the taxpayer will not result in an accuracy-related penalty -- should be adopted.

      Finally, penalties should not be used to raise revenue. This principle is closely linked to the first, i.e., that penalties should be used solely to punish intentional misconduct. Hence, penalties should be structured, interpreted, and applied to encourage voluntary compliance and facilitate the orderly administration of the tax laws (e.g., by encouraging disclosure); legislation implementing penalties should not be revenue-based. Moreover, penalties should not be used as "bargaining chips" in audit negotiations. To do so undermines taxpayer belief in the fairness of the tax system.

      TEI's comments on specific aspects of the current penalty regime follow. The comments focus on current law and do not discuss issues such as the proposed corporate tax shelter penalties set forth in the Clinton Administration's FY2000 Budget. The issues raised by these proposals will be addressed in a separate submission.

   2. Clear Standard of Conduct

      Penalties should not be imposed where the required standard of conduct is not clearly defined or communicated. Both Congress and the IRS bear responsibility in this area. Congress has the responsibility for enacting legislation that clearly defines what is required of taxpayers. The IRS also bears responsibility for defining requirements and, perhaps more important, for communicating these requirements to taxpayers in a simple, timely, and understandable manner.(1) Consistent with its new mission, the IRS should continue to seek to inform taxpayers of their tax obligations through a variety of means, including the posting of guidance on the IRS's website. The IRS's efforts in this latter regard are commendable.

      The IRS's recent actions regarding the Electronic Federal Tax Payment System (EFTPS) provide an example of how the IRS should work cooperatively with taxpayers to achieve compliance (rather than simply punish). Because the requirements were not well known and because of problems encountered by taxpayers in striving to comply, the IRS has repeatedly delayed the imposition of penalties for failing to use EFTPS. It opted instead for outreach programs to better educate the public. This approach encourages voluntary...