(Archived Content)
FROM THE OFFICE OF PUBLIC AFFAIRS
LS-351Mr. 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:
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.