AICPA Offers Comments on JCT's Tax Gap Report

Dear Chairman Baucus and Ranking Member Grassley:

The American Institute of Certified Public Accountants supports the Senate Finance Committee's efforts to identify constructive ways to close the tax gap, particularly in light of the current estimate of about $345 billion in lost revenues for the U.S Treasury. You can be assured we are strongly interested in providing the Finance Committee with continuing, thoughtful input as your committee's investigation of this critical tax administration matter moves forward. Therefore, we are pleased to respond to the Finance Committee's October 19, 2006 press release which requests comments on certain tax gap initiatives that are taken from the August 3, 2006 Joint Committee on Taxation staff report, Additional Options to Improve Compliance.

Our comments address the proposals that call for: (1) imposing basis reporting requirements for publicly-traded securities; (2) expanding the reporting requirements for (a) real estate taxes, (b) the proceeds of auction sales, (c) mortgage interest, and (d) individuals with an interest in offshore bank accounts and offshore trusts; and (3) denying deductions and credits with respect to untimely returns of nonresident aliens and foreign corporations. We anticipate soon sending the Senate Finance Committee a separate letter with respect to the JCT option involving the self-employment tax for partners and S corporation shareholders of personal service companies.

The AICPA is the national, professional association of CPAs, with approximately 350,000 members, including CPAs in business and industry, public practice, government, and education; student affiliates; and international associates. Our members advise on federal, state, and international tax matters and prepare income and other tax returns for millions of taxpayers. They provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America's largest businesses. It is from this broad perspective that we offer our thoughts today.

We appreciate the opportunity to comment on the above tax gap proposals contained in the Joint Committee staff report. We would be pleased to discuss the content of these comments with you or your staff at any time. If you have any questions, please contact me at (212) 773-2858, or jeffrey.hoops@ey.com; James E. Brennan, Chair of the AICPA IRS Practice and Procedures Committee, at (212) 773-3209, or james.brennan@ey.com; or Benson Goldstein, AICPA Technical Manager, at (202) 434-9279, or bgoldstein@aicpa.org.

Our comments address the proposals that call for: (1) imposing basis reporting requirements for publicly-traded securities; (2) expanding the reporting requirements for (a) real estate taxes, (b) the proceeds of auction sales, (c) mortgage interest, and (d) individuals with an interest in offshore bank accounts and offshore trusts; and (3) denying deductions and credits with respect to untimely returns of nonresident aliens and foreign corporations.

Impose Basis Reporting Requirements for Publicly-Traded Securities

The AICPA supports the concept of requiring brokers to report to the IRS a customer's adjusted basis in publicly-traded securities sold during the preceding taxable year. While we believe that this proposal could significantly increase tax compliance with respect to the reporting of capital gains and loss transactions over the longer term, we stress that the technical problems associated with implementation of this proposal in the short-term should not be underestimated.

We believe that the technical problems involved with the proposal can be addressed and overcome, but the pace with respect to implementation of a capital gains basis reporting initiative should not get ahead of the ability of the IRS to utilize such basis information for examination purposes. Otherwise, taxpayers would be subjected to additional reporting burdens without a commensurate ability within the Service to utilize the basis information for enforcement purposes. In particular, we take note of the June 2006 Government Accountability Office (GAO) report¹ acknowledging the challenges relating to: (1) the Service's computer system capacity to store and use additional data and (2) the potential that the Service will be unable to process and match capital gains and loss transaction data reported on Form 1040, Schedule D.

This proposal also requires the brokers to furnish customers with information statements showing the same basis information that the brokers provide the IRS. Assuming the information is provided by brokers to taxpayers in an understandable form, we believe this is a positive requirement. We would encourage brokers to provide this basis information involving capital gains and loss transactions to taxpayers in a format that would enable taxpayers and tax preparers to download the basis information directly into their tax return preparation software. This would enable a taxpayer to provide the IRS with details of each capital gain and loss transaction on a separate line on Form 1040, Schedule D and D-1. Absent the availability of such software, we urge the IRS to maintain its current policy of permitting individual taxpayers to provide summary totals for security transactions on Schedule D and D-1, coupled with the attachment of brokerage statements to the Form 1040.

The JCT proposal includes special rules for reporting basis when the reporting broker executed the sale, but not the original purchase. We support the requirement that, when securities are transferred from one broker to another, the transferring broker must furnish the transferee broker with sufficient detail relating to the basis of the securities being transferred. However, we are concerned about the compliance burdens placed on taxpayers who receive securities by gift, upon death resulting in a stepped-up basis, or through a direct purchase from the issuing company, and who later transfer the securities into a brokerage account. In these cases, the proposal requires the taxpayer to furnish the basis information to the transferee broker. We urge caution in providing for the routine assessment of a civil penalty against taxpayers for a failure to furnish correct basis information due to the rigorous recordkeeping burdens that may be associated with retaining such information.

Taxpayers will have difficulty in tracking the basis of securities involved with corporate spinoffs, recapitalizations, and mergers. Moreover, we appreciate that the Joint Committee staff recognizes there will be circumstances when brokerage houses may inaccurately report basis amounts to customers, such as when (1) a taxpayer sells securities involving a wash sale under Internal Revenue Code section 1091, and (2) a corporation or regulated investment company (RIC) makes a distribution determined to be a return of capital. Reporting basis information to customers may also prove problematic in cases in which taxpayers have chosen the specific identification method of calculating the basis and holding period of a stock sale. As part of any reporting requirements in this area, brokers should be required to provide straightforward mechanisms by which taxpayers can electronically notify the broker of a specific lot that should be sold. These situations need to be carefully reviewed before implementing a broad capital gains and loss basis reporting rule.

The JCT staff report raises the issue as to whether the proposal's basis reporting requirements should apply to transactions involving qualified retirement plans, IRAs, qualified tuition plans and similar tax-favored arrangements. Tracking basis for these tax- favored plans would not reflect the tax-free (e.g., Roth IRAs and Section 529 plans) or ordinary income tax treatment (e.g., 401(k) plans and traditional IRAs) of distributions from these plans. Therefore, we recommend against requiring basis-tracking for these plans and arrangements.

If this basis-reporting proposal is enacted into law, we support the JCT's position that the provision be made effective for transactions involving securities first purchased 18 months after the date of enactment for all of the reasons cited above.

Reporting Requirement for Real Estate Taxes

Another Joint Committee on Taxation staff option would require state and local governments to report to the IRS and taxpayers the amount of real estate taxes paid (excluding nondeductible amounts). Billed as an alternative option, the JCT staff also suggests that mortgage lenders be required to report to the IRS and taxpayers the amount of real estate taxes paid by taxpayers through escrow accounts.

While not addressed by either of these two options, the JCT staff proposal will need to take into account how a real estate tax reporting regime might apply to cooperatives; such as whether the cooperative corporation will have to report on a Form 1099 the exact amount of real estate taxes paid on behalf of each shareholder.

The AICPA conceptually supports the JCT's two alternative approaches to reporting real estate taxes. We agree with the JCT staff's acknowledgement that this reporting requirement might impose administrative burdens on governmental entities that outweigh the compliance benefits. We commend the JCT staff for asking the GAO to (1) analyze the extent to which taxpayers are overstating the deduction for real estate taxes, particularly with respect to improper deductions for user fees; (2) determine whether localities (that charge user fees for services) are providing taxpayers with real estate tax bills that clearly distinguish between deductible and non-deductible amounts; and (3) determine whether mortgage lenders are providing taxpayers with accurate real estate tax information. With respect to this immediately preceding point, we have concerns about whether taxpayers receive the correct information regarding the proper amount of real estate taxes to deduct when a sale or purchase of property occurs during the year. It is our understanding the pro- rations that occur during a property "closing" are rarely reflected in the mortgage lender's year-end report to the taxpayer.

We believe that mortgage lenders may be better suited for complying with an information reporting regime that requires lenders to provide the IRS and taxpayers with a breakdown between deductible real estate taxes and non-deductible user fees, as opposed to placing the administrative burden on state and local governments. Having said that, we appreciate that the Joint Committee staff -- in asking for the GAO study -- acknowledges that the revenue gains from any form of this information reporting initiative might not yield sufficient enough revenues for the Treasury to justify the offsetting compliance burdens imposed on state and local governments, mortgage lenders, or taxpayers.

Reporting Requirements for Proceeds of Auction Sales

Under this proposal, brokerage information reporting requirements would be expanded to include proceeds from property sold at auctions, including collectibles or motor vehicles. The JCT staff report also provides an alternative option which would generally expand brokerage information reporting to generally cover auction sales by individuals. We suggest that Congress proceed cautiously in this area and first analyze the true level of non-compliance with respect to auction sales.

It is not at all clear as to the level of non-compliance that exists for both traditional live auctions and sales taking place over the Internet. Thus, we commend the Joint Committee staff in recognizing that any information reporting regime for auction sales should take into account the value, gain, or proceeds derived from the sale of property exceeding a certain dollar threshold, and that low-value, low-gain items sold by individuals should be exempted from reporting. In effect, the JCT staff report seems to suggest that defining the types of property subject to information reporting will be a challenging matter.

Once a review is completed regarding auction sales, Congress may conclude that the taxpayers who participate in auction sales are involved with transactions that are more apt to generate a loss on the sale of the property -- as opposed to a gain. If true, the implementation of an information reporting regime might trigger the exact opposite of what the proposal is striving to accomplish; that is, information reporting on auction sales may cause confusion among the taxpaying public at large and might result in taxpayers inadvertently claiming unallowable losses on their tax returns. Congress and Treasury may find that a preferable approach to auction sales is for the government to implement an "educational" advertising campaign (using traditional media and the Internet) to inform taxpayers about when auction sales proceeds are taxable.

Reporting Requirements for Mortgage Interest

The JCT tax gap options include a proposal for expanding the information reporting by mortgage companies to taxpayers and the IRS through (1) identification of whether the interest paid was in connection with a financing or refinancing and (2) identification of debt proceeds that exceed the $100,000 home equity limit. According to the October 19, 2006 Senate Finance Committee press release, "[t]he proposal would make it easier for taxpayers and the IRS to calculate the correct amount and timing of interest deductions and reduce erroneous deductions for non-deductible items like prepaid interest (points) paid in connection with a refinancing."

The AICPA supports the concept of expanding information reporting by mortgage companies. However, due to the complexity of the interest tracing rules, it is not clear that tax return preparation will necessarily be any more accurate even with increased information reporting in this area. For example, the limitation on deductible interest for a home equity loan generally focuses on indebtedness incurred for personal reasons. We believe it will remain difficult for the IRS to determine whether borrowings in excess of the $100,000 limit have been incurred for purposes of making capital improvements to a personal residence. There is the potential that this proposal may cause the IRS to inadvertently (but significantly) increase the level of taxpayer audits of persons who otherwise accurately prepare and file their returns.

Reporting Requirements for Individuals with an Interest in Offshore Bank Accounts and Offshore Trusts

In our opinion, the JCT proposal imposing a due diligence requirement on preparers with respect offshore bank accounts and trusts held by clients is unnecessary. First, the current standards under Circular 230 and the AICPA's Statements on Standards for Tax Services (SSTS) No. 3, Certain Procedural Aspects of Preparing Returns, adequately ensure preparer due diligence for foreign accounts and trusts. Second, we believe the proposal would likely add significant recordkeeping burdens on preparers without any appreciable increase in closure of the tax gap.

Under this proposal, a due diligence requirement is imposed on income tax preparers to determine whether a taxpayer must file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR). The proposal requires income tax preparers to explain (1) the FBAR reporting requirements to the taxpayer, (2) the meaning of certain terminology, such as "financial interest" and "signature authority", and (3) the applicable civil and criminal penalties.

Circular 230 already imposes significant due diligence standards on practitioners. In general, Circular 230, section 10.22(a) requires a practitioner to exercise due diligence in the preparation or assistance in the preparation of returns and other documents relating to Internal Revenue

Service matters. Moreover, Circular 230, section 10.34(c) acknowledges the immense difficulties preparers face in preparing tax returns for clients; that is, the government recognizes that a preparer cannot offer complete assurance of the veracity of a taxpayer's positions on a return. This latter regulation states that "[a] practitioner . . . generally may rely in good faith without verification upon information furnished by the client." (Emphasis added.) In fact, the AICPA's SSTS No. 3 is consistent with Circular 230's recognition that a practitioner may generally rely in good faith on the information furnished by the client."

Circular 230, section 10.34(c) and SSTS No. 3 are also consistent in requiring a preparer to make reasonable inquiries if the information furnished by the client appears to be incorrect, incomplete or inconsistent either on its face or based on the facts known to the preparer. While imposing what we view is a burdensome recordkeeping requirement on preparers with respect to offshore accounts and trusts, the JCT initiative would not do anything appreciable to make lawful taxpayers out of clients bent on committing fraud or hiding assets offshore. In fact, for such taxpayers, page 27 of the JCT staff report acknowledges that "imposing a due diligence requirement on the return preparer will probably have little to no effect on increasing the compliance rate for taxpayers interested in concealing income or in engaging in criminal activity.

The JCT staff report further discusses a category of taxpayers who fail to file because these taxpayers hire professionals to structure transactions in a way to avoid offshore account and trust reporting requirements. For this category, the JCT staff suggests that the number of transactions subject to the filing (reporting) requirements be increased by requiring the reporting of accounts and interests in accounts held "directly or indirectly" by taxpayers. While we are cognizant of the difficulties in defining what constitutes an account "indirectly" held by taxpayers, we recommend that any such change in the definitions regarding offshore accounts be accomplished through the issuance of regulations.

Denial of Deductions and Credit with Respect to Untimely Returns of Nonresident Aliens and Foreign Corporations

Nonresident aliens and foreign corporations engaged in the active conduct of a trade or business in the U.S. are taxed on a net basis with respect to income that is effectively connected with a U.S. trade or business (ECI). In determining the taxable portion of the ECI, taxpayers generally are allowed deductions to the extent such deductions are connected with ECI. However, otherwise allowable deductions and credits may be taken only by filing a true and accurate tax return in the "manner" prescribed by subtitle F of the Internal Revenue Code (Code), by including on the return all the information deemed necessary for the calculation of such deductions and credits. A question has arisen whether the term "manner" incorporates the Code's timely filing requirements.

The JCT staff report proposes denying deductions and credits with respect to untimely filed returns of nonresident aliens and foreign corporations. According to the Report, the courts that have considered the issue generally have held that if a foreign person files returns before the Service has issued a notice of deficiency, then the foreign person is not precluded from taking otherwise allowable deductions.

However, in 1990, Treasury and the Service issued regulations under sections 874 and 882 generally providing that a foreign person may receive the benefit of deductions and credits only if the foreign person timely files, in the manner prescribed in the Code, a true and accurate return of the person's taxable income. The validity of Treas. Reg. section 1.882-4(a)(2) was tested in Swallows Holding, Ltd. v. Commissioner.² There, the taxpayer, a foreign corporation, failed to file its returns in a timely manner as defined under the regulations. The Tax Court held Treas. Reg. section 1.882- 4(a)(2) to be invalid to the extent it imposed a timely filing requirement, on the grounds that there was no authority for imposing that requirement by regulation. The Tax Court, looking to the language used in section 882(c)(2) (which states the return must be filed in the "manner" prescribed, and omits the term "timely"), determined that Congress did not intend to require the returns to be filed timely.

In light of the Tax Court's holding in Swallows Holding, the JCT report proposes that new legislation either specify the filing deadlines (or the events after which a foreign person's deductions and credits should be denied) or specify that deductions and credits should be denied with respect to foreign person's returns that are not timely filed, and delegate to Treasury the authority to define what is meant by "timely." Regardless of the outcome in the pending Swallows holding appeal, the JCT report suggests a legislative solution in order to resolve uncertainty concerning the application of the timely filing requirement.

While it is appropriate to resolve this issue by legislation, and the government has legitimate concerns regarding late filing by non-resident aliens and foreign corporations, the penalty suggested (loss of deductions and credits) is too harsh, imposing a draconian punishment for what is often a foot fault. For example, a foreign corporation may have large revenues but very narrow profit margins (or even losses, as was the case in Swallows Holding), and it may legitimately conclude that it is not engaged in a U.S. trade or business (given the inherently factual and judgmental nature of the analysis). However, if it is ultimately determined that its U.S. activities do rise to the level of a trade or business, it will be taxed under this proposal on its gross revenue, such that its tax liability will be far greater than its actual net income. This is essentially confiscatory policy on behavior that is far from egregious.

Accordingly, we recommend that any penalty be tailored to fit the offense, perhaps by assessing a penalty as a percentage of the tax underpayment, analogous to section 6662. In this way U.S. tax interests will be protected but foreign corporations and non-resident aliens will be treated fairly.

² 126 T.C. 96 (2006, appeal filed, (3d. Cir. July 5, 2006).