TEI RESPONDS TO IRS TASK FORCE REPORT ON CIVIL TAX PENALTIES.

TEI then challenges the purpose of civil tax penalties. These penalties, according to TEI, "should have a single goal -- to encourage compliance by punishing voluntary, not inadvertent, deviations for the prescribed and existing standard of conduct." To this end, the Service should not impose retroactive penalties, nor should it enact penalties as source of revenue, TEI states. The indiscriminant imposition of penalties, the group argues, could undermine the Service's attempts to encourage voluntary compliance.

In general, TEI agrees with the Service's four criteria -- fairness, simplicity, administrability, effectiveness -- for evaluating specific penalties. It stresses that, when applying these criteria, the Service should balance its reading of the specific statutory provision by also taking into account a taxpayer's good faith effort to comply. TEI criticizes the report's recommendation that the Service apply these four criteria "on a targeted basis," since this could lead to a "proliferation of penalties." Instead, it suggests that the Service judiciously apply a limited number of penalties.

TEI agrees with the Task Force report's conclusion that the goals for the administration of civil penalties have been inadequately developed. To expedite administration, TEI urges the Service to resolve disputes at the audit level, instead of at the appeals level.

TEI's 32-page response has been placed in the September 12, 1988 Tax Notes Microfiche Database as Doc 88-7511. Alternatively, it is available from Tax Notes Complete Access Service for $26.80.

On June 8, 1988, the Internal Revenue Service released for public comment a discussion draft entitled "A Philosophy of Civil Tax Penalties" which had been prepared by the Executive Task Force for the Commissioner's Penalty Study. In the transmittal letter, the chair of the Executive Task Force wrote that arriving at a consensus concerning "the philosophy and criteria that penalties should conform to is paramount in determining whether deficiencies exist in the current structure or administration of penalties."

Tax Executives Institute agrees that in order to achieve a penalty framework that is "fairer, simpler, and easier to administer," the first step is to develop a consensus on what the proper role of penalties should be in the tax system. We commend the IRS Task Force seeking to establish a credible framework for further consideration of the penalty area. We pledge to cooperate in this effort, especially as it relates to the business tax community.

In this regard, on April 5, 1988, Tax Executives Institute filed a position paper with the IRS in which we offered our preliminary thoughts on the proper philosophical basis for civil tax penalties. That submission, which also contained our recommendations concerning the structure and administration of the penalty system, ¹ anticipated the issuance of the Task Force's Report when it asserted that "the philosophical, or (if you will) moral, basis for the imposition of penalties" had to be identified if the inquiry was to be successful.

In the comments that follow, TEI offers its reactions to the report of the IRS Task Force. ² Specifically, we discuss the extent to which we believe the Institute's views on the philosophical tenets that must underlie the penalty system are consistent not only with those of the IRS Task Force but also with those set forth in the July 28, 1988, report of the Section of Taxation of the American Bar Association. ³ By discussing the similarities among the three reports as well as their differences, we hope to contribute to the emergence of a consensus for the development of a rational penalty system. We also discuss why adherence to uniform principles of fairness and simplicity mandates that many of the Internal Revenue Code's civil penalty provisions should be substantially modified or repealed outright.

I. BACKGROUND

Tax Executives Institute, Inc. approaches the subject of the Code's penalty provisions from a vantage point different from those of other organizations of tax professionals. We represent the corporate tax community and are only tangentially involved with individual tax rules and penalties. The Institute's 4,300 members are employed by the 2,000 largest corporations in North America and are charged with the day-to-day management of their companies' tax departments. Most of our members are certified public accountants or attorneys, and many are both.

TEI represents a cross-section of the business community, and is dedicated to the development and 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 organization, we are firmly committed to maintaining a tax system that works -- one that is both administrable and with which taxpayers can comply.

II. DEFINITION OF A CIVIL THE PENALTY

The IRS Task Force defined the term penalty as "an adverse consequence imposed on a person for failure to comply with a federal tax rule." (Page 3.) As far as it goes, this proffered definition is unassailable: clearly, a penalty should not be imposed unless the taxpayer fails to comply with a federal tax rule. The definition, however, may be misconstrued to suggest that -- in applying the Code's penalty provisions -- there are only two types of taxpayers: compliant and noncompliant.

Although such a bifurcation has obvious appeal, we submit it accords insufficient weight to the level of uncertainty that currently exists with respect to what the existing "federal tax rules" are. It is for this reason that TEI argued in its April submission that civil tax penalties --

"should be exacted only for deviation from A CLEARLY DEFINED STANDARD OF CONDUCT that is timely established and promulgated, either by Congress or the Treasury Department and Internal Revenue Service."

Stated differently, TEI believes that the Task Force's definition should be revised to take into account that the substantive tax rules are not always well known and, consequently, compliance or noncompliance is not always the choice that confronts the taxpayer. We agree that penalties, which are imposed for violating substantive rules, must be viewed separately from the substantive rules themselves. We suggest, however, that before a penalty assertion can be justified, the pertinent federal tax rule must be known or at least "knowable" (i.e., subject to reasonable interpretation by a prudent person). ⁴

We submit, moreover, that this issue is fundamentally one of definition (rather than administration). That is to say, the operative definition should give weight to the concept of culpability. The definitional act -- the somewhat facile division of the world into "good" (compliant) and "bad" (noncompliant) taxpayers -- should not sanction the imposition of penalties where the underlying law is unclear. ⁵ As the ABA Report suggests, the inquiry should be whether a taxpayer is at fault for not knowing what the law is. (ABA Report, at page 34.)

III. THE PURPOSES OF CIVIL TAX PENALTIES

In our April comments, TEI stated that penalties should have a single goal -- to encourage compliance by punishing voluntary, as distinct from inadvertent, deviations from the prescribed and existing (i.e., clearly identified) standard of conduct. From this conclusion, we drew two corollaries: first, penalties should not be enacted or increased on a retroactive basis; and second, penalties themselves should never be enacted as a source of revenue. As we stated in our April comments, "retroactive or revenue-inspired penalties place in jeopardy the moral support for both the penalty scheme and our entire self-assessment system."

We also recommended in our April comments that the following three principles should mark all penalty provisions:

FIRST, penalty provisions should be known and understandable to both taxpayers and the IRS.

SECOND, a penalty's severity should be appropriate to the taxpayer's culpability.

THIRD, the circumstances in which a penalty will NOT be asserted, even in the face of the taxpayer's failure to abide by the prescribed standard of conduct, should be identified.

These principles were implicitly embraced by the subsequently released ABA Report, which concluded that the following legal criteria should govern the adoption, interpretation, and application of penalties:

1. A penalty should reflect its limited force in preventing undesirable behavior. Penalties are not the only means to prevent conduct that threatens harm to the tax system.

2. A penalty should reflect minimum standards, not ideal conduct. A penalty that imposes too high a standard will inevitably draw into question its own legitimacy by subjecting a broad segment of taxpayers to punishment.

3. A penalty should establish a certain and not imprecise standard to give a fair warning of what is actually required.

4. A penalty statute should give an independent and reasonably complete warning of the prohibited conduct. The occasion on which a sanction is to be imposed should be reasonably free from doubt.

5. The same misconduct should not be subject to more than one penalty.

6. A penalty should serve an educational function for the affected taxpayer and taxpayers in general.

7. The punishment imposed by a penalty should correspond with the seriousness of the threat to the tax system created by the conduct involved.

(ABA Report, at pages 12-15.)

TEI is pleased that the IRS Task Force has embraced principles similar to those espoused by TEI in its April comments (as well as by the ABA in its report). Specifically, the Task Force concluded that "the sole purpose of civil tax penalties should be to enhance voluntary compliance." ⁶ (Page 7.) In reaching this conclusion, the Task Force expressly rejected revenue raising as a proper purpose of penalties, as well as the use of penalties as a means of punishing noncompliant behavior or of reimbursing the government for the cost of its compliance program. (Page 6.)

We commend the IRS Task Force for recognizing the limits of civil tax penalties as a compliance tool. We specifically embrace the statement in the Task Force's Report that "[i]f the taxpayer is ignorant of his or her obligations and this ignorance is not the result of a failure to pay adequate attention to his affairs, imposing a penalty probably does not serve a goal of specific deterrence." (Page 8.) Thus, both penalties and the underlying substantive law must be known and understandable to the taxpayer and the IRS before noncompliance can be justifiably punished. ⁷

We also believe that any evaluation of the penalty system must take into account that penalties are only one of the tools that the IRS has at its disposal to encourage compliance with the tax laws. (Page 9.) Thus, due weight should be given to the other "weapons" in the IRS's compliance "arsenal." Perhaps most important are the IRS's educational efforts, which should be directed at ensuring that the substantive tax rules -- the expected standard of behavior -- are known. In addition, the development and implementation of effective examination and collection programs should not be overlooked in an effort to rationalize the injudicious enactment or assertion of penalties.

With particular regard to corporate taxpayers, the Coordinated Examination Program (CEP), which subjects certain corporate taxpayers to perpetual audit, has proven to be an effective and cost-efficient way for the IRS to deal with the complexity and resulting uncertainty that this group of taxpayers confronts on an annual basis. We would hope that one of the assumptions underlying the CEP program is that the role of TEI members and other corporate tax professionals is not to direct corporations to be noncompliant; rather, it is to minimize a corporation's tax liability, as well as its tax compliance cost, while complying with the law.

In other words, the CEP program -- even though generating substantial revenues for the IRS -- is not premised on the affected taxpayer's being intentionally noncompliant or acting in bad faith. Thus, the program acknowledges that taxpayers may--in the words of the IRS Task Force's Report -- have "an acceptable reason for failure" (page 9) and that --

"the appropriate enhancement of compliance may be the removal of the barrier [to compliance] rather than punishment of the noncompliant behavior." (Page 9.)

We submit that the indiscriminate wielding of the penalties sword in respect of these taxpayers -- without adequate regard for whether the applicable standard of conduct is discernible -- is not only unfair and counterproductive but also inconsistent with the stated purpose of the penalties system -- encouraging voluntary compliance.

IV. THE CRITERIA FOR EVALUATING SPECIFIC PENALTIES

From its discussion of the purposes and limitations of penalties, the IRS Task Force's Report proceeds to address the evaluation of particular penalties. Specifically, the Task Force concluded that penalties should be judged on the basis of their fairness, simplicity, administrability, and effectiveness. (Page 9.) TEI agrees that the four criteria developed by the Task Force are relevant in evaluating particular penalties. We offer the following comments with respect to each criterion.

A. FAIRNESS. TEI is especially heartened by the Task Force's articulation of three distinct components of the fairness criterion: culpability, equity, and severity. In particular, we agree with the Task Force that --

o the quality of the taxpayer's intent in not complying should be taken into account and that taxpayer who, though noncompliant, is not compliant through "excusable ignorance" or other "excusable cause," should be penalized only if the general deterrence purpose of the penalty is sufficiently compelling (page 10); and

o a penalty for conduct that is sure to be discovered should not be as severe as a penalty for noncompliant conduct that is likely not to be discovered (page 11).

B. SIMPLICITY. As to the simplicity criterion, TEI obviously agrees that both the substantive tax rules and applicable penalties must be "understandable and understood." (Page 11.) We similarly agree that simplicity may mean different things to different groups of taxpayers.

We must take issue, however, with the implication that corporations may properly be held to a higher standard of conduct than other taxpayers. Concededly, "[t]he practitioner or the sophisticated financial institution may be able to deal with more complexity than can many individual taxpayers." (Page 11.) Nevertheless, the substantive tax laws that corporations must contend with are exceedingly more complex than those applicable to individuals. For example, no matter how complex the individual tax rules might seem (even taking into account the passive activity loss rules), that complexity pales in comparison with the foreign tax credit separate limitation and interest allocation rules.

C. ADMINISTRABILITY. The Task Force's Report states that "[p]enalties should be administrable and administered with reasonableness, responsiveness, and reproducibility." (Page 11.) The report continues to state that "when a rule could result in an inconsistent assertion or nonassertion [of the penalty] in a particular situation, the written rule should permit the administrator to take appropriate action." (Page 12.) The ominous implication of the statement is that in such cases the penalty should be levied.

TEI agrees that penalties should achieve reasonable results and that the concept of uniformity is certainly a meritorious one. We submit, however, that in exercising its discretion under the penalty provisions, the IRS should properly be disposed in such cases not to assert the penalty. Thus, if the literal application of the written rules would result in the non-assertion of a penalty, in no event should a taxpayer be subject to the penalty based on an administrator's judgment of what might be "appropriate." Conversely, where the taxpayer has made a good faith effort to comply (as determined under a facts-and-circumstances test), the penalty should be waived even though its assertion might be rationalized under a literal reading of the statutory provision. ⁸

D. EFFECTIVENESS. As to judging the effectiveness of penalties, TEI believes it is appropriate to assert progressively more onerous penalties for continued failures to comply if such failures relate to a particular deduction, particular income item, or to a particular information reporting requirement. In this regard, we believe the Task Force's proposed "tracking system," pursuant to which a taxpayer would be minimally penalized for the initial instance of noncompliance but subject to stiffer penalties for ongoing noncompliance, merits consideration. Stiffer penalties should not be asserted, however, simply because the taxpayer was noncompliant for more than one tax period when the later infraction is not directly related to the first.

The Task Force concluded its discussion of the applicable criteria by stating that a proper analysis of the four standards should be approached on "an issue-by-issue, penalty-by-penalty basis and temptations to simplify or paint with a broad brush should be carefully considered, if not avoided entirely." (Page 13.) TEI disagrees that compliance should be approached on a targeted basis, and submits that the Task Force's proposed approach could be used to justify a further proliferation of the number and type of penalties. We suggest that the judicious application of a limited number of properly drawn penalties (such as a revised negligence penalty) to all areas of the tax law could effectively meet the four criteria listed above.

V. THE GOALS FOR ADMINISTERING PENALTIES

The Task Force concluded that "the goals of administering the penalties have been inadequately developed." (Page 15.) In an effort to address this shortcoming, the Task Force suggested that penalties should be imposed, contested, and resolved in a manner that is responsive, reasonable and reproducible. (Page 11, 15-16.)

With respect to the goal of "reproducibility," the Task Force stated that "a particular set of facts should give rise to the same outcome, regardless of what office or individual makes the final decision." (Page 15.) TEI agrees in principle, but believes that the penalties system should lend itself to the resolution of penalty issues at the audit level. Specifically, we recommend that the IRS's Penalty Screening Committees (PSCs) should be utilized in the manner discussed in our April submission. ⁹ We do not believe CEP taxpayers should be forced to go to the Appeals Division to "negotiate" a proposed penalty. Nor should the Appeals Division have the authority to initially raise a proposed penalty with a taxpayer. Thus, if the examining agent in a CEP audit does not assert a penalty, the Appeals Officer should not be permitted to use the penalty as a perceived "bargaining chip."10

VI. DISCUSSION OF SPECIFIC PENALTIES

Part VII of the Task Force's Report is devoted to a discussion of six major penalty groups: (i) understatement, (ii) failure to file and failure to pay, (iii) information returns, (iv) preparer, promoter, and protester, (v) exempt organization, and (vi) employee plans.

The Task Force has done a generally commendable job of identifying the major issues that need to be addressed in respect of each of these categories of penalties. We suggest, however, that in framing the issues, the Task Force frequently deviated from the philosophy and goals set forth in the first six parts of its report. Stated simply, although suggesting (albeit tentatively) certain amelioratory changes to some penalty provisions, part VII of the Task Force's Report seemingly embraces penalties that deviate from the principles that should underlie a rational penalty system.

In the comments that follow, TEI offers its reactions to the Task Force's comments on specific penalty categories. For simplicity's sake, our views generally follow the organization of the Task Force's Report. ¹¹

A. NEGLIGENCE AND FRAUD PENALTIES. In its April comments, TEI argued that there should be no penalty in the absence of negligence or fraud -- that is, where the taxpayer does not engage in any proscribed conduct. We recommended, however, that the penalties for negligence and fraud should be refined and toughened, and the definitions of culpable conduct (negligence and fraud) should be clarified, either by statute or in implementing regulations.

We specifically urged that the level of the NEGLIGENCE PENALTY be substantially increased, but further recommended that the penalty should be based simply on an appropriately determined percentage of the amount of any deficiency attributable to negligence (NOT on the entire underpayment). Adoption of this latter recommendation would harmonize the negligence and fraud penalties and prevent situations where the assertion of a fraud penalty would result in a lower penalty than would the assertion of a negligence penalty. We also recommended that the penalty interest provisions be repealed. ¹²

TEI is pleased that the IRS Task Force has recommended that consideration be given to (i) whether the interest component of the negligence penalty should be repealed; (ii) whether the negligence penalty should be targeted; and (iii) whether the rate of the negligence penalty should be increased. (Page 19.) The IRS's adoption of TEI's recommendations in this regard would contribute to the development of a rational penalty system. The Task Force also concludes that the imposition of multiple penalties for a single instance of misconduct "seems unnecessary" (page 20) -- a conclusion TEI wholeheartedly supports. Accord ABA Report, at pages 38-39.

In this regard, we note that the ABA Report not only supports the repeal of the interest component of the negligence penalty (ABA Report, at page 39), but is also in accord with TEI's recommendation that the negligence penalty should be asserted solely with respect to the amount attributable to negligence, and not on the entire underpayment. (ABA Report, at pages 37-38.) In addition, TEI believes that the negligence penalty should not be imposed where the taxpayer discloses his position. For example, a taxpayer should not be penalized for intentionally disregarding rules and regulations where the taxpayer reasonably believes the regulation is not supported by the underlying statutory provision AND that position is disclosed on the appropriate income tax return. Accord ABA Report, at page 35.

B. SUBSTANTIAL UNDERSTATEMENT PENALTY. As both our April comments and the preceding discussion make clear, TEI is very much concerned about the theoretical basis for, and the application of, the substantial understatement penalty imposed by section 6661 of the Code. We have recommended that the provision be repealed, and are pleased that the ABA Report espouses a similar recommendation. (ABA Report, at pages 47-48.) Like the ABA, TEI believes that culpable taxpayer behavior can be adequately addressed by a refined negligence provision. ¹³

Given our recommendation that section 6661 be repealed, TEI is understandably dismayed by the approach taken by the IRS Task Force toward the substantial understatement penalty. The Task Force properly frames the issue as "what behavior should be penalized" (page 16), but proceeds to suggest that the failure to disclose "aggressive positions" is behavior that should be defined as noncompliance and, hence, penalized.

TEI continues to believe that the substantial understatement penalty is flawed in concept and application. The principal question is, concededly, what behavior should be expected from taxpayers. Its answer: a good faith effort to comply with the tax laws. Consequently, taxpayers "who endeavor in good faith to fairly self- assess [should] not be penalized." H.R. Rep. No. 97-760, 97th Cong., 2d Sess. 575 (1982) (Conference Report on the Tax Equity and Fiscal Responsibility Act of 1982) (discussion of section 6661). As the ABA Report states, the penalty should "reflect minimum standards, not ideal conduct." (ABA Report, at page 12.) Hence, even though taxpayers should aspire to more than non-fraudulent, non-negligent behavior, they should not be penalized for not achieving the ideal -- the filing of a virtually "perfect" tax return.

TEI is also concerned about the disparate treatment potentially accorded equally compliant (or noncompliant) taxpayers under section 6661 because of the 10-percent threshold for application. Thus, if two taxpayers -- one with a substantial amount of taxable income and the second with a net operating loss -- misreport the identical item on their return (for the same "reasons"), only the second may be subject to the substantial understatement penalty since the amount of the item might not equal or exceed 10 percent of first taxpayer's income tax liability. ¹⁴ In view of the goal of fairness and its component "equity," we suggest that it might be appropriate to revisit, as an independent matter, the use of a percentage threshold in section 6661.

TEI also believes that proponents of section 6661 misapprehend how taxpayers (especially large corporate taxpayers such as those that TEI members represent) make return reporting decisions and how the substantial understatement penalty operates. Thus, the Task Force intimates that the penalty is asserted against taxpayers that CONSCIOUSLY decide not to report "aggressive positions" -- those that choose to play the so-called audit lottery. For most CEP taxpayers, however, that is simply not the case. First, such taxpayers are under continual audit by the IRS and, accordingly, could not engage in the "audit lottery" even if they chose to. Perhaps more fundamentally, most of the section 6661 penalty situations with which TEI is familiar deal NOT with aggressive positions having been taken on the tax return, but rather with a multi-year and in-depth CEP audit uncovering facts that were unknown to the corporate tax department at the time the return was prepared. ¹⁵ Thus, the disclosure provisions afford no relief to CEP taxpayers in these situations.

As discussed in our April submission, TEI commends the IRS for adopting several of our recommendations concerning the scope of section 6661. For example the development of Revenue Procedure 85-26, 1985-1 C.B. 580, concerning the application of the qualified amended return provisions of the section 6661 regulations to taxpayers who are subject to the coordinated examination (CEP) program, and the expansion of the "adequate disclosure" revenue procedure (currently, Revenue Procedure 88-37, 1988-30 I.R.B. 31) to include treatment of items disclosed on Schedule M-1.

If section 6661 is to be retained, however, further recognition should be given to the special scrutiny to which CEP taxpayers are subjected. In this regard, the Task Force implied that the severity of penalties is a function of the small likelihood of an audit. (Page 19.) With respect to CEP taxpayers, however, the likelihood of an audit is quite high -- 100 percent. Consequently, consideration should be given to amending section 6661 to include a provision such as the following (which we proffered several years ago):

SECTION 6661(d). -- PROVISION FOR REGULARLY EXAMINED TAXPAYERS. -- With respect to a taxpayer that had, at the time the return referred to in subsection (b)(2)(A) was filed, at least 10 consecutive tax years examined by the Secretary and reasonably believed that the return being filed would also be examined, the standard of "reasonable basis" shall be substituted for the requirement of "substantial authority" in subsection (b)(2)(B)(i). For purposes of this subsection, the term "reasonable basis" shall include, without limitation, the treatment of an item by the taxpayer consistent with treatment found to be appropriate during a prior examination by the Secretary absent a change in the applicable statute. ¹⁶

Indeed, inasmuch as continually audited taxpayers cannot play the so- called audit lottery, we submit there is merit in the proposal to exclude such taxpayers from section 6661's reach altogether.

Even apart from a statutory change, we recommend that the IRS accord due weight to the enormous compliance burden faced by corporate taxpayers as well as to the manner in which corporate tax departments operate. Specifically, any determination of the taxpayer's reasonable belief (see page 18) should relate directly to the corporate tax department or, in the event outside tax advisers are used, to the management of the corporation who is in communication with such outside tax advisers. As then-Commissioner Egger assured TEI during the Institute's April 13, 1983, liaison meeting with senior National Office representatives:

"[T]he substantial understatement penalty is not aimed at companies acting in good faith, . . . TEI members will encounter far less trouble with the provision than they might think.

* * *

". . . [T]he burden imposed by section 6661 is great and . . . the corporate tax department must be able to rely on the company's internal controls. The issue . . . goes to the taxpayer's good faith. If a taxpayer follows its normal procedures but there is a 'glitch,' the penalty should not be imposed. In those cases, there should be a waiver." ¹⁷

Thus, where the company has established reasonable controls and has made a good faith effort to comply, the tax department's lack of knowledge with respect to certain facts should not give rise to the substantial understatement penalty.

Finally, we recommend that, if the substantial understatement penalty is retained, the recommendations set forth in our April submission with respect to (i) the waiver of the penalty, (ii) the definition of substantial authority, and (iii) the scope of the adequate disclosure provision be adopted. We note that our recommendations generally accord with the alternatives set forth in the ABA Task Force. (ABA Report, at pages 49-51.)

C. INFORMATION RETURN PENALTIES. In recent years, the information reporting requirements imposed by the tax law have grown enormously. Because of the scope of these rules and the corresponding number of opportunities for inadvertent -- if not unavoidable -- noncompliance, TEI believes it is important for the attendant penalties for noncompliance to be reevaluated.

Specifically, TEI agrees with the IRS Task Force that information return penalties should not unduly burden third parties nor be a mechanism of first resort in achieving compliance. (Page 20.) More fundamentally, we agree that if the taxpayer has instituted reasonable business practices to assure compliance and has made a good faith effort to comply, then any otherwise applicable penalty should be waived. Where there is an intentional determination not to comply with a known reporting requirement, of course, the assertion of penalties would be appropriate.

We similarly endorse the Task Force's statement that the penalty system should educate payers to comply voluntarily and, consequently, that first-time offenders should generally be warned rather than penalized. (Page 20.) We note, however, that the policy of not penalizing taxpayers in such situations is not being uniformly honored in the field. In this regard, we recommend that consideration be given to issuing a revenue procedure on the assertion of information return penalties, a principal goal of which should be uniformity of treatment. Accord ABA Report, at pages 118-19.

D. ESTIMATED TAX PENALTY. TEI is very concerned about the Task Force's characterization of the Code's estimated tax penalties. Specifically, the Task Force's Report states that "[w]hile denominated penalties, these additions to tax are, in reality, interest." (Page 27.) The report rationalizes its conclusion, by noting:

"Thus, when all is said and done and the taxpayer settles an account which includes this addition to the tax, the taxpayer merely pays to the Government the amount his or her funds earned at the time they should have been paid to the Government." (Page 27.)

The Task Force also intimates that corporations should be held to a higher standard than individuals with respect to estimated taxes, and suggests that the penalty might properly be increased since the high repeat rate shows that there are taxpayers who intentionally disregard the requirement. (Page 27.)

TEI submits that, regardless of how it is calculated, the estimated tax penalty is punitive in nature. (As Shakespeare might say, a penalty called another name would be deceit.) Nomenclature aside, we believe the Task Force's characterization of the penalty as a "mere" interest charge misses the point, which is that the overwhelming complexity of the tax laws makes it virtually impossible for corporations to accurately estimate their tax liability.

Contrary to the Task Force's bald assertion that taxpayers INTENTIONALLY disregard the estimated tax rules, the barriers to compliance are almost insurmountable. There is no doubt that corporate taxpayers are aware of their obligation to pay estimated tax. In today's climate of rapid and far-reaching change, however, the calculation of the amount to be deposited remains an obstacle. ¹⁸ This is especially the case where one set of substantive rules has an undeniable rippling effect on myriad others.

Indeed, in the current environment, so-called large corporations are faced with the unenviable choice of either subjecting themselves to a penalty (under section 6655) for underestimating their liability OR overpaying their taxes (in order to avoid the penalty). Concededly, if a corporate taxpayer's resources were unlimited and sufficient time were available, the precise estimation of its tax liability would be possible. Neither condition, however, is present. In this regard, we repeat our recommendation that --

(i) "large taxpayers" be permitted to base their estimated tax installments on their prior year's (or years') tax liability, OR

(ii) the interest-on-overpayment provisions (section 6611(a)) be amended to pay interest to taxpayers that are effectively compelled to overpay their estimated taxes.

E. FAILURE TO DEPOSIT PENALTIES. The Task Force rightly characterized the operation of the penalty for failure to deposit taxes in a timely fashion as "draconian." (Page 28.) The penalty is not time sensitive and, thus, is the same without regard to how delinquent the taxpayer's deposit is.

TEI agrees that the level of the penalty should turn on how long the taxpayer's noncompliance continues (thereby providing an incentive to correct errors). Moreover, in light of the large number of failure-to-deposit penalties that are incorrectly asserted (and subsequently abated), we favor the adoption of a procedure whereby the penalty is not asserted automatically but rather the taxpayer is provided with an opportunity to explain why it should not be asserted. (See page 28.) Such a procedure would contribute to increased taxpayer confidence in the fairness of the system.

F. EMPLOYEE PLAN PENALTIES. There can be no serious doubt that the Task Force is correct in stating that the underlying law in respect of employee plans (including those relating to plan disqualification) is "exceedingly complex." (Page 30.) We also agree that the mechanical disqualification of pension plans for failure to comply with the Code's complicated provisions will harm rank-and-file workers. The specter of disqualification (as well as the assertion of applicable excise taxes and penalties for failure to comply with myriad disclosure and reporting requirements) could potentially discourage employers from maintaining such plans. (See page 30.)

We endorse the Task Force's call for the development of a less formidable system of sanctions to promote compliance with tax and labor laws relating to employee plans. Specifically, we support the proposition that targeted excise tax provisions can more properly and fairly effectuate the policies underlying the Code's employee benefit provisions. (We do recognize, however, that in extreme cases disqualification may remain an appropriate sanction.) We recommend, moreover, that in administering the employee plan provisions, due consideration should be given (as the Task Force states) to whether the taxpayer reasonably believed that the position he had taken was correct. (See page 18.) In this regard, we believe that good faith or de minimis errors should not place the entire plan in jeopardy.

VII. CONCLUSION

Tax Executives Institute appreciates the opportunity to present our views on the IRS Task Force's Report on civil tax penalties. We believe that much of the report merits support and look forward to working with the Task Force in crafting the administrative and legislative proposals necessary to develop a rational and equitable penalty system.

TEI would be pleased to respond to any questions the Task Force might have about our comments. In this regard, please do not hesitate to call Charles W. Rau, chair of TEI's Task Force on Penalties, at (202) 887-3249 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.

Respectfully submitted,

We would be pleased, upon request, to provide the IRS Task Force with additional copies of our April submission.

² For simplicity's sake, the Executive Task Force is referred to in these comments as "the IRS Task Force" or simply "the Task Force." Unless otherwise noted, page references are to the typewritten version of the report of the IRS Task Force.

³ The report of the ABA Section of Taxation, which is captioned "Penalties Study Report," was prepared by a Penalties Task Force whose members were drawn from the Section's Committee on Civil and Criminal Penalties and its Committee on Administrative Practice. In these comments, the report is referred to as "ABA Report."

⁴ Thus, where there are two or more reasonable interpretations of the statute, taxpayers should not be penalized for adopting the interpretation most favorable to the determination of their tax liability, even if -- ultimately--that interpretation is not sustained as a matter of substantive law.

⁵ In this regard, we endorse the statement in the Task Force's report that "[g]iven that the purpose of penalties is not to punish the noncompliant, the fact of noncompliance is an insufficient basis for the imposition of a penalty." (Page 8.) We recommend that this thought be incorporated into the definition of a legitimate penalty.

We also recommend that in assessing whether a taxpayer's noncompliance should be subject to a penalty, consideration should be given to how long the applicable substantive rule has been outstanding. Where the underlying substantive provision is recently enacted or where the IRS has not yet issued necessary guidance, penalties should be only sparingly imposed for noncompliance. This assumes, of course, that there is a need for such administrative guidance; where the statute is clear on its face, the taxpayer's noncompliance -- even within the "grace period" -- should not merit special treatment.

⁶ The Task Force also stated that penalties serve to establish "norms of conduct." (Page 5.)

⁷ As we stated in our April comments, all penalty provisions should be placed within a single chapter or subchapter of the Code, with cross-references to and from the substantive provisions where appropriate. The adoption of this recommendation would, by itself, enhance taxpayer and IRS understanding of penalties.

⁸ This would be consistent with Blackstone's maxim, "It is better that ten guilty persons escape than one innocent suffer."

⁹ For-convenience sake, the portion of our April comments relating to the operation of PSCs (pages 25-28) is attached as an appendix to these comments.

¹⁰ See ABA Report, at page 84 (expressing concern about the potential for abuse where the assertion of a penalty is threatened during negotiations with the IRS).

¹¹ Thus, the order in which we discuss the specific penalties should not be construed as indicative of their relative importance to the Institute.

¹² As we stated in our April comments, "the penalty interest provisions serve no compelling function other than increasing the amount of the penalty (which is accomplished much more easily by raising the level of the basic penalty); repeal of the penalty interest provisions will also make computation of the penalty easier."

¹³ We agree with the ABA Report that section 6661 was "adopted by Congress based on an incomplete, inadequate or misconceived notion of the application of the negligence penalty and its suitability to deal with taxpayers who purportedly relied on advice from tax advisers." (ABA Report, at page 48.)

¹⁴ Indeed, the same taxpayer could find itself on either side of the penalty threshold with respect to the same item, depending on yearly fluctuations of its total income, deductions, and credits.

¹⁵ In our April comments, we listed several particular cases in which the substantial understatement penalty has been asserted -- at least at the audit level. Those situations included cases where IRS personnel have --

o asserted a section 6661 penalty after the taxpayer discovered on audit that an error had been made in making a Schedule M-1 adjustment and disclosed it to the examiner (the taxpayer's perception being that, absent taxpayer disclosure, the agent would not have found the item); and

o informed a taxpayer that the preparation of tax returns on the assumption that the financial books of account of a publicly traded and independently audited company were accurate was not sufficient to merit a waiver of the penalty at the audit level.

¹⁶ The adoption of a reasonable cause standard in such cases would be consistent with the Task Force's statement (at page 10) of "excusable cause."

¹⁷ A more comprehensive quotation from the approved minutes of the 1983 liaison meeting is set forth in our April submission.

¹⁸ The Task Force's report refers to the "high repeat rate" for the assertion of the estimated tax penalty, but offers no empirical data on the extent to which the "repeat offenders" are individual taxpayers, small corporate taxpayers, or "large corporations" (those that cannot avail themselves of the prior year's tax safe harbor).

Appendix: Excerpt from TEI's April 5, 1988, Statement on the the Civil Penalty Provisions of the Internal Revenue Code

[Page 25]

2. UTILIZATION OF PENALTY SCREENING COMMITTEE. Based on comments received from a number of our members, TEI questions whether Penalty Screening Committees (PSCs) are functioning appropriately in all districts. For example, in certain districts members believe that PSCs are, in fact, not reviewing proposed section 6661 assertions. In other districts, Penalty Screening Committees are perceived as mere "rubber stamps" for proposed penalty assertions.

An additional question relates to whether PSCs should review only situations where a penalty is proposed to be asserted or

[Page 26]

whether their role includes reviewing cases where the section's mathematical threshold is surpassed but the revenue agent (auditor) concludes that no penalty should be asserted. As a fundamental matter, TEI believes that the non-assertion of section 6661 penalties should NOT be reviewed by PSCs in order to avoid implied pressure to justify non-application or, more to the point, to assert the penalty in such cases. Routine quality control measures, however, would continue to be appropriate.

The stage during the audit at which a possible section 6661 penalty is forwarded to the PSC, as well as the development of the legal and factual facets of the automatic (by operation of statute) and discretionary waiver of the penalty, also seems to differ by district. To minimize confusion and facilitate the uniform application of National Office policy concerning the penalty, TEI recommends that the following procedure be implemented with respect to CEP audits in all districts.

o At the point during the audit when the Coordinating Agent determines that the section 6661 dollar threshold may be crossed and the Coordinating Agent tentatively concludes that the penalty may apply, the taxpayer should be given an Information Document Request (IDR) (Form 4564) that affords the taxpayer an opportunity to provide its rationale (as well as supporting authorities) for why the penalty should not be asserted. The taxpayer should be given a reasonable amount of time (say, 30 days) to respond to the IDR.

o Following receipt of the taxpayer's response to the IDR, the Coordinating Agent, with the

[Page 27]

approval of the Case Manager, should prepare a report to the PSC. A copy of the report should be provided to the taxpayer.

o The taxpayer should be given up to 30 days to submit a written response to the Coordinating Agent/Case Manager's report, which should be forwarded to the PSC. (Ideally, the Coordinating Agent/Case Manager's report and the taxpayer's response should be simultaneously provided to the PSC.)

o The PSC should make a decision whether the section 6661 penalty should be asserted. The Coordinating Agent/Case Manager, however, should retain authority not to assert the penalty, notwithstanding the PSC's decision.

Adoption of the foregoing procedure would standardize the handling of proposed section 6661 assessments in respect of all CEP taxpayers, thereby aiding uniformity of treatment. It would also permit more detailed development of the sometimes complex factual and legal questions attendant to a proposed CEP penalty at the audit stage and subject the matter to PSC scrutiny before the penalty is asserted by the IRS. Thus, adoption of the procedure would assure that issues relating to the possible existence of substantial authority, adequate disclosure, and the discretionary waiver of the penalty are more fully reviewed at the audit level. It would also permit a taxpayer to present its views on the applicability of the discretionary waiver to the PSC. Finally, it would avoid situations of possible intimidation of taxpayers by revenue agents or Appeals Officers using the section 6661 penalty as a lever to induce agreement from a taxpayer on a substantive issue that would otherwise be unjustified.

[Page 28]

We also suggest that it would be appropriate for the National Office to publish standards that would be utilized by all PSCs in applying section 6661 discretionary waivers. (See Item No. 6, "Development of a Penalties Revenue Procedure," below.)