Significant problems encountered by corporate taxpayers: comments submitted to IRS Taxpayer Advocate.

On May 9, 1997, Tax Executives Institute submitted the following comments to Lee R. Monks, Taxpayer Advocate of the Internal Revenue Service, on the significant problems faced by corporate taxpayers. The comments were prepared under the aegis of TEI's IRS Administrative Affairs Committee, whose chair is Robert L. Ashby of Northern Telecom Inc. Other members of the Institute participating in the development of TEI's comments were Stephen W. Boocock of Allegheny Teledyne, Inc.; Patrick J. Ellingsworth of Atlantic Richfield Company; John A. Gurovich of US West, Inc.; Sheldon A. Kimel of Brunswick Corporation; Robert J. McDonough, Jr. of Wang Laboratories, Inc.; Thomas B. Rogers of Apple Computer, Inc.; and Karen N. Wilson of NL Industries, Inc.

On behalf of Tax Executives Institute, I am pleased to submit the following comments on significant problems encountered by corporate taxpayers in their dealings with the Internal Revenue Service. We understand that the comments will be used in formulating the Taxpayer Advocate's annual report to Congress, which is due to be filed by December 31, 1997.

Tax Executives Institute is the principal association of corporate tax executives in North America. Our 5,000 members represent more than 2,700 of the leading corporations in the United States and Canada. 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 with which taxpayers can comply.

Last year, Congress passed the Taxpayer Bill of Rights 2, which requires the IRS's Taxpayer Advocate, among other things, to report to Congress on the top problems facing taxpayers. It came as no surprise to the Institute that your first report under TBOR 2 identified complexity as "the single most burdensome aspect of taxpayer compliance." TEI wholeheartedly agrees.

Simplification and the need to address tax law complexity have been major themes of TEI submissions for the past decade. We recognize that some complexity is unavoidable. TEI members conduct business in a complicated, sophisticated, and everchanging marketplace. It would be foolhardy to think that corporate tax law will ever be truly simple. It would also be wrong to assign the responsibility for the law's complexity exclusively to the Internal Revenue Service. There is plenty of blame to go around, with a full measure belonging to those who propose and enact our tax laws and to those who administer them. It would similarly be in error to conclude that the situation is hopeless. The law can be simpler -- and the IRS can clearly play a major role in the simplification effort. For example, the recent check-the-box regulations significantly streamlined the entity classification rules to the benefit of taxpayers and the government alike. The new entity classification rules demonstrate that both the tax laws and their administration can be improved. TEI believes that the tax system could generally benefit from more of the kind of "outside the box" thinking that produced these regulations.(1) Laws and implementing regulations can be simplified, recordkeeping requirements can be reduced, tax forms and schedules can be streamlined, audits can become more efficient, and burdens can be minimized.

Simplification has many facets. It lies not only in crafting legislative rules and regulations that are comprehensible and easily administered, but in providing timely guidance on what those rules and regulations mean. If taxpayers know what the tax system demands of them, they will be able to adapt their recordkeeping and compliance practices accordingly. If the IRS interpretation is not known until years after the fact, taxpayers cannot possibly comply with the laws. Hence, we believe that many of the burdens imposed by the Internal Revenue Code are attributable to the IRS's not publishing sufficient, timely guidance on the law's scope. The best example of this is perhaps the Treasury Department and IRS's issuance of only limited guidance on the proper treatment of certain expenditures as ordinary or capital in nature (which affects their current deductibility). The lack of guidance has spawned considerable audit activity as field agents have sought to capitalize expenses that have long been treated as currently deductible, based on the Supreme Court's decision in INDOPCO v. United States, 503 U.S. 79 (1992). In TEI's view, the IRS National Office has missed an opportunity to bring clarity to the area by issuing generally applicable guidance. We renew our request that such guidance be made a top priority.(2)

In other areas, the IRS's guidance may further complicate an already complex body of law. For example, in the 1980s Congress tried to simplify the deductibility of contributions to foreign employee pension plans by enacting section 404A. A decade after the law was enacted, however, the IRS issued proposed regulations that in our view (and that of other commentators) undermine congressional intent -- as well as conflict with IRS guidance issued in the interim period. To make matters worse, the proposed regulations were retroactive, requiring in some instances for companies to recalculate their pension contributions back to the 1970s. In spite of taxpayer protests concerning the complexity of the regulations and their challenge to the IRS's authority to implement them, the regulations have yet to be withdrawn.

Closely related to the need for simplification and guidance is the need for more effective training of IRS personnel. Complex and changing laws obviously require better training, not only on technical tax matters but also in the use of computers and software programs. For too many years, the IRS has been forced to play "catch up" with technological advances; its agents are often unable to process data using taxpayers'equipment. Their paper-based approach hampers their ability to audit effectively and efficiently. We recognize that the IRS has tried to develop their own programs (such as STAR for foreign tax credits and the nascent Los Alamos project for calculating hedging transactions), but the agency still lags behind in its ability to review and analyze taxpayers' commercial activities. The lack of technological ability is troubling for the future of tax administration. Equally important, the IRS's desire to develop algorithmic quick fixes may yield "fool's gold" solutions that ignore the complexity of the global economy and fail to withstand scrutiny.

Below are six specific areas where TEI believes significant improvements can be made.

Interest Netting

The IRS and Treasury recently issued a report on interest-netting problems faced by taxpayers who simultaneously owe money to -- and are owed money by -- the federal government. Among our members, this is a common occurrence. The report concludes that legislation is necessary to permit "global netting" of interest. A call for legislation to provide for global netting on a prospective basis was included in the Clinton Administration's simplification proposals issued in April.

TEI does not wish to seem ungrateful, but we believe it nothing short of scandalous that it has taken the government 11 years to address the global interest-netting issue. In the legislative history of the Tax Reform Act of 1986, Congress signaled its desire to ameliorate the unfairness of section 6621's interest-rate differential (whereby the interest rate imposed on underpayments is higher than the rate paid on overpayments). H.R. Rep. No. 99-841, 99th Cong., 2d Sess. II-785 (1986) (Conference Report). Twice since then (in 1990 and 1994) Congress formally reiterated its intention that netting procedures be developed. Notwithstanding these express concerns, the IRS failed to develop any netting rules and even argued in court (in the Northern States Power case) that the Code's interest differential permits the government to exact interest payments from a taxpayer who at all times is a net creditor of the government. Such heavy-handed actions, even if defensible under a literal reading of the Code, prompted Congress in TBOR 2 to mandate a joint IRS-treasury Department study on interest netting.

TEI has long believed that Treasury Department has ample authority to resolve the netting problem by regulatory action. That the IRS-treasury study concluded otherwise is disappointing, if for no other reason than it betrays a total lack of urgency to provide taxpayers with redress. Now, taxpayers will be forced to wait even longer for the enactment of legislation and the issuance of regulations before a fair system of interest netting is implemented. What is more, the contour of the Treasury's proposals in our view is unfairly and arbitrarily circumscribed. This situation cannot help but contribute to an environment in which cynics call for tearing the current tax system out by its roots and in which those calls resonate with the public at large. There are ways to address the IRS's administrative concerns about the agency's ability to net interest on overpayments and underpayments, and they should have been implemented years ago.

Tax and Interest

Computations

TEI members are concerned about the IRS's computation processes, especially in Appeals. Specifically, computations that were agreed to during the examination are changed, sometimes without notice to the taxpayer, and frequently the taxpayer does not have an opportunity to discuss the computations with the relevant Appeals personnel. Even where that is not the case, the process seems to take an inordinate amount of time and often merely duplicates what was done during the examination. TEI believes that there should be a coordinated computation unit that both Examination and Appeals could call on, rather than have each division do the calculations independently. Appeals should not start from scratch when it receives a case. We also suggest that by performing the computations upfront, considerable time could be saved.

A separate, but related issue is the computation of interest. Our members report difficulties in verifying interest computations. Indeed, many members find it almost impossible to obtain a copy of the interest computations to verify whether they are correct and often must seek repeated iterations before obtaining a reliable figure. Without access to the IRS's interest worksheets, taxpayers may be forced to hire outside consultants (normally retired Service Center employees) to verify computations. At a minimum, taxpayers should receive an explanation of how interest is calculated.

Inappropriate Threat of

Penalties

TEI strongly believes that a rational penalty system must recognize that taxpayers who endeavor in good faith to comply with our amorphous body of tax law should not generally be penalized. Penalties should only be used to punish non-compliant behavior. Thus, penalties -- or the threat of penalties -- should not be used as a bargaining chip to compel a settlement of issues -- such a practice is anathema.

Nevertheless, the specter of the penalties often casts a shadows over the resolution of the underlying tax issues. We recognize that the IRS has a responsibility to assert penalties in appropriate cases, but submit that a system that encourages or permits penalties to be used as a weapon borders on the unprofessional and is open to abuse. Taxpayer concerns about the IRS's approach to penalties are heightened by the 1997 Examination Program Letter, which provides that one of the criteria for the evaluation of district offices is the number of penalties proposed during the audit.(3)

Taxpayers' concerns about the misuse of the penalty provisions is particularly acute in respect of pension plan audits. The IRS's closing agreement program (CAP) is intended to provide a mechanism for settling -- on a basis short of plan disqualification -- issues relating to minor defects in the administration of pension plans. In developing the plan, the IRS seemingly recognized that the pension law is highly complex and that small operational defects may arise even when the taxpayer acts in good faith and with due diligence, but should not result in the disqualification of the plan and the attendant heavy tax consequences for employers and employees. TEI members report, however, that the theory underlying the CAP program is often turned on its head in practice. Rather than fostering the rational administration of pension plans, CAP has been used in some cases to force taxpayers to pay exorbitant penalties in order to forestall disqualification of their pension plans. Anecdotes of taxpayers' paying a King's ransom to stave off plan disqualification -- which are not isolated -- can only underscore concerns over how the IRS views the role of penalties in the tax system.

The IRS's Coordinated

Examination Program

The Coordinated Examination Program (CEP) represents the effort to deal with the special challenges posed by the tax returns of the largest companies in the country. Companies in the CEP program are under continual audit by the IRS. A team of two or more agents maintain offices on the taxpayer's premises and interact on virtually a daily basis with the taxpayer's personnel. The IRS team will often include economists, engineers, international examiners, and computer specialists. These agents will issue a multitude of information document requests (IDRs) and prepare a large number of Notices of Proposed Adjustments (NPAs) to which the taxpayer must respond. During the past five years, the IRS has successfully undertaken a number of initiatives to reduce the burden on companies that are part of the CEP program and generally to make the CEP program operate more efficiently. TEI is pleased to have cooperated with the IRS in these endeavors.

On the whole, TEI is supportive of the CEP program. At the same time, we have concerns about the effectiveness of communications and program initiatives from the IRS National Office through the Regional and District Offices to the individual field agents and specialists who conduct CEP examinations. Hence, although the National Office has developed programs to reduce taxpayer burdens and enhance the management and conduct of CEP cases, there has been an inconsistent implementation of these initiatives by field personnel. More training is needed in the field to educate agents about the benefits of these initiatives to taxpayers and the IRS and to encourage them to use them on a regular basis.

Specifically, some taxpayers have seen a decline in voluminous and unfocused IDRS as a result of initiatives to involve the taxpayer more in the audit planning process, but others continue to receive extraordinarily large numbers of specific requests that sometimes bear little relation to the taxpayer's business. Again, greater efforts must be undertaken to impress upon field agents the need to use burden-reducing techniques. In this regard, taxpayers continue to be concerned that the IRS's measures for evaluating agent performance and its establishment of compliance and program production goals have contributed to an environment in which proposed adjustments have greater weight than sustained adjustments.

Finally, TEI members remain frustrated with the role of the specialist in the CEP examinations. Case managers often seem to lack, or cede, control over the specialists and hence fail to properly "integrate" their work into the overall audit. This has led to delays, poor development of facts, and the raising of insubstantial or meritless issues. These issues may ultimately be dropped -- frequently they are -- but not before the expenditure of considerable time and money by the taxpayer as well as the IRS. We are pleased that local TEI chapters have begun to work with some IRS districts to improve the overall audit process. Effective supervision of the specialists and better integration of their work into the examination process on an across-the-board basis, however, should remain a top priority.

Record Retention Agreements

Some of the most significant burdens imposed on corporate taxpayers relate to the requirement that extensive records be maintained in respect of taxable years subject to audit. Although taxpayers clearly have a responsibility to maintain records to support the positions taken on their tax returns, we believe much can be done to minimize the burden that currently exists (especially for those corporate taxpayers that have many years open to IRS examination). Many IRS districts are reluctant, however, to enter into record retention agreements. We believe that the use of such agreements can minimize taxpayers' burdens and streamline audits. IRS districts should be encouraged to enter into agreements with taxpayers concerning what records should be kept.

Moreover, in 1993 TEI worked extensively with a team of IRS representatives in developing an alternative to Rev. Proc. 91-59, 1991-2 C.B. 841, which sets forth the IRS's basic requirements in respect of the retention of records. The 1991 revenue procedure had been criticized -- rightly so -- as being unduly restrictive and negative, and the 1993 project was intended to empower taxpayers to control their record retention programs. The product of the 1993 project was a compromise -- neither TEI nor the IRS representatives viewed the draft as perfect, but both sides saw it as a significant improvement over Rev. Proc. 91-59. Nevertheless, nearly four years have passed since TEI formally submitted the proposed revision to the Commissioner. We believe immediate attention should be given to this project, which affects all corporate taxpayers.

TEFRA Partnerships

A TEFRA partnership is any partnership that is not a small partnership (defined as a partnership consisting of fewer than 10 natural persons). Thus, any joint venture between two or more corporations is subject to the TEFRA partnership rules.

The TEFRA rules are extremely complex and present numerous traps for the unwary. For example, the statute of limitations for a TEFRA partnership is not the same as the statute of limitations for a corporate partner and the audits are performed outside the scope of the "normal" CEP audit. If a refund arises from the audit of a TEFRA partnership, the partner's statute of limitations may well have expired, thereby barring a refund claim.

The TEFRA partnership procedural rules have produced a great deal of frustration among taxpayers, in part because CEP agents do not always seem conversant with these myriad provisions. The simplest solution would be to exempt CEP taxpayers from the TEFRA partnership rules and we believe that the IRS should be encouraged to seek such a legislative solution. (In this regard, we note that the Clinton Administration's simplification proposals include some clarification of the TEFRA partnership rules.) At a minimum, the IRS should include a section detailing the many and varied TEFRA partnership rules in its Internal Revenue Manual.

TEI appreciates the opportunity to recommend issues to be included in the Taxpayer Advocate's 1997 report to Congress. If you have any questions or need additional copies of these comments, please do not hesitate to call Timothy J. McCormally of the Institute's professional staff at [phone].

(1) In contrast, taxpayers are still awaiting final regulations to simplify the calculation of a foreign corporation's earnings and profits through the use of generally accepted accounting principles. The proposed GAAP E&P regulations were issued almost five years ago, but, in spite of a TEI request, the project is not even included on the IRS's 1997 business plan for completion this year. Thus, even when the IRS reaches a creative solution, taxpayers have been left to wonder when the project will become reality.

(2) Since the Supreme Court's 1992 decision in INDOPCO, TEI has filed numerous submissions with the IRS, elaborating on the types of guidance needed. Upon request, we shall provide you with copies of those comments.

(3) Under the Field Office Performance Index (FOPI), districts are measured on various criteria, including the cycle time and the recommended additional tax and penalties. Document 6790 (Rev. 12-96), Examination Program Letter for Fiscal Year 1997, APP. F. We regret to say that if the IRS evaluates districts on the basis of penalties asserted, then the assertion of penalties -- as a bargaining chip or otherwise -- will increase.