Tax penalty provisions of the Budget Reconciliation Act of 1989.

Tax Penalty Provisions of the Budget Reconciliation Act of 1989

November 14, 1989

On November 14, 1989, Tax Executives Institute filed the following comments with members of the House-Senate Committee on Conference concerning the penalty provisions of the Budget Reconciliation Act of 1989. The Institute's submission was prepared under the aegis of TEI's IRS Administrative Affairs Committee, whose chair is Linda B. Burke; Charles W. Rau, former chair of the Institute's Penalties Task Force, participated in the development of the Institute's comments.

Tax Executives Institute, Inc. supports the enactment of legislation reforming the civil penalty provisions of the Internal Revenue Code and urges Congress to include such provisions in the Budget Reconciliation Act of 1989. The House Bill (H.R. 3299) contains a comprehensive set of provisions reforming the tax law's penalty provisions. Although the Senate budget legislation is silent on the subject, the Senate Finance Committee approved substantially similar legislation on October 4; in addition, on October 24, a separate penalties bill (S. 1784) was introduced by Senator David Pryor.

TEI believes that penalty provisions of the House Bill, the Finance Committee Bill, and the Pryor Bill represent a definite improvement over current law, and we are convinced that the enactment of any of the bills would be a long and much needed step forward. This letter discusses significant differences among the three bills and the need to clarify certain issues in the Conference Committee Report.

Accuracy Penalties -- Adopt Three-Tier Penalty System

A principal difference between the House and Finance Committee Bills (on the one hand) and the Pryor Bill (on the other) is that Senator Pryor's bill would maintain a three-tier penalty system, whereas the House and Finance Committee Bills would adopt a two-tier system by essentially equating substantial understatements of tax liability with negligence. TEI supports the provision in the Pryor Bill.

In contrast to the House and Finance Committee Bills which would impose a 20-percent penalty for both substantial understatements of tax liability and negligence (proposed section 6662 of the Code(1)), the Pryor Bill would impose a 15-percent penalty for substantial understatements (proposed section 6662) and a 25-percent penalty for negligent behavior (proposed section 6663). Thus, S. 1784 would recognize that the degree of taxpayer culpability in respect of negligence is significantly greater than that in respect of substantial understatements. We believe such a distinction is valid as a matter of both tax policy and equity.

Clarify "Reasonable Cause" and "Good Faith" Standards

All three bills would provide that no penalty will be imposed if the taxpayer acts in good faith and with reasonable cause (proposed section 6724(a) under all three bills; proposed section 6664(c) under the House and Finance Committee bills, and proposed section 6666 under the Pryor Bill).

TEI supports the enactment of a statutory reasonable cause exception. We recommend, moreover, that the Conference Report include the following example of what constitutes reasonable cause for purposes of filing information returns and payee statements, as well as for purposes of the Code's delinquency and substantial understatement penalties:

Reasonable cause will be

deemed to exist where (i) a

taxpayer establishes

reasonable business procedures to

ensure compliance with its

obligation, and (ii) the

taxpayer makes a good faith

effort to comply with those

procedures.

Additionally, we ask that the Committee Report confirm that "[i]n determining whether a corporate taxpayer has exercised good faith, the inquiry should be directed to those persons within the company who have tax responsibility or to such outside tax advisers as the company may retain."

Finally, we urge the conferees to reject the proposal in the House and Finance Committee Bills to limit the reasonable cause exception to the valuation overstatement penalty where the taxpayer has not obtained a qualified appraisal (proposed section 6664(c)(2)). The Pryor Bill would not impose this limitation, thereby implicitly recognizing that in certain circumstances a taxpayer can satisfy the reasonable cause exception without obtaining a qualified appraisal.(2)

Accuracy Penalty -- Reliance on "Secretarial List"

The House and Finance Committee Bills would require the Secretary of the Treasury (or his designate) to prescribe a list of positions affecting a significant number of taxpayers for which the Secretary believes there is not substantial authority, but would not permit taxpayers to rely on the list (proposed section 6662(d)(2)(D)). The Pryor Bill does not contain the "Secretarial list" provision.

TEI submits that taxpayers should be given the right to rely on the Secretarial list on the grounds that tax administrators, taxpayers, and tax advisers have a shared responsibility in maintaining a viable self-assessment tax system. If taxpayers do not have the right to rely on the list, however, the relief offered by the provision will be of limited value. Indeed, the provision could be characterized as a "one-way" street. We recommend that if the Secretarial list provision is retained in the penalty reform package, taxpayers should be subject to the substantial understatement penalty only for failing to disclose issues contained in the list.

Apply Identical Standard to Taxpayers and Tax Advisers

Under all three bills, taxpayers would be subjected to a higher standard ("substantial authority") than would the return preparers and advisers on whom they rely ("realistic possibility of being sustained on the merits" under the House Bill and "reasonable basis" under the Finance Committee Bill).(3) TEI cannot fathom a tax policy basis for this double standard -- especially since tax advisers are held out to the public (by licensing, professional standing, etc.) as available to provide expert tax advice.

Indeed, TEI believes that the application of the same standard to both taxpayers and their advisers would be consistent with the goal of recognizing the mutual obligation to our tax system that should be shared by taxpayers, practitioners, and the government. Consequently, we believe it would be appropriate to revise the substantial understatement penalty to incorporate the "realistic possibility" standard set forth in the return preparer provisions of both the House and Pryor Bills.

Failure to File Correct Information Returns -- Remove Limitation

The House and Finance Committee Bills would provide that no penalty will be imposed in respect of the filing of incorrect information returns where the error is corrected by August 1; the number of information returns to which this provision applies, however, is limited to the greater of (i) 10 or (ii) one-half of one percent of the total number of information returns required to be filed (proposed section 6721(c)). The Pryor Bill would grant the Secretary of the Treasury authority to fix the self-correction deadline and would further eliminate the limitation on the number of returns that can be so corrected (proposed section 6721(c)).

In light of the substantial uncompensated burden already placed on payers to file information returns, TEI supports the provision in S. 1784 that would remove the limitation on the number of information returns that can be corrected penalty-free.

Failure to Furnish Correct Payee Statements -- Time-Sensitivity and Gross-Receipts Exceptions

The House and Finance Committee Bills would impose reduced information return penalties where the payer's failure is cured within a specified period and would impose a lower ceiling on the total amount of such penalties that could be levied in the case of the payer's having gross receipts of not more than $5 million (proposed section 6721(d)). Those bills, however, would not extend these time-sensitivity and gross-receipts exceptions to the penalty for failure to furnish correct payee statements (proposed section 6722).

The Pryor Bill, in contrast, would apply these exceptions in respect of both the information return and the payee statement penalties (proposed sections 6721(d) and 6722(c)). TEI supports the Pryor Bill's provision, which we believe would motivate payers to file delinquent payee statements. Thus, S. 1784 properly places the emphasis not on penalizing inadvertent or short-term failures but rather on ensuring that payees receive the necessary information to ensure compliance with the income tax laws.

Information Return and Payee Statement Penalties -- Adopt Anti-Stacking Rule

Under the House and Finance Committee Bills, it would be possible for two penalties to be levied in respect of the same payment -- for example, one penalty could be imposed for filing an incorrect information return, and a second penalty could be imposed for filing an incorrect payee statement (proposed sections 6721 and 6722). The Pryor Bill contains an "anti-stacking" provision to ensure that only one penalty would be imposed in such situations (proposed section 6724(b)).

TEI supports the anti-stacking provision of S. 1784, which would ensure that the potential overlap of related penalties will not frustrate the congressional policy underlying the time-sensitivity provisions. We also urge that the Committee Report clarify that where a single failure to provide certain information (e.g., a correct taxpayer identification number) could lead to the imposition of penalties under both proposed section 6721 (penalty for filing an incorrect information return) and proposed section 6723 (penalty for failure to comply with other information reporting requirements), only the section 6721 penalty would be imposed.

Repeal Special Interest Rate on Underpayments Attributable to Tax-Motivated Transactions

The House and Finance Committee Bills would repeal section 6621(c) which provides that the interest rate on underpayments attributable to "tax-motivated" transactions will be imposed at 120 percent of the normal tax interest rate. The Pryor Bill would retain the special rule.

TEI supports the provision in the House and Finance Committee Bills. We believe current law (which S. 1784 would retain) is not only unduly complex but is fraught with ambiguity over the scope of the phrase "tax-motivated transactions."

Date for Triggering Maximum Penalty for Failures to Deposit Tax

All three bills would impose a 15-percent penalty where a failure to make a required deposit of tax continues beyond a specified date (proposed section 6656(b)(1)(B)). (Lesser penalties apply where the failure is cured earlier, thereby encouraging complicance.) Whereas the House and Finance Committee Bills would impose the maximum 15-percent penalty based on a taxpayer's failure to make a required deposit within a specified number of days after a delinquency notice to the taxpayer is issued under section 6303, the Pryor Bill would measure the specified period from the date a notice is required under section 6331(d) before a levy can be made.

TEI supports the section 6331(d) trigger provision contained in the Pryor Bill but urges the conferees to adopt the effective date provision of the House and Finance Committee Bills. Thus, we recommend that the reforms in the failure-to-deposit provisions of the Code apply in respect of deposits required to be made after December 31, 1989.

Reform Corporate Estimated Tax Penalty Provisions

Regrettably, none of the bills addresses the Internal Revenue Code's corporate estimated tax penalty for those large corporations with taxable income of more than $1 million in any of the preceding three years. Consequently, the group of taxpayers that objectively is least able to accurately estimate their tax liability -- because tax depreciation, foreign tax credits, etc., are determined only on an annual basis -- will continue to be the only taxpayers that are unable to base their estimated tax payments on their prior years' liabilities.

In effect, large corporations are required to overpay their estimated taxes, without the benefit of interest, in order to avoid an underpayment penalty while other taxpayers may avail themselves of a statutory safe harbor. This odious situation, moreover, is attributable not to sound tax policy but rather to revenue considerations.

TEI has long recommended that Congress either (i) restore an estimated tax safe harbor for large corporations (e.g., permitting them to base their estimated tax payments on their prior years' liabilities), or (ii) at least provide for the payment of interest on forced overpayments of estimated tax installments. We recognize that the constraints and the exigencies of the budget reconciliation process may prevent needed reform of the corporate estimated tax provisions in 1989. We respectfully submit, however, that no inquiry into the penalty area can properly be considered complete until this subject is meaningfully addressed.

Consequently, to ensure that the revenue and equity issues raised by the corporate estimated tax area are fully explored, we recommend that the Conference Report instruct the Treasury Department to conduct a study of the need for corporate estimated tax relief for large taxpayers.

Conclusion

Tax Executives Institute believes that penalty reform is absolutely necessary to restore confidence in the fairness and integrity of our self-assessment tax system. We urge the conferees to include the reform provisions in the 1989 Budget Reconciliation Act.

(1)Unless otherwise noted, all references to sections are to sections of the Internal Revenue Code of 1986, as such section would be amended by the three penalty reform bills. (2)Comprehensive rules under section 170 already govern the substantiation of the value of charitable contribution property. TEI submits that, where a taxpayer fully abides by the substantiation regulations and otherwise acts in good faith, the assertion of a valuation overstatement penalty would be improper. Consequently, such a taxpayer should not be precluded from relief under the reasonable cause exception. (3)The "substantial authority" standard is set forth in proposed section 6662(d)(2)(B)(i) under the House and Finance Committee Bills and proposed section 6662(b)(2)(B)(i) under the Pryor Bill; the "realistic possibility of being sustained on the merits" standard is set forth in proposed section 6694(a)(1) (under the House and Pryor Bills). The Finance Committee Bill does not address the standard to be applied to tax advisers and return preparers, thereby retaining the "reasonable basis" standard of current law (section 6694's penalty for negligent or intentional disregard of rules and regulations).

PHOTO : 1989 Annual Conference: Outgoing TEI President Larry Langdon pins the International

PHOTO : President's pin on Bill Burk's lapel as Barbara Burk looks on.