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IRS Penalty Handbook: information return penalties.

On March 10, 1994, Tax Executives Institute submitted the following comments to the Internal Revenue Service on the portions of the IRS's draft penalty handbook relating to information reporting penalties. The comments took the form of a letter from TEl President Ralph Welland to Joan R. Dolian, the IRS's Director, Penalty Administration. They were prepared under the aegis of the Institute's IRS Administrative Affairs Committee, whose chair is Robert D. Adams

of Halliburton Company, and its Payroll and Other Taxes Subcommittee, whose chair is Clifford H. Omo of Mobil Administrative Services Company, Inc. Michael J. Nesbitt of Paychex, Inc., Nathan Rosen of MCI Communications Corporate, and Joseph A. Cottonaro of Hershey Foods Corporation contributed materially to the preparation of the comments.

In response to the IRS's request, Tax Executives Institute is pleased to provide the following comments on the draft of Chapter 10, Information Return Penalties, of the IRS Penalty Handbook.

General Comments

As noted in our comments on the draft of Chapter 11 of the IRS Penalty Handbook, TEI believes that the draft Handbook represents a good effort at outlining the applicable penalties. We suggest, however, that the IRS include more examples relating to situations where penalties should not be asserted (for example, with respect to inconsequential omissions) and the application of the reasonable cause exception. We believe that such an approach will provide more guidance to agents and will help ensure that penalties are asserted only where there is taxpayer misconduct.(1)

Sections (20)(10)12.23 and (20)(10)33: Intentional Disregard of the Rules and Regulations

A. Section 6723 Penalty. Section (20)(10)12.23 of the draft provides that the intentional disregard of the rules and regulations penalty applies when the facts and circumstances show that the filer knowingly or willfully failed to comply with the requirements of sections 6721 (failure to file correct information returns), 6722 (failure to furnish correct payee statement), or 6723 (failure to comply with other informationreporting requirements) of the Code. Subsection (3) states that there is no dollar limitation for the intentional disregard of the rules and regulations penalty.

The draft Handbook is correct that under sections 6721 and 6722, an additional penalty is provided with no maximum limitation for the intentional disregard of rules and regulations. It is incorrect, however, with respect to the section 6723 penalty. That penalty provides a maximum penalty of $100,000 for the failure to comply with a specified informationreporting requirement; there is no specific provision, however, for the intentional disregard of rules and regulations. We recommend, therefore, that the reference to section 6723 be deleted. (The reference to the intentional disregard of rules and regulation penalty should also be deleted from section (20)(10)51(5).

B. Facts-and-Circumstances Test. Section (20)(10)12.23(1) provides that one of the factors to be taken into account in determining knowledge or willfulness is whether the filer made the same failure in prior years.

Many fliers--particularly small businesses and businesses operated by individuals for whom English is not a first language--may not be fully aware of all filing requirements. While ignorance of a filing requirement should generally not, by itself, be deemed sufficient to establish reasonable cause, a pattern of failure among these filers may not constitute willfulness. For purposes of the more substantial penalty for intentional disregard of the rules and regulations, we suggest that such filets be given the benefit of the doubt. The Handbook should clearly state that the filer should reasonably have been expected to be aware of the requirements before the penalty is imposed. TEl therefore recommends clarifying subsection (a), as follows:

(a) Did the person make the same failure in prior years where the person could

have been reasonably expected to be aware of the filing requirements? Pattern of

conduct-repeated offense."

C. Cost of Compliance. We must confess some puzzlement over the statement in section (20)(10)33(3) of the Handbook that "when determining if the flier knowingly or willfully failed to timely file or failed to include correct information, determine if the penalty is less than the cost of complying with the information reporting requirements." What is the effect (if any) of a determination that the amount of the penalty is lower than the cost of compliance? If the cost of compliance is higher (or lower), is the penalty not to be asserted in such circumstances? Is the relief provision available only for minor offenses? If so, the cost of compliance should also be taken into account when assessing the other informationreporting penalties." In any event, the section should be clarified.

Section (20)(10)(10)2: Reasonable Cause

A. Existence of Reasonable Cause. Section (20)(10)(10)2 of the draft sets forth the circumstances under which the IRS can waive an information-reporting penalty because the filer has established reasonable cause. Subsection (9) provides that reasonable cause exists where

* the filer acted in a responsible manner, both before and after the failure occurred;

* there are significant mitigating factors; or

* the failure was the result of circumstances beyond the filer's control.

TEI believes that penalties should generally apply only in situations involving taxpayer misconduct, and not where good faith efforts are made to enforce reasonable business procedures. Reasonable procedures established by a corporation's tax department should generally form the basis for a finding of reasonable cause. We therefore recommend that subsection (9) be amended to read, as follows:

(9) Reasonable cause for the information return penalties exists when there ha s been no intentional disregard of the filing obligation, and the filer acted in a

"responsible manner" (as defined in subsection (10)), both before and after the failure occurred.

We also recommend that subsection (10) include the following example:

A filer will generally be deemed to have acted in a responsible manner if it s tax department acted in a responsible manner in directing another division of th e company to prepare or file information returns but that division; despite reason able follow-up procedures, failed to properly implement such direction.

B. Definition of "Responsible Manner." Section (20)(10)(10)2(10) discusses when a filer is considered to be acting in a responsible manner in handling account information such as account numbers and balances. This subsection includes the following statement:

(a) For example, if a bank made the same failure with respect to its savings account customers, would a reasonably prudent person consider this action to be below the standard of care that the bank should use?

Handling account numbers and balances is one of the primary operations performed by banks. More important, this process involves accounting for funds entrusted to the banks by their customers. As such, a reasonably prudent person would hold a bank to a very high standard of care with respect to such information. This same reasonably prudent person would most likely not apply the same standard to, for example, a small business's handling of the account number of, and amount of payments to, one of its vendors. The Handbook sets too high a standard for the average filer. We suggest the quoted language be deleted.

C. Significant Mitigating Factors. Section (20)(10)(10)2(11) discusses the significance of a filer's history of compliance for purposes of establishing reasonable cause. For this purpose, consideration is given to whether the filer was previously penalized under sections 6721, 6722, or 6723 of the Code.

TEI believes that this section should state that consideration is given to the filer's established history of compliance with the reporting requirements with respect to which the failure occurred, in accordance with Treas. Reg. [sections] 301.6724-1(b)(2). In other words, a previous assessment of a penalty under section 6723 should not taint the filer's history of compliance with sections 6721 and 6722.

In addition, the Handbook should explain what constitutes being "penalized" for purposes of evaluating the filer's history of compliance. For example, if no penalty is assessed under section 6721 because the failures are within the de minimis exception, has the filer been penalized? If penalties are waived because the filer clearly demonstrated reasonable cause, has the filer been penalized? We suggest that the answer to both questions is "no." If a filer's history is a factor in determining whether a penalty should be imposed, isolated failures or failures as a result of events beyond the filer's control should not categorize that filet as one with an established history of noncompliance. The Handbook should clearly reflect this philosophy.

D. Events Beyond a Filer's Control. Section (20)(10)(10)2(12) sets forth the events that are generally considered to be beyond the control of the filer. Subsection (a), Availability of Business Records, provides that business records must not have been available - (1) as a result of unforeseen circumstances,

(2) in a manner that would prevent timely compliance (ordinarily at least a two-week period prior to the due date of the information return), and

(3) the unavailability was caused by a supervening event.

Treas. Reg. [sections] 301.6724-1(c)(2) provides that the business records must have been unavailable "in a manner which would prevent timely compliance (ordinarily at least a two week period prior to the due date (with regard to extensions) of the required return or the required date (with regard to extensions) for furnishing the payee statement) .... " We recommend that the italicized language be added to section (20)(10)(10)2(12)(a)(2).

E. Supervening Event

1. Statutory or Regulatory Changes. Section (20)(10)(10)2(12)(b) sets forth the definition of a "supervening event." Subsection 2 includes the following example --

a statutory or regulatory change that relates directly to the data processing and is made so close to the time the information return or statement is required

that the change cannot be made ....

To conform with Treas. Reg. [sections] 301.6724-1(c)(2)(ii), this subsection should provide that reasonable cause exists where the change "is made so close to the time the information return or statement is required that, for all practical purposes, the change cannot be made." For example, consider a situation where the filer could comply with the change only by having employees working around the clock and incurring substantial overtime costs. Although compliance may be technically feasible in these circumstances, no penalty should be imposed because the cost would have been prohibitive. The addition of the italicized language would apply a reasonableness standard to the efforts that a filer must make in order to comply with a statutory or regulatory change.

2. Addressing a Return to a State Taxing Authority. Subsection 5 provides that erroneously addressing a return to a state taxing authority does not, in itself, constitute reasonable cause. Subsection 6 provides, as follows:

Further documentation of the circumstances the taxpayer asserts as reasonable cause is needed as evidence the taxpayer exercised ordinary business care and prudence (as required by Regulation 301.6651-1(c)), and was nevertheless unable to file o n time. Acceptable documents must include all of the following: 1) an excellent fi ling compliance record, including no incidence of late filing within the three previo us tax years; 2) dated or certified mail documents showing the filing took place with t he state prior to the due date; and 3) evidence that the mistake was due to extenua ting circumstances, and not to carelessness or willful neglect.

Subsection (12)(b)6 contains language that could suggest an application beyond the narrow context of a taxpayer who mistakenly files a return with a state. The subsection refers to the regulations under section 6651 which, by its terms, does not apply to failure to file information returns. We suggest that the subsection refer instead to the section 6724 regulations that are applicable in this context, i.e., the requirement that taxpayers asserting reasonable cause for late filing show they acted in a "reasonable manner" in handling their filing obligations. Thus, we suggest that the first sentence of subsection (12)(b)6 read, as follows:

A taxpayer who erroneously addressed a return to a state taxing agency must de mon- strate that he or she acted in a reasonable manner, as required by Treas. Reg. [ sections] 301.6724-1(d)(1).

Moreover, the requirement that a taxpayer must show no incidence of late filing within the three previous tax years has no basis in the applicable Code or regulations. We recommend that this statement be deleted.

F. Actions by the IRS, Payee, or Other Person. Section (20)(10)(10)2(13) sets forth the procedures for establishing reasonable cause with respect to returns filed on magnetic media. Subsections (i), (j), and (k) refer to the documentation required to establish reasonable cause as the result of the taxpayer's reliance on actions by the IRS, a payee, or other person. These subsections should not be limited to magnetic media filings, and indeed, appear to be drafted for broad application. We recommend that the subsections be renumbered as subsection (14) and placed perhaps under the caption, "Taxpayer's Reliance on Other Parties." (This change would require that subsection (14) be renumbered as "(15).")

Moreover, subsection (i), which deals with establishing reasonable cause as a result of actions by the IRS, provides that the filer must show it relied on erroneous written advice provided by the IRS. Section (20)333.8 of the Consolidated Penalty Handbook (issued in July 1992), however, recognizes that the IRS may abate penalties where a taxpayer relied on erroneous oral advice from the IRS. The information required to be provided under this section of the Draft to support the filer's statement is essentially the same as that included in section (20)333.8. We recommend therefore that this subsection provide that reliance on erroneous oral advice may establish reasonable cause.

G. Supplying Information Well in Advance of Due Date. Section (20)(10)(10)2(13)(j)(2) requires that taxpayers seeking to establish reasonable cause as the result of actions by the taxpayer's agent must show that proper information was provided to the agent "well in advance" of the due date of the return. This provision sets a higher standard than Treas. Reg. [sections] 301.6724-1(c)(5)(i), which provides that the taxpayer must have provided the information to the agent "sufficiently in advance of the due date of the return or statement to permit timely filing of correct returns .... " The language of the regulations is clearer and we recommend that it be substituted for the "well in advance" language.

H. Requesting an Extension of Time. Section (20)(10)(10)2(14) provides a series of questions to be addressed to determine whether the filer has established reasonable cause. Section (20)(10)(10)3.1(1) describes when a filer will be considered to have acted in a responsible manner. Each section implies that a filer has not acted responsibly -- and will not be able to establish reasonable cause -- if an extension of time to file has not been requested.

As previously discussed, small businesses or businesses operated by non-English speaking individuals may not be fully aware of all filing requirements. It is uncertain whether these filers would be aware of the availability of the extension. TEI recommends that both sections provide that consideration should also be given to whether the filet reasonably should have been aware of the availability of the extension.

I. Prompt Correction of Errors. Section (20)(10)(10)3.1(2) outlines when correction of a failure will be considered "prompt," which the Draft states is 30 days after the occurrence of certain events. We note, however, that the time period outlined for prompt correction is not an absolute requirement. See Treas. Reg. [sections] 301.6724-1(d)(1). We suggest that the language be revised to read "[c]orrection of a failure is ordinarily considered prompt .... "

In addition, the regulations state that the correction is considered prompt if it is made within 30 days "after the cause of the failure is removed or the failure is discovered or on the earliest date thereafter on which a regular submission of corrections is made." The Handbook should be revised to conform with the regulations.

Section (20)(10)23: Special Abatement Procedures

Section (20)(10)23(5) provides that section "404(k) dividend distributions, reported on Form 1099-DIV, are not subject to penalties." The Draft explains that these "dividends "are not true dividend distributions reportable under IRC Section 6042, but are actually Employee Stock Option Plan (ESOP) distributions reportable under IRC section 6047."

The Handbook is correct that section 404(k) dividend distributions are not subject to the penalties discussed in detail in the Draft, i.e., information-reporting penalties under sections 6721, 6722, and 6723 of the Code. Such distributions are, however, subject to the penalty imposed under section 6652(e) for failures to file information returns required under section 6047. We suggest that the Draft be clarified to take into account the section 6652(e) penalty.

Section (20)(10)36.5: Responses to CAWR Assessment of Late Filing Penalties

Section (20)(10)36.5 relates to procedures for the assessment of penalties for failure to file, or for filing incorrect, Forms W-2. Subsection 4 provides that a "copy of a Form W-3 with a timely signature date should not be accepted alone as evidence [of filing Forms W-2] because a fictitious document can be easily prepared." TEl suggests that the Handbook provide examples of what will be considered sufficient evidence of filing Forms W-2.

Sections (20)(10)12.3, (20)(10)34, and (20)(10)43: Exceptions and Special Rules

A. "Inconsequential" Errors and Omissions. Section (20)(10)12.3(1) provides that the penalty will not be assessed for any failure to include correct information on an information return, tax return, or payee statement if the failure is considered "inconsequential." The term "inconsequential" is defined as "one that does not prevent or hinder the Service in the processing of the information, putting the return to its intended use, or the payee from timely and correctly reporting the information on their tax return." TEI recommends that the IRS include examples (similar to those provided elsewhere in the draft) of "inconsequential" errors that should not be subject to a penalty.

Moreover, because of the subjective nature of the test, TEI recommends adding a statement to sections (20)(10)34(2) and (20)(10)43(2) that where a filet did not correct a failure because he or she reasonably believed the error to be inconsequential, that belief constitutes evidence of reasonable cause. Filers should not be penalized for their lack of knowledge concerning whether a minor error makes it difficult for the IRS to process or match the information return. (The statement could also specify that the exception would not apply to any failures that the IRS has specifically identified as never being considered inconsequential.)

B. Payee's Address. Section (20)(10)34(2)(b) lists the errors and omissions that are never considered inconsequential for purposes of the failure to file correct information returns penalty. Included in this list are "significant" items in a payee's address. Treas. Reg. [sections] 301.6721-1(c)(2), however, which defines those errors and omissions that are never considered inconsequential for purposes of this penalty, makes no reference to the payee's address. In fact, if the payee's name and TIN are correct, the IRS should have no difficulty in processing or matching the information return, notwithstanding any errors involving the payee's address. This requirement should be deleted.

Section (20(10)15.5: Special Notice Review Procedures

Section (20)(10)15.3 provides procedures for all civil penalty notices. The draft Handbook provides that certain notices must be reviewed prior to mailing, including notices for "Large Complex Corporation" cases. Although we commend the IRS for providing for the review of certain notices, we note that the term "Large Complex Corporation" is not defined. We suggest that a definition be included in the Handbook.

Exhibit (20)(10)00-7: TIN Validation

Exhibit (20)(10)00-7 provides an explanation of the taxpayer identification number (TIN) validation process. The draft states, "Proximal matches allow for transposition of the second and third characters of the name control provided. NOTE: THIS APPLIES TO SSNs ONLY."

TEI members' experience suggests that, given the IRS's current technology, matches of TINs are difficult, if not impossible, to achieve. The inability to confirm taxpayer identification numbers is one of the most frustrating aspects of information reporting. An accurate, complete TIN verification system is vital. We strongly recommend that, until such a system is in place, the IRS should use restraint in assessing penalties.

Section (20)(10(10)3.3: Solicitations -- Missing TINS

Section (20)(10)(10)3.3 outlines the solicitation requirements for missing TINs. Subsection (2) requires that the initial solicitation be made at the time the account is opened or the transaction occurs.

In many instances, the "account" that is "opened" is a relationship with a vendor, payments to whom may u]timately need to be reported by the flier on a Form 1099. This relationship is initiated when the vendor is contacted to provide services, and the contact will frequently be made by an individual with no responsibility for the preparation of the information return. Individuals having such responsibility may not even become aware of the arrangement until an invoice is received, at which time it is too late to make the initial solicitation. While we recognize that the requirement mirrors Treas. Reg. [sections] 301.6724-1(e)(1)(i), we believe reasonableness should mark its application. Requiring that the initial solicitation be made within a reasonable period of time, such as 30 days, after the person responsible for preparation of the information return should have initially been aware of the opening of the account is more in keeping with the overall tone of the information reporting penalty.


A. Section (20)(10)12.2. Section (20)(10)12.2(3) provides that filers must file Forms W-2 with the Social Security Administration no later than February 28 of the year following the calendar year in which the funds were distributed. To conform with Treas. Reg. [sections] 31.6071(a)-1(a)(3)(ii), which takes into account leap years, the due date should be the last day of February. A similar reference to February 28 should be amended in section (20)( 10)36.5(2)(g)6.

B. Section (20)(10)15.2(7). This section states that before making a manual adjustment, "you should use the research Command Codes . . . to make sure that the penalty is being assessed on the correct filer's account." Verifying that the correct filer is being assessed a penalty should not be optional. TEI recommends changing "should" to "must" in this statement.


Tax Executives Institute appreciates this opportunity to present our views on the draft of the Handbook concerning information reporting penalties. If you have any questions, please do not hesitate to call Robert D. Adams, chair of TEI's IRS Administrative Affairs Committee, at (214) 978-2695 or Mary L. Fahey of the Institute's professiona] staff at (202) 638-5601.

1 We should note that we find the numbering system used in the IRS Penalty Handbook particularly confusing. We recognize that this system is not limited to Chapter 10, but is used throughout the Handbook. It seems, however, extraordinarily complex.

2 See also section (20)(10)42 which contains the same statement.

3. Editor's Note: Several miscellaneous comments pointing out typographica] or minor errors have been omitted and the remaining items have been recaptioned.
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Title Annotation:Tax Executive Institute IRS Administrative Affairs Committee and Payroll and Other Taxes Subcommittee
Publication:Tax Executive
Date:Mar 1, 1994
Previous Article:Announcement 93-144: early referral of issues to appeals and the role of appeals in the competent authority process.
Next Article:Proposed Section 162(m) regulations on deductions for executive compensation.

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