Advisory of March 23, 2004, announcing the hearing

WITNESSES

Internal Revenue Service, Hon. Mark W. Everson, Commissioner

U.S. General Accounting Office, James R. White, Director of Tax Issues

Internal Revenue Service Oversight Board, Nancy Killefer, Chair

LFS Professional IRSs, Inc., Allen I. Orwick

American Bar Association, Tax Section, Richard Shaw

American Institue of Certified Public Accountants, Tax Executive Committee, Robert Zarzar

National Association of Enrolled Agents, James D. Leimbach

Tax Executives Institute, Inc, Timothy J. McCormally

Scorse, Gerald E., New York, NY, statement

2004 TAX RETURN FILING SEASON AND THE IRS BUDGET FOR FISCAL YEAR 2005

U.S. House of Representatives,
Committee on Ways and Means,
Subcommittee on Oversight,
Washington, DC.

The Subcommittee met, pursuant to notice, at 3:04 p.m., in room 1100, Longworth House Office Building, Hon. Amo Houghton (Chairman of the Subcommittee) presiding.

[The advisory announcing the hearing follows:]

Chairman HOUGHTON. Good afternoon, ladies and gentlemen. We are delighted to have you here. I am going to make an opening statement, and then I will ask the Democratic leader of this Committee, Mr. Pomeroy, to make his statement. Nice to see you here, Mr. Portman.

Mr. PORTMAN. Good morning, Mr. Chairman.

Chairman HOUGHTON. Nice to see you here. Commissioner, we are obviously honored that you are going to be here expressing your views and giving us your wisdom. During the next 3 weeks, as most people know, tens of millions of Americans will perform a key duty of citizenship. They are going to be filing their Federal income tax returns. Millions of aspiring citizens and residents will also file. As we all know, this is a great country for a variety of reasons, not the least of which is our sense of honesty and decency. For most, rather than gaming the system on April 15th, they will try to uphold it. I don't think there is another Nation in the world that does this as well. It is for the benefit of the vast majority of law-abiding taxpayers that we are holding this hearing today. We owe it to these honest and decent taxpayers to see that we are served by a Federal tax agency that treats all taxpayers with dignity and respect and one that is both efficient and strong enough to deter cheating and bring the others to justice.

Appearing before us today, is Internal Revenue Service (IRS) Commissioner Mark Everson, who has made it one of his key priorities to reverse the decline in voluntary compliance consistent with taxpayer rights. On the next panel, we are going to have representatives from the IRS Oversight Board and the U.S. General Accounting Office (GAO). Finally, we have a distinguished panel of practitioners who represent some of the organizations that have helped the IRS and Congress to shape tax policy and tax administration in the past. I welcome you all and look forward to your testimony, all of the witnesses, and I am now pleased to yield to our Ranking Democrat, Mr. Pomeroy.

Mr. POMEROY. I think the Chairman. I thank him for his leadership of this Committee, for convening this meeting and for being my friend. An important function of the Subcommittee on Oversight is to keep an evaluation of how the tax-filing season is proceeding. We are aware that there will be 130 million tax returns filed during this filing season which ends in about 2 weeks. During this time, we will have received over 50 million e-filed returns, issued over 100 million tax refunds and answered nearly 40 million telephone calls from taxpayers seeking assistance. The reports indicate that the 2003 tax return filing season is progressing smoothly, and we certainly look forward to your further testimony on that. I must say that I am concerned about the Washington Post story. I will just read you the lead paragraph:

"President Bush's 2005 budget request for the IRS would seriously shortchange the Agency's tax-collection activities, leaving half a million tax accounts uncollected, 15 million service calls unanswered and nearly 46,000 audits unscheduled, according to the President's own IRS Oversight Board." So, as we look at the performance of the IRS relative to this tax-filing season, I would also like to have one eye down the road where we will be in 1 year, if we cannot adequately fund these essential collection activities the statutes direct the IRS to perform. I would cite this article that is in today's paper to everyone to really look at the daunting issues before the IRS relative to performing activities.

Congress has to understand--I think Congress may have a tendency to note problems in the field, haul in the Commissioner or other representatives of the IRS, rail indignantly about the administrative failings relative to the tax season and never accept any responsibility for the fact that we have never given you the resources you need to do the job. I hope if nothing else could come from this hearing, Mr. Chairman, it would represent a bit of Congress owning up to its own responsibilities to giving you the resources so that the job can done in the first place. There is a specific item of concern that I have asked to be addressed in the course of this hearing, and I am very pleased that among the practitioner panel, Allen Orwick, a constituent of mine from North Dakota, will be on the panel.

He will be presenting testimony concerning the recent e-file program and also talk about a recent ruling by the IRS regarding the Conservation Reserve Program CRP), a recent Chief Counsel's letter ruling that now appears to change what has been longstanding practice relative to the treatment of CRP rent to retired farmers as active income from the farm requiring the self-employment tax to be administered. This is different than it has been in the past, has caused a lot of concern in farm country, can be clarified in ways that I will suggest in the course of this hearing. Thank you for, even while we talk about the macro issues, allowing the discussion of this particular issue, so important not just to North Dakota, but all of farm country. Mr. Chairman, thank you, and I look forward to this hearing.

Chairman HOUGHTON. Thank you very much. We are going to try to move this thing along pretty fast. Unless anybody has an opening statement, we are going to go right to Mr. Everson. There are going to be votes. I do not know when they are going to be. They may be at 3:30 p.m. We are going to do the best we can, and we will roll this thing as fast as we can, and then we will have to just stop until we have the votes, and then we will be coming back. I would like to introduce, once again, the Honorable Mark Everson, Commissioner of the IRS. Thanks for being here.

Mr. EVERSON. Thank you, Mr. Chairman, Ranking Member Pomeroy, and Members of the Subcommittee. I appreciate the opportunity to testify this afternoon on the President's 2005 budget request for the IRS and the 2004 tax filing season. At the onset, let me indicate how much I appreciate the Subcommittee's ongoing support for the IRS. In particular, I am very thankful for your efforts to secure adequate budgetary resources for the IRS.

Mr. Chairman, Ranking Member Pomeroy, and Congressman Portman, in your March 24th letter to Chairman Istook and Ranking Member Olver of the Appropriations Subcommittee, with jurisdiction over the IRS, you wrote: "we hope you will fully fund the President's budget, and in particular the 10.7-percent increase in enforcement funding." You went on to write that the "new monies for enforcement will allow the IRS to make up ground in compliance that was lost while the IRS conducted the IRS restructuring." Thank you.

As you know, my working equation for the IRS is service "plus" enforcement equals compliance not service "or" enforcement. The IRS must do both. We must run a balanced system of tax administration based on a foundation of taxpayer rights. Earlier this month, we released our enforcement statistics for fiscal year 2003. They demonstrate that we have arrested the enforcement decline which began in the 1990s and worsened with the implementation of Restructuring and Reform Act of 1998 (RRA 98). Audits, criminal investigations and monies collected were all up. In particular--and you can see the chart over on the easel--when compared with the fiscal year which started October 1, 2000, audits of taxpayers with incomes over $100,000 were up by over 50 percent.

[The charts are being retained in the Committee files.]

The President's 2005 budget request for the IRS will continue to rebuild our enforcement activities. I would note that two-thirds of the new monies will be devoted to enhancing our compliance efforts in the high-income and corporate arenas, as well as increasing our criminal investigations. These incremental resources will help us address the tax gap--the difference between what is owed and what is paid, due to nonfiling, underreporting, and underpayment--and secure billions of extra dollars for the Department of the Treasury.

Furthermore, over a 4-year period, we have seen an increase in the percentage of Americans who think it is okay to cheat on their taxes from 11 percent to 17 percent. I find this alarming, as do you. I believe, however, that enhanced enforcement efforts will improve attitudes concerning compliance by reassuring the average American, who pays his or her taxes, that when he or she pays, neighbors and competitors will do the same. I am convinced we can augment our enforcement activities without diminishing our commitment to service. Our filing season results thus far in 2004 show that we can. Through last Friday, returns filed have increased almost 2 percent, but our electronically filed returns are up 12 percent from last year. Electronic filing is more reliable, both for the taxpayer and the IRS, and it is faster, allowing the IRS to issue refunds in half the time.

Also, noteworthy is that the Free File Initiative, which helps low- and middle-income taxpayers, has grown in volume by over 24 percent from last year. Our other IRS indicators, for the most part, also show improvement. We have handled increased call volumes with stable resources and bettered our level of service, and there is increased usage of automated services both on the phone and the Internet. While we made some changes to improve tax law accuracy and had some start-up problems earlier in the season, in recent weeks, our tax law accuracy results have recovered. While we have 2 weeks yet to go, I expect good results through the remainder of the filing season. Thank you.

[The prepared statement of Mr. Everson follows:]

Chairman HOUGHTON. Thank you very much. I would just like to ask one question to kick this off, and then I am sure that others would like to ask some questions. What is the relationship between the number of audits and the increase in revenues?

Mr. EVERSON. There are two components, I would say, Mr. Chairman. When you address audits or any of our enforcement activities, there is a direct relationship to revenues, which is to say that through an audit or through a criminal investigation or any enforcement action, you secure the incremental dollars for the Treasury, and then there is what some call a spillover effect, which is to say changes in behavior more broadly. If you are sitting at the country club and down in the locker 5 yards away you hear somebody saying, "Geez, I never should have gotten into that abusive shelter. I was audited by the IRS, and now I have got to pay the monies due, interest and penalties," well, not only have we recovered money from that audit, but we have had a change in behaviors that we believe takes place when that fellow who overheard that conversation is a little more conservative and reluctant to engage in a pattern or practice of abuse.

Chairman HOUGHTON. When you take a look at the audits of $100,000-taxpayers on the rise, does it give you the feeling that we are regaining the sense of trust that we so desperately have held onto for so many years?

Mr. EVERSON. I think that one component of this erosion in the attitudes towards compliance was a feeling on the part of many that others were getting away with something they should not be getting away with. So, clearly, we needed to augment the audits. I cannot tell you a magic number as to where those ought to be, frankly, Mr. Chairman. I think we need to do more, particularly in the high income. We need to do audits responsibly, though, in a way that treats people fairly and does not, in any way, intimidate folks as we go through the process.

Chairman HOUGHTON. Mr. Pomeroy?

Mr. POMEROY. I think that that chart is interesting and alarming. It shows to me how quickly things can come apart in terms of a national mores that you better pay what you owe. I believe that we have got a period of about 6 years there of declining audits, and ultimately a substantially fewer set of audits at the bottom of the trough than at the beginning of the decline. You indicate national statistics showing that those who believe you can cheat on your taxes has gone from 11 percent to 17 percent. I suspect, just from anecdotally, it might even be higher. After all, who is going to respond to a pollster, "do you think it is okay to cheat on your taxes or not?" I believe there will be people that will never fess up to such a thing, but would do it in a heartbeat if they had the chance.

That is why I believe that Congress, in administering, as the ultimate authority on our Nation's revenue collection system, has to be very careful. We cannot go off on some kind of ideological lark/funding on compliance because we are mad at taxes and basically try to make ideological statements about the role and function of government based upon whether you can do the job that you are statutorily required to do. We can fight tax rates, tax levels, we can fight role of government. Those are stand-alone questions that need their own fighting, but we can't fight them by proxy by trying to hurt and cripple the IRS from doing the job it is supposed to do.

I will read to you a statement from the Chair of your Oversight Board, which was presented in testimony yesterday, and ask whether you agree or disagree with the statement. Admittedly, this is from Nancy Killefer, the Chair, not your words, but the statement, "the IRS is doing a better job of identifying egregious noncompliance. Now, it needs the resources to fight back. In the past 2 years, IRS has sharpened its compliance focus to identify and pursue promoters and participants of abusive tax shelters and tax evasion schemes. For example, the agency is now targeting its resources on promoters of illegal tax schemes that are often marketed to high-income individuals, but are also finding their way to middle-market businesses. Despite this focus, enforcement activities are still at an unacceptable level simply because the IRS does not have the resources needed to accomplish its mission. It continues to be outmanned and outgunned. In fiscal year 2003, the agency was able to pursue only 18 percent of known cases of abusive devices designed to hide income, leaving an estimated $447 million uncollected, and that is from known cases. We knew $447 million was out there. We knew it was illegally withheld from tax payment, but we didn't have the resources to go and get it." Do you ascribe to the statements made by the Chair? Let me put it differently. Do those statements made by the IRS Oversight Board Chairman accurately reflect the situation?

Mr. EVERSON. I agree that the IRS needs more resources to combat compliance issues. I believe that the President has made a very strong commitment to improved tax administration, through the 5 percent budget increase. The increase is over 10 percent, as you know, in the enforcement funding for the IRS. I think that coupled with our own emphasis on improving our business processes on the enforcement side, much as the IRS has done on the service side over the last several years, we will further improve our compliance and enforcement efforts, and bring in more monies, bring up the audits and increase the investigations and the criminal prosecutions. There will be more to do, undoubtedly. I will continue to look at the funding levels on an ongoing basis and discuss, within the Treasury Department and with Office of Management and Budget (OMB), what I believe is necessary to run a balanced program.

What I want to emphasize at this point is my principal goal to make sure that we do secure 100 percent of the President's request. That is the real key for me, if you will, because, as you have indicated, in the past, on average, over the last 10 years, there has been a 3-percent shortfall between what President Clinton or President Bush has requested and what ultimately the Congress has provided. So, I would like to first secure the full funding of the President's request this year, which would be a departure from the past. If we need more from there, I will take that up in the 2006 budget process within the Administration.

Mr. POMEROY. Mr. Chairman, if I might have a couple of more minutes' leave. I will pursue quickly. When we have some of the major accounting firms in this country marketing these shady or illegal tax-dodge schemes, I think it goes to show you the impunity with which noncompliance has become socially acceptable. Are the major accounting firms out of that business?

Mr. EVERSON. I think we are seeing changes in what I would call the larger accounting firms and the larger blue-chip corporations. Our concern has been, though, that as we clamp down in one area, we continue to see issues in mid-size businesses or also on a continued basis with wealthy individuals. We have a great partnership with the Department of Justice on this issue. They are supporting us in litigation with the accounting firms and the law firms. As you know, first time ever where we have litigated against law firms, in terms of those who are acting as promoters, so that they are handled as promoters.

There are matters before the Justice Department now that include criminal investigations that will send a real signal through the professions, and I do expect that this will continue to receive a lot of attention on an ongoing basis. I was at the President's Corporate Fraud Task Force meeting just a week ago, and this was emphasized to all, not just by myself, but by the leader of the task force, the Deputy Attorney General, that combatting abusive tax shelters are part of the effort to clean up corporate governance and should receive top priority.

Mr. POMEROY. Thank you.

Chairman HOUGHTON. Mr. Portman?

Mr. PORTMAN. I thank you, Mr. Chairman. Commissioner, thank you for being here today. It is timely to talk about the filing season, but also to go over some of these budget issues with regard to 2005. I will say that, as I read this, your budget request this year is a 4.8-percent increase over the enacted amount from 2004.

Mr. EVERSON. Correct.

Mr. PORTMAN. This is a substantial increase. I just did the math, which may be wrong, but it seems to me that from 2002 to now we have a 13.5-percent increase during this Administration. I sometimes fight for more than that, as do my two colleagues on the left. They happen to be to my left right now.

[Laughter.]

We have had substantial increases at a time when, frankly, we are looking at practically a freeze in your budget for the non-defense and non-homeland security domestic discretionary spending, and so I am pleased that we had the 4.8 percent. I appreciate your comment that a lot of this is about allocation. In fact, when I look--and I know Ms. Killefer is going to testify later, and I look forward to her testimony, although I need to run out to another meeting, and I will try to come back--but Congress has funded, since 1998, all but about 1 percent of what the IRS has requested, and we have increased funding every year. Again, I would like to see more sometimes. There is a sense out there somehow that Congress has cut funding. We have not.

There have been allocation of those resources, as you say, during the restructuring more toward customer service and less toward enforcement, and I think that is now being corrected, and I think appropriately so. I couldn't agree with you more that they are not inconsistent with one another. I will also say that we were 2.6-percent below the request from the Oversight Board in the past 3 years.

This year, it looks like we will be more below, but I think that request is about 5 percent above yours. So, these are not big numbers as compared to the overall budget, and although I would like to see more funding into enforcement, I think it would be wrong to leave the impression that somehow Congress has been reducing this funding. We fight for it for every year, and we will fight for it again this year, to be sure that the IRS gets additional funding which is needed. Three other quick questions if I could. One on simplification. You have indicated in your statement and elsewhere that simplification would help you, particularly the Sub S filings have increased. Do you have any advice for us, as Congress, as to how we could help you to enforce this Tax Code?

Mr. EVERSON. I think simplification is critical because there really are two components to compliance: One is the service side, and by service we mean helping taxpayers understand their filing obligation and facilitating their participation. Clearly, there is a very real drag on understanding obligations and on facilitating participation in the system that occurs from the increasing complexity of the Tax Code. Some people just throw up their hands, increasing errors that are made. So, anything that we can do on simplification in terms of the Tax Code is important.

The other point I would make is that, as you and I have discussed, as you add more missions to the IRS, you also put further stresses on the tax administration system. When you get a new responsibility to embed a benefits program, say, in the IRS, you have to devote adequate management, and technical, and human resource talents to achieving that new program. It makes it more complicated to administer the Tax Code and diverts our attention from other normal activities.

Mr. PORTMAN. Those are key points I hope we will always keep in mind. That is really where the Commission ended up was, yes, we need a change at the IRS, but ultimately the Tax Code itself was one of the major problems, and this Subcommittee has been focused on the simplification issue, but it is as to compliance, as you say, but also as to cost--

Mr. EVERSON. Yes.

Mr. PORTMAN. What your costs are increase. This goes to the next question I have, which is training. Are you putting adequate resources against training, and could we put more resources against training, which would then lead to having better audits, more targeted audits and perhaps less resources over time in enforcement?

Mr. EVERSON. I think we are carefully looking at our training, particularly in what we will need to do as we augment the enforcement resources, because we are not going to just hire several thousand more Revenue agents, Revenue officers and criminal investigators. We also have a very seasoned work force, and we are going to have a lot of turnover, particularly in our people who do the corporate returns or in appeals. It is critical, therefore, that as we add new people and as we ask others to step up to greater responsibility, that we do our training. We are trying to benchmark now against the corporations as to how they train their work force, but I think this is an area where we are going to have to devote a lot of attention. I do not think our plans are yet fully crystallized, but they need to be.

Mr. PORTMAN. We would like to work with you on that training. Final question, quickly. You talked about increased audits of those making over $100,000 a year. How about your audits of corporations, where are they, and does it concern you that audits are off on corporations, if I understand that to be the case?

Mr. EVERSON. I think that we will see, when we look at corporate audits for 2004 versus 2003, that we have arrested what was a decline that was much like the decline in individual audits. Part of the most recent decrease was really related to the fact that as we have worked on these abusive shelters, and as we have devoted more resources to promoters, we did draw down a bit some of the numbers of the audits we were doing. So, I think that this was, in fact, at least in fiscal year 2003, a wise decision, and it was one that was based on a risk assessment as to where the real problems were. I would note that part of the President's budget request, for instance, it will double audit rates for corporations between $10- and $250 million of assets. Right now, the audit rate is about 5 percent or so. It will double it to 10 percent. That is an important step, and it is why we need the money.

Mr. PORTMAN. Thank you, Commissioner. Thanks for your good work.

Mr. EVERSON. Thank you.

Chairman HOUGHTON. Mr. Ryan?

Mr. RYAN. Thank you, Mr. Chairman. Thank you, Mr. Everson, for being here. I have two very specific questions. My first question is in regard to child tax credit overpayments as a result of the child tax credit advance payments that were sent out last year. I can go through the whole scenario, but the sense basically where you have divorced couples, you have this anomaly where they take every other year, they claim their children as a dependent. So, what you had in this last year, with an advance payment on the child tax credit, was in 2002 spouse, ex-spouse claimed the dependent, and in 2003 they got the advance payment. Whereas, the other spouse takes the credit of the child as a dependent in 2003, and according to your rules, it is my understanding, they will get the full tax credit. What is the estimate of the difference? It is also my understanding that you will not claw back or require a repayment from the other spouse who doesn't legitimately claim the dependent in 2003. What is the measurement of those overpayments of child tax credits?

Mr. EVERSON. I am going to have to supply--

Mr. RYAN. Could you look into that for me.

Mr. EVERSON. Supply that for you for the record. I will say this, that--

Mr. RYAN. I just wanted to make sure I was clear on how I--

Mr. EVERSON. I think that is a question I cannot answer directly. I will say this, that the most common problem we have seen so far in the filing season is accounting correctly for the child credit. It accounts for about two-thirds of the errors that we are seeing. We automatically correct for the calculation, but I am not sure that our corrections would run to the matching that you are talking about in this instance.

Mr. RYAN. Let me just make sure I can clarify your policy, which is you will not require a repayment by a spouse who gets the advance credit from having their child as a dependent on 2002, even though, in 2003, they will not have that person as a dependent, and you will give that 2003 parent who claims them that year as a dependent the full tax credit; is that correct?

Mr. EVERSON. I want to make sure that I have a correct understanding of that. We will give you a complete answer to that.

Mr. RYAN. If you could, and I would like to just see an estimate if I could.

Mr. EVERSON. Certainly.

Mr. RYAN. My second question is with the The Federal Tax Refund Offset Program (TOPS) program. It allows government agencies to submit to the IRS claims for delinquent debts up to 10 years old. The State of Wisconsin is currently participating in this, and it is for the purpose of recovering State-owed debts. Right now, local municipalities are not permitted to participate in the TOPS program to include debts owed to local and municipal agencies. Do you believe that the current system could accommodate local municipalities to participate in TOPS? If not, what would your position be on allowing them to do so?

Mr. EVERSON. I am going to want to take a look at this because we are working very actively with the States in a whole variety of ways. You may know recently we signed an agreement, and we are implementing it, cooperating with 46 different States on the abusive tax shelter transactions.

Mr. RYAN. Right.

Mr. EVERSON. We are working everywhere we can to help the States. As to whether there is additional capacity in this question, I will come back to you on that.

Mr. RYAN. Could you get back to me in writing. Specifically, you will find, as you look into this, that a lot of States already have agreements with the State government, where their local municipalities and counties can work together to reclaim debts. Does the current statute allow you to give that same participation that you are giving right now to States to municipalities and county governments or does it not, and what is your position if it does?

Mr. EVERSON. I will take a look at that and make sure we come back to you.

Mr. RYAN. That would be great. Thank you.

Mr. EVERSON. Thank you, sir.

Chairman HOUGHTON. Thanks, Mr. Ryan. Mr. Johnson?

Mr. JOHNSON. Thank you, Mr. Chairman. Good evening.

Mr. EVERSON. Good afternoon.

Mr. JOHNSON. Glad to see you. Let me ask you a technical question, if I might. Is there ever a time when you would have tax people walk up to somebody's door unannounced?

Mr. EVERSON. Unannounced, in the sense of just launching an audit or a criminal investigation?

Mr. JOHNSON. I am a guy in a house, and I am sort of, I have got a case in mind, and I will talk to you about it privately, but where the wife is at home, in a residential area, good housing, and two people walk up to the door and say, "You did not file your tax returns."

Mr. EVERSON. I do not think that is our normal procedure. What we would tend to do is contact someone, initially by a letter, indicating that we would like to--we are initiating an audit. We do audits that are either correspondence audits, which is a big block of the work, or else field audits, where we would visit a taxpayer.

Mr. JOHNSON. Yes, but not without notice.

Mr. EVERSON. I would imagine that this was an exceptional circumstance. I would like to understand what the circumstances were.

Mr. JOHNSON. Well, you are not denying that it never happens, then.

Mr. EVERSON. I do not know that it has happened, but you seem to know more than I do about a specific case, so--

Mr. JOHNSON. No, I am trying to solve the problem, if I could.

Mr. EVERSON. Right.

Mr. JOHNSON. If you do not have enough people, and you need more money, blah, blah, blah, and yet you have got people running out there being accusatory without first warning the people that they are going to, I do not think that is right.

Mr. EVERSON. We have, and we do follow very specifically, procedures that were put into place about notices on collections, and there were changes in the new law, as you know, from 1998. If our people are violating those procedures, they are held accountable. So, if you could tell me about the case, I would be happy to take a look at it, and if there has been some irregularity that is improper, I will make sure that we deal with it.

Mr. JOHNSON. Well, and I know that you have people in there that you can talk to, too, about those sorts of things, but I have never encountered you being heavy-handed like that before, and I will talk to you separately about it. One of the proposals in this year's budget would make changes in 1203, called, "The 10 Deadly Sins" provision. Can you explain why those changes are necessary and important?

Mr. EVERSON. I think that if you go back to the hearings that took place in the mid and late 1990s, clearly, I agree with the substance of the reforms, taken as a whole, that came out of RRA 98. There was a big gap between the service level that Americans had every right to expect of the IRS and what we were actually delivering or failing to deliver.

At the same time, I think there was a climate that was a difficult climate. Some charges were made against IRS employees which, as you would remember, were subsequently found to be unproven or slightly exaggerated. The folks who have worked in the Agency inform me that all of this had a real overhang, in terms of for a while a reluctance to pursue the enforcement activities. To some degree, that clearly contributed to the decline in actions. In terms of these "deadly sins," I think that what we are trying to get at there is simply to allow more discretion to the Commissioner to mitigate some of these areas of problems if, on a balanced basis, that seems warranted. It doesn't make it in any way automatic. It just says that there should be more discretion in some cases if it is warranted.

Mr. JOHNSON. Thank you very much. Thank you, Mr. Chairman.

Chairman HOUGHTON. Thank you. Mr. Pomeroy.

Mr. POMEROY. Thank you, Mr. Chairman. I have been looking with great interest at a couple of these charts that you brought along. I'm wondering if you could put up the enforcement chart, just to show you the pattern that we have followed. It tracks very closely this audit history. Then, after that, Commissioner, if you don't mind, if you would pull up the exempt organizations and just give us as brief read on that one.

Mr. EVERSON. This simply says that over a period of years we have kept the resources stable in terms of manpower on the service side, the infrastructure side of the IRS. We brought down year after year the enforcement personnel. That red line is the number of revenue agents, revenue officers and criminal investigators. Those are the people who develop cases for potential prosecution by Justice. We brought that back up, and it will go up further with the President's 2005 request, if we get the funding. So, we're bringing it back up.

I would say it's not only about money, but it's also about bettering our procedures and also about prioritization, because it comes back to the Chairman's question on what is the effect of the audits. You don't only have a direct effect; you have the indirect effect, too. So, it's not only about augmenting resources. Just to zoom in on something that this Committee has had an interest in, which is credit counseling and sureties, you had a hearing when I was here last November looking at credit counseling organizations. The challenge, as you know, one of our enforcement priorities is to discourage, deter abuses within tax-exempt entities.

Mr. POMEROY. Just to refresh the audience's memory on this one, if I recall, now we see omnipresent debt counseling ads everywhere you turn. Some of the main entities involved in that, as we looked in the course of this hearing, basically operating under the guise of being nonprofits, had extremely highly-paid founders or Presidents. It was in the millions in terms of wages, something that would certainly raise all kinds of questions about whether they are actually operating appropriately in a tax-exempt structure, and whether the value of what they offer to the consumer comports with what they say it does.

Mr. EVERSON. That's correct. In fact, I indicated last week that I expected, as a result of ongoing audits that we have underway, we will be lifting tax-exemption status for some of these entities and may, in fact, also end up making criminal referrals. So, this is a very serious area of focus for us. All this does is it zooms into that tax-exempt area and says that, over time, you had a real increase in total assets, you've had an increase in the returns filed, and now, after years of the staffing going down, we're bringing the staffing back up.

To show you just what has to be done here, we are also harnessing technology, again improving procedures. So, I would hasten to add that I don't expect that you need to take these lines up as high as the increases in the activity, but clearly, you can't continue on this trajectory that we've been on. We have arrested it and we're bringing it back up. I think you see from the budget request that we've got new monies and new personnel coming into this tax-exempt area. This is not just credit counseling; this is the whole tax-exempt sector.

Mr. POMEROY. I would just note that I had hoped our hearing might have some positive effect in terms of diminishing that blatant and what I find to be offensive practice of their solicitations. It seems as though they have redoubled their efforts. So, I'm looking forward to this getting out of the private matter of internal IRS auditing and into the much more publicized criminal arena, because I believe many of their activities are criminal. If we hang one or two from the yardarm, maybe it will have some positive effect in terms of their activities in the future.

Mr. EVERSON. That may very well happen. What I suggested, Congressman, last week on the Senate side--they had a hearing on this, the Levin/Coleman permanent Subcommittee. As we went through this, I was shocked, because I found that the schemes of the interlocking relationships between the charity and the related profit-making entities, they rivaled the complexity of the interlocking network of reinforcing relationships that you see in the tax shelter area. That is all the more disturbing because these aren't people out there just trying to make money; these are folks who are supposedly serving the public good. Yet they have become equally sophisticated in some instances and equally, I would say, hardened towards their true mission.

Mr. POMEROY. I totally agree with that. A final question. The CRP payments to retired farmers has since the 1988 letter ruling largely been viewed as not subject to self-employment tax. A letter ruling issued in May of 2003 was written broadly enough so that it appears to apply now to retired farmers with CRP income. This would be very much unlike other rental income they would be receiving.

We learned in a meeting with IRS staff in North Dakota last Friday that that letter ruling was not drafted with contemplation of the circumstance of retired farmers. The result of it has been to put a big question mark on the shoulders of taxpayers and retired farmers alike about what to do with this income. Needless to say, it represents a very substantial new tax obligation to people living on fixed incomes, especially when they all had available the option of renting the land in the first place, which would carry no self-employment tax.

I will hand you a copy and put into the record a treatise by Dr. Neil Harl, who is a tax expert operating out of Iowa, on the question of the tax status of this income for retired farmers. He recommends withdrawal of the letter ruling of 2003, sorting this out in a more comprehensive way and dealing with it going forward, based on a more comprehensive resolution but lifting the cloud that affects this tax filing season.

[The information follows:]

Self-employment Tax Aspects of the Conservation Reserve Program*  by Neil E. Harl**

  I.        The Food Security Act of 1985 instituted a 10-year conservation reserve program (CRP) under which the Secretary of Agriculture entered into contracts with owners and operators of highly erodible cropland to take such cropland out of crop production and place it in conservation and soil and water improving use in exchange for payments of cash and commodities.  16 U.S.C. § 3831, added by Pub. L. No. 99-198, Sec. 1231, 99 Stat. 1508 (1985).  Final regulations were issued in 1987 implementing the program.  7 C.F.R. Pt. 704, 52 Fed. Reg. 4,269 (1987).

II.        The self-employment tax treatment of CRP payments

A.  Initially, tax practitioners relied on prior authority drawn from other settings.  E.g., Rev. Rul. 60-32, 1960-1 C.B. 23 (payments under soil bank program includible as self-employment income of owner-operator).

B.   The Associate Chief Counsel, Technical, of IRS, stated in 1987, that where the farm operator or owner is materially participating in the farm operation, CRP payments constitute receipts from farm operations includible in net earnings from self-employment.  Letter from Peter K. Scott, Associate Chief Counsel, Technical, March 10, 1987.  The Commissioner of Social Security agreed.

C.  In 1988, the Internal Revenue Service, in a letter ruling, indicated that, for a retired taxpayer who is not materially participating, payments received under the federal Conservation Reserve Program would not be considered net income from self-employment.  Ltr. Rul. 8822064, March 7, 1988 (no tenant involved; landowner’s activities under CRP did not constitute material participation).

D.  In a 1996 Tax Court case, Ray v. Commissioner, T.C. Memo. 1996-436, the Tax Court held that, for taxpayers who materially participate in the operation, CRP payments are to be reported as self-employment income if the CRP land had a “direct nexus” with the farming business.  The Tax Court found that a direct nexus in that case existed where the CRP land was in the same general vicinity as the farming operation, the CRP seeding was maintained with equipment used in the farming operation and the farmer admitted that, at the termination of the CRP contract, the land involved would be used in the farm business.

E.   A 1996 letter ruling involving a husband and wife as directors and officers of a family ranch corporation held that they had materially participated in the overall operation.  Ltr. Rul. 9637004, May 1, 1996.

F.   In 1998, the Tax Court held that CRP payments were “rents” and, therefore, not subject to self-employment tax by virtue of I.R.C. § 1402(a)(1).  Wuebker v. Commissioner, 110 T.C. 431 (1998).  The Tax Court said the primary purpose of the CRP contract was to achieve specified environmental benefits by converting highly erodible cropland to soil conserving use.  Thus, the contract payments represented compensation from the use restrictions on the land rather than remuneration for the taxpayer’s labor.  However, that case was reversed on appeal in 2000 by the Sixth Circuit Court of Appeal.  Commissioner v. Wuebker, 205 F.3d 897 (6th Cir. 2000).

G.  Legislation was first introduced in April of 2000 to treat CRP payments as rent for self-employment tax purposes and reintroduced in 2001 and 2003.  S. 2422, S. 2344, H.R. 4212, 106th Cong., 2d Sess. (2000); S. 315, 107th Cong., 1st Sess. (2001); S. 665, S. 1316, 108th Cong., 1st Sess. (2003).

H.  In a Chief Counsel’s Letter Ruling dated May 29, 2003, IRS took the position that a landowner’s activities under a CRP contract amounted to material participation and the payments should be reported on Schedule F, not Schedule E or Form 4835.  CCA Ltr. Rul. 200325002, May 29, 2003I.  The letter ruling did not except retired landowners (taxpayer B is an individual not engaged in the trade or business of farming) and so the 2003 CCA Letter Ruling was counter to Ltr. Rul. 8822064, March 7, 1988.

The text of the CCA Letter Ruling, CCA Ltr. Rul. 200325002, May 29, 2003, is included in full in Appendix A hereto.

III.       In summary, before the issuance of CCA Ltr. Rul. 200325002, May 29, 2003, landowners could be separated into four categories with respect to liability for SE tax on CRP payments¾

A.  Landowners who were retired when the land was bid into CRP and were not materially participating in retirement were not liable for SE tax on the CRP payments.  Ltr. Rul. 8822064, March 7, 1988.

B.   For landowners who were not carrying on the trade or business of farming and there was no direct nexus between the CRP land and a farming business (or landowners who were carrying on the trade or business of farming but there was no direct nexus between the CRP land and the farming business), the landowner was not liable for SE tax on the CRP payments.  See Ray v. Commissioner, T.C. Memo. 1996-436.

C.  For landowners who were carrying on the trade or business of farming and there was a direct nexus between the CRP land and a farming business, the individual or individuals were liable for SE tax on the CRP payments.

D.  For landowners who retired after the land was bid into the CRP program, and who were liable for SE tax on CRP payments before retirement, there were conflicting authorities¾

1.   Some authorities have focused on the taxpayer’s status at the time the agreement was entered into and that status prevailed for the duration of the contract.  Notice 87-26, 1987-1 C.B. 470 (dairy termination payments); Rev. Rul. 60-32, 1960-1 C.B. 23 (soil bank payments).

2.   Other authorities suggested that it is the taxpayer’s status at the time payment is received that determines liability for SE tax.  Soc. Sec. Rul. 67-42 (cropland adjustment income; dictum).

IV.       Recommendations

A.  Withdrawal of CCA Ltr. Rul. 200325002, May 29, 2003, or reissuance with a narrowing of the ruling to harmonize with Ltr. Rul. 8822064, March 7, 1988, would remove much of the current confusion.

B.   The CCA Ltr. Rul. seems to apply to all federal conservation programs also.  It would be helpful to know whether that was intended.

C.  Guidance on the matter of SE tax liability for those who retire during the term of the CRP contract would be helpful.

APPENDIX A

CCA Ltr. Rul. 200325002, May 29, 2003.

TO:  Virginia E. Cochran, Deputy Area Counsel (Great Lakes & Gulf Coast Area), Office of Division Counsel/Associate Chief Counsel (Tax Exempt & Government Entities), CC:TEGE:GLGC:DAL

FROM:  Michael A. Swim, Senior Technician Reviewer, Employment Tax Branch 1, Office of Division Counsel/Associate Chief Counsel (Tax Exempt & Government Entities), CC:TEGE:EOEG:ET1

SUBJECT:  Conservation Reserve Program & SECA

This Chief Counsel Advice responds to your request for advice regarding the Conservation Reserve Program (CRP) of the United States Department of Agriculture (USDA) and Self-Employment Contributions Act (SECA) tax.  In accordance with section 6110(k)(3) of the Internal Revenue Code, this Chief Counsel Advice should not be cited as precedent.

ISSUES

1.  Whether annual “rental” payments received by Taxpayer A, who is an individual, for land enrolled in the CRP constitute self-employment income to Taxpayer A that is subject to SECA tax where Taxpayer A was engaged in the trade or business of farming prior to enrolling the land in the CRP and Taxpayer A personally fulfilled her CRP contractual obligations.

2.     Whether annual “rental” payments received by Taxpayer B, who is an individual, for newly acquired land, that had been enrolled in the CRP by the land’s previous owner and the enrollment is continued by the Taxpayer B, constitute self-employment income to Taxpayer B subject to SECA tax where Taxpayer B was not engaged in the trade or business of farming prior to acquiring the land but Taxpayer B personally fulfilled his CRP contractual obligations.

3.     Whether the annual “rental” payments respectively received by Taxpayer A and Taxpayer B under the CRP should be reported (i) on Schedule F (Form 1040), Profit or Loss from Farming, as farming income from a trade or business, (ii) on a Schedule E (Form 1040), Supplemental Income and Loss, as rental income from real estate, or (iii) on a Form 4835, Farm Rental Income and Expenses, as rental income from crop or livestock production.

CONCLUSIONS

1.     The annual “rental” payments received by Taxpayer A for land enrolled in the CRP constitute self-employment income to Taxpayer A that is subject to SECA tax where Taxpayer A was engaged in the trade or business of farming prior to enrolling the land in the CRP and Taxpayer A personally fulfilled her CRP contractual obligations.

2.     The annual “rental” payments received by Taxpayer B for newly acquired land, that had been enrolled in the CRP by the land’s previous owner and the enrollment is continued by Taxpayer B, constitute self-employment income to Taxpayer B subject to SECA tax where Taxpayer B was not engaged in the trade or business of farming prior to acquiring the land but Taxpayer B personally fulfilled his CRP contractual obligations.

3.     The annual “rental” payments respectively received by Taxpayer A and Taxpayer B under the CRP constitute self-employment income to the recipient taxpayer that is subject to SECA tax and is not rental income that is excludible under the rentals-for-real-estate exclusion.  The respective payments received by each recipient taxpayer must be reported on a Schedule F and Schedule SE (Form 1040), Self-Employment Tax, filed by that taxpayer with that taxpayer’s Form 1040, U.S. Individual Income Tax Return.  The use of Schedule E or Form 4835 is not allowed.

FACTS

The CRP, 16 U.S.C. §§3801, 3831-36, is a USDA voluntary conservation reserve program under which land is enrolled through the use of contracts.  The program generally assists owners and operators of land to conserve and improve the soil, water, and wildlife resources of such land.  The CRP offers, among other things, annual “rental” payments to owners and operators for converting highly erodible cropland normally devoted to the production of an agricultural commodity to less intensive use.  In general, the durations of contracts are from 10 to 15  years.  The Farm Security and Rural Investment Act of 2002, Pub. L. No. 107-171, provides that up to 39.2 million acres can be enrolled in CRP at any one time during the 2002 through 2007 calendar years.

No specific taxpayer or detailed factual situation was provided in regards to the requested advice.  Accordingly, we address two hypothetical situations.

Taxpayer A was a farmer who owned highly erodible cropland.  After planting crops on the land for six years, Taxpayer A decided to enroll Taxpayer A’s cropland into the CRP and entered into a CRP contract with the USDA.

Under the CRP contract, Taxpayer A agreed to certain terms and conditions as to the cropland under contract.  Among the terms and conditions, Taxpayer A Agreed to:  (1) implement a conservation plan for converting the land normally devoted to the production of an agricultural commodity on the farm to a less intensive use, such as pasture, permanent grass, legumes, shrubs, or trees; (2) not to use the land for agricultural purposes except as permitted by the USDA; (3) establish approved vegetative cover or maintain existing cover on the land; and (4) not engage in or allow grazing, harvesting, or other commercial use of the land, except with USDA’s permission (e.g., harvesting and grazing in response to a drought or other emergency).

Taxpayer B purchased highly erodible cropland that had been enrolled in the CRP by its previous owner.  As the new owner, Taxpayer B executed an agreement to continue and assume all obligations of the CRP contract under the same terms and conditions as the original owner.  These terms and conditions were identical to those in Taxpayer A’s CRP contract.  Taxpayer B was not engaged in the trade or business of farming prior to acquiring the cropland that was and continues to be subject to a CRP contract.

Taxpayer A and Taxpayer B each personally fulfilled their duties under their respective CRP contracts and received annual “rental” payments.  Neither Taxpayer A nor Taxpayer B disputed the taxability of the CRP payments as includible in gross income under section 61.  However, both taxpayers reported the payments as rental income not subject to SECA tax.  Taxpayer A reported the amounts received as rental income from real estate on Schedule E. Taxpayer B reported the amounts as rental income from farm production and crop shares on Form 4835.

LAW AND ANALYSIS

Section 1401 imposes SECA tax on the self-employment income of every individual.  SECA tax consists of the Old-Age, Survivors and Disability Insurance tax (OASDI tax which is commonly referred to as social security tax) and the Hospital Insurance tax (HI tax which is commonly referred to as Medicare tax).

Section 1402(b), in pertinent part, defines “self-employment income” as the net earnings from self-employment derived by an individual (other than a nonresident alien individual, except as provided by an agreement under section 233 of the Social Security Act) during any taxable year; except that such term shall not include¾

(1) in the case of the OASDI tax imposed by section 1401(a), that part of the net earnings from self-employment which is in excess of (i) an amount equal to the contribution and benefit base (as determined under section 230 of the Social Security Act) which is effective for the calendar year in which such taxable year begins, minus (ii) the amount of the wages paid to such individual during such taxable years; or

(2)   the net earnings from self-employment, if such net earnings for the taxable year are less than $400.

Section 1402(a) defines the term “net earnings from self-employment” as the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by subtitle A which are attributable to such trade or business, plus the individual’s distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which the individual is a member, with certain enumerated exceptions.

Section 1402(a)(1) generally excludes from the computation of “net earnings from self-employment” rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares) together with the deductions attributable thereto, unless such rentals are received in the course of a trade or business as a real estate dealer, with an exception.  Under this exception, any income derived by the owner or tenant of land must be included in the computation of “net earnings from self-employment” if¾

(A)  such income is derived under an arrangement, between the owner or tenant and another individual, which provides that such other individual shall produce agricultural or horticultural commodities (including livestock, bees, poultry, and fur-bearing animals and wildlife) on such land, and that there shall be material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) in the production or the management of the production of such agricultural or horticultural commodities, and

(B)   there is material participation by the owner or tenant (as determined without regard to any activities of an agent of such owner or tenant) with respect to any such agricultural or horticultural commodity.

See also, Income Tax Reg. §1.1402(a)-4.

Section 1402(c) provides that the term “trade or business” when used with reference to self-employment income or net earnings from self-employment shall have the same meaning as when used in section 162 (relating to trade or business expenses), with certain enumerated exceptions.  In order for an individual to have net earnings from self-employment, the individual must carry on a trade or business, either as an individual or as a member of a partnership.  Whether or not the individual is engaged in carrying on a trade or business will be dependent upon all of the facts and circumstances in the particular case.  See also, Income TaxReg. §1.1402(c)-1.

In considering whether an individual is engaged in a trade or business, the U.S. Supreme Court has stated that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.  A sporadic activity…does not qualify.”  Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987) [87-1 USTC ¶9191].  The question of whether a taxpayer is engaged in a trade or business requires an examination of the relevant facts in each case.  Id. at 36.

In order for income received by an individual to be taxable as self-employment income, not only must the income in question derive from a trade or business carried on by the individual, but there must be a nexus between the income and the trade or business.  Newberry v. Commissioner, 76 T.C. 441, 444 (1981) [CCH Dec. 37,756].  The income “must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer.”  Id. at 446.

In determining what income is includible in self-employment income, sections 1401 and 1402 are to be broadly construed to favor coverage for Social Security purposes.  Braddock v. Commissioner, 95 T.C. 639, 644 (1990) [CCH Dec. 47,046].  In order to achieve this end, the rental exclusion under section 1402(a)(1) is “narrowly construed.”  Johnson v. Commissioner, 60 T.C. 829, 833 (1973) [CCH Dec. 32,117], see also Delno v. Celebrezze, 347 F.2d 159, 165 (9th Cir. 1965) (noting that a parallel provision of the Social Security Act relates Congress’ specific intent for the “rental exclusion to be narrowly restricted to payments for occupancy only”).

In Wuebker v. Commissioner, 205 F.3d 897 (6th Cir. 2000) [2000-1 USTC ¶50,254], the Sixth Circuit reversed a Tax Court decision that CRP payments received by Frederick and Ruth Wuebker (taxpayers) were excludible from their self-employment income as rentals from real estate.  The Sixth Circuit held that CRP payments received by a farmer in exchange for the farmer’s implementation of a conservation plan were includible in self-employment income from the trade or business of farming that were subject to SECA tax pursuant to section 1401.

In Wuebker, the taxpayers had been farming for approximately twenty years when they enrolled a portion of their farmland into the CRP.  The Sixth Circuit held that because the taxpayers were “engaged in the business of farming prior to and during the term of their CRP contract” and their “agreement…required them to perform several ongoing tasks with respect to the land enrolled in the CRP, the very land they already owned and had previously farmed,” the CRP payments “were ‘in connection with’ and had a ‘direct nexus to’ their ongoing trade or business.”  Id. at 902.  The Sixth Circuit noted that the taxpayers were required under the CRP contract to perform tasks that are intrinsic to the farming trade or business (e.g.,tilling, seeding, fertilizing, and weed control) that required the use of their farming equipment.  Id. at 903.

The Sixth Circuit found that the taxpayers’ contention that their involvement with the CRP land was insufficient to constitute “material participation” within the meaning of section 1402(a)(1) had no bearing on whether the CRP payments constituted rentals from real estate.  The issue of material participation arises only when there is an arrangement between an owner or tenant and another individual whereby the other individual is to produce agricultural or horticultural commodities on the land.  No such arrangement was present in Wuebker.

In addition, because of the narrow construction required of the exclusion for rentals from real estate, the Sixth Circuit held that the CRP payments were not true rental payments for the use or occupancy of property.  The essence of the CRP program is to prevent participants from farming of the property and to require the participants to perform various activities in connection with the land continuously throughout the life of the contract with the government’s access limited to inspection.  Id. at 904.  Furthermore, the Sixth Circuit looked to the “substance, rather than the form, of the transaction”[1] in determining that the income derived from the CRP contract is includible in self-employment income earned in lieu of farm income, for which SECA tax was due.

The CRP payments are not excludible per se as rentals from real estate.  Rent is defined as “consideration paid…for the use or occupancy of property (esp. real property).”  Id. at 904 citing Black’s Law Dictionary 1299 (7th ed. 1999).  Under a CRP contract, the USDA does not obtain the right to “occupy” the land enrolled in the CRP.  The government’s access is limited to inspecting the property and determining whether the recipients of the CRP payments are in compliance with the CRP contract.  See id. at 904.

In Hasbrouck v. Commissioner, T.C. Memo. 1998-249 [CCH Dec. 52,783(M)], taxpayers purchased land that had already been enrolled in the CRP.  The taxpayers, who fulfilled their obligations under the terms and conditions of the CRP contract, considered themselves engaged in the trade or business of farming and reported their CRP income and expenses on Schedule F.  Prior to the purchase, the taxpayers were not engaged in the trade or business of farming.  The Service initially reclassified the income and expenses as rentals from real estate on the basis that the taxpayers were not engaged in the trade or business of farming when they acquired the land.  The Service, however, following the decision in Ray v. Commissioner, T.C. Memo 1996-436 [CCH Dec. 51,573(M)], reconsidered its position, and conceded the case.

In Ray, the Tax Court found that payments received under a CRP contract were includible in self-employment income.  In this case, the taxpayers were engaged in the business of farming and cattle grazing and had acquired additional land that had been previously enrolled in the CRP.  The Tax Court held that there was a sufficient nexus between the CRP payments received and the taxpayer’s trade or business of farming to support the finding that the payments were includible in self-employment income subject to SECA tax.

In Rev. Rul. 60-32, 1960-1 C.B. 23, the Service held that annual payments received under the Soil Bank Act[2], an earlier acreage reserve program of the USDA, were includible in determining the recipient’s net earnings from self-employment, if the recipient operated his farm personally or through agents or employees.  The Service reasoned that the payments were in the nature of receipts from farm operations in that they replaced income which producers could have expected to realize from the normal use of the land devoted to the program.  This was also true if the recipient’s farm was operated by others and he participated materially in the production of commodities, or management of such production, within the meaning of section 1402(a)(1).  However, if the recipient did not so operate or materially participate, payments received were not to be included in determining net earnings from self-employment.

In Rev. Rul. 65-149, 1965-1 C.B. 434, the Service addressed whether grain storage fees paid to a farm operator under the price support loan program of the Commodity Credit Corporation are to be regarded as attributable to the operator’s trade or business of farming and considered in computing the operator’s self-employment income.  The Service argued that income derived from the operation of a farm, regardless of the form of the income (cash sales, Commodity Credit Corporation loans, Government subsidies, including soil bank payments, conservation reserve payments, etc.), should be treated in a manner consistent with the position set forth in Rev. Rul. 60-32.  That is to say, if this income is received by a farm operator, or a landlord who materially participates, it should be treated as self-employment income.  If it is received by a landlord who does not materially participate, it should be treated as rental income and excluded from net earnings from self-employment.

More recently, in Announcement 83-43, 1983-10 I.R.B. 29, the Service concluded that if a farmer participates in the Payment-in-Kind (PIK), or any other land diversion program sponsored by the USDA, and receives cash or a payment in kind from the USDA with respect to the diverted acres, the farmer is liable for SECA tax on the cash or payment in kind received.  The announcement further provided that, for estate tax purposes (sections 2032A and 6166), land diverted from the production of an agricultural commodity under a USDA land diversion program will be treated as being used as a farm for farming purposes and in the active conduct of a farming business.

Furthermore, participation in a USDA land diversion program and in the devotion of such land to conservation purposes under such programs will be treated as material participation in the operation of a farm with respect to the diverted acres.

As to reporting requirements, section 6017 provides that every individual (other than a nonresident alien) having net earnings from self-employment of $400 or more for the taxable year shall make a return with respect to SECA tax.  Income Tax Reg. §1.6017-1(a)(2) provides that the return required by section 6017 for SECA tax shall be Form 1040.

Schedule SE is the form used to report net earning from self-employment and SECA tax.  See 2002 Instructions for Schedule SE, Self-Employment Tax.

Schedule F is the form used to report farm income and expenses.  See 2002 Instructions for Schedule F, Profit or Loss From Farming.

Schedule E is the form used to report income and expenses for rentals of real estate (including personal property leased with real estate) and royalty income and expenses.  See 2002 Instructions for Schedule E, Supplemental Income and Loss.

Form 4835 is the form used by landlords or sub-lessors to report farm rental income and expenses based on the crops or livestock produced by the tenant where the landlord or sub-lessor did not materially participate (for SECA tax purposes) in the operation or management of the farm.  The use of Form 4835 only applies to those circumstances where there is an arrangement between an owner or tenant and another individual whereby the other individual is to produce agricultural or horticultural commodities on the land.  See General Instructions for Form 4835.

In each case, the annual “rental” payments that Taxpayer A and Taxpayer B individually receive for land enrolled in the CRP are in the nature of receipts from farm operations earned in lieu of income that each taxpayer could have expected to realize from the normal use of their respective cropland, if they had not enrolled the cropland in the CRP.  See Rev. Rul. 60-32.

Pursuant to the terms of the CRP contract, each taxpayer is required to engage in soil conservation practices, to establish or maintain approved vegetative cover on the cropland, to not use the land for agricultural purposes except as permitted by USDA, and to not conduct any harvesting or grazing on the cropland.  The income is derived from the income-producing activity of the taxpayers in performing under the CRP contract.  The CRP contracts require Taxpayer A and Taxpayer B to perform tasks that are intrinsic to the farming trade or business.  The fact that Taxpayer A was previously engaged in the trade or business of farming prior to enrolling Taxpayer A’s land in the CRP is an additional fact that helps establish that Taxpayer A is continuing to be engaged in the trade or business of farming.  However, Taxpayer B, who was not engaged in farming prior to the purchase of land subject to a CRP contract, becomes engaged in trade or business of farming in personally fulfilling Taxpayer B’s obligations under the terms and conditions of the CRP contract.  See Hasbrouck.  As long as Taxpayer A and Taxpayer B are actively fulfilling their respective obligations under their respective CRP contracts, they will both individually be considered to be engaged in the trade or business of farming.

The CRP payments are in connection with and have a direct nexus to the taxpayer’s ongoing business of farming.  See Wuebker; see also Ray.

Although the payments are labeled as “rental” payments for purposes of the CRP, the narrow-construction placed on the section 1402(a)(1) exclusion for rentals from real estate eliminates these payments from its provisions.  See Wuebker.  Further, under our facts, neither Taxpayer A nor Taxpayer B leased the land to a third party, such as another individual, on a rental basis.  Thus, the test regarding material participation by the owner of rented land to a third party is irrelevant.[3]

The income derived from the CRP contract is includible in self-employment income subject to SECA tax.  Taxpayer A must report the CRP payments as self-employment income from farming subject to SECA tax.  Similarly, Taxpayer B must report the CRP payments as self-employment income from farming subject to SECA tax.

After having concluded that CRP payments are includible in self-employment income from farming, such CRP payments should be reported on Schedule F, filed with Form 1040.  See Pub 225, Farmer’s Tax Guide; and Instructions for Schedule F; Cf. Hasbrouck.  Any profit or loss from farming should then be reported on a Schedule SE for SECA tax purposes pursuant to form instructions.  See 2002 Instructions for Schedule F, Profit or Loss From Farming.

CRP payments are not considered rental income from real estate nor are they rental income from farm production or crop shares.[4]  Accordingly, the use of Schedule E or Form 4835, under our facts, is not allowed.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This memorandum does not address cost-share assistance.

This writing may contain privileged information.  Any unauthorized disclosure of this writing may have an adverse effect on privileges, such as the attorney client privilege.  If disclosure becomes necessary, please contact this office for our views.

Please call if you have any further questions.

APPENDIX B

 Ltr. Rul. 8822064, March 7, 1988.

*Presented at a conference, Washington, D.C., sponsored by Cong. Earl Pomeroy, June 8, 2004.

**Charles F. Curtis Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa; Member of the Iowa Bar.

[1] Although the CRP contract referred to the payments as annual “rental” payments, such reference does not compel the conclusion that they should fall within the rentals-from-real estate conclusion.  Wuebker at 904; citing Cline v. Commissioner, 617 F.2d 192, 195 (6th Cir. 1980) [80-1 USTC ¶9315] (“Courts must look to the substance, rather than the form, of the transactions…”).

[2] Soil Bank Act, Title I of the Agricultural Act of 1956, 7 U.S.C. 1801-37 (repealed 1965).  Under §103(a) of the Act, the Secretary of Agriculture is authorized and directed to carry out an acreage reserve program from the crops of specified commodities.  Producers participating in the program are compensated for reducing their acreage of a commodity below their farm acreage allotments or their farm base acreage, whichever may be applicable.  Producers must enter into a contract where they agree to perform various activities in connection with the land.

[3] Under the rentals-from-real estate exception, the owner of a farm operated on a rental basis must include the rental income in determining net earnings if (1) such income is derived under an arrangement between the owner and another individual which provides that there be material participation by the owner in the production or the management of the production of such commodities, and (2) there is material participation by the owner with respect to such commodity.

[4] An arrangement for the production of agriculture or horticulture commodities is not present under the CRP contract for either Taxpayer A or Taxpayer B.

Under the Food Security Act of 1985, the Secretary of Agriculture instituted a 10-year conservation acreage reserve program under which the Secretary enters into contracts with owners and operators of highly erodible cropland to take the cropland out of production of intertilled crops and place the land in conservation and soil and water conserving uses.  Those bidding their lands into a CRP program are compensated on a pre-acre basis in cash or, occasionally, commodities.  Not more than 25 percent of the acreage in a county may be placed in the reserve, unless the Secretary of Agriculture determines that additional acres in the program in that county will not affect adversely the local economy.

Approximately 34 million acres are presently enrolled in the CRP program.  Periodically, the Secretary of Agriculture announces that, for a designated time, owners wanting to enroll land in the Conservation Reserve Program can make an offer in bid form to idle the land in exchange for the bid price per acre.  In accepting bids, the Secretary of Agriculture is to take into consideration the extent of erosion on and the productivity of the land involved; accept offers that provide for permanently vegetated stream borders and filter strips; establish criteria for different regions of the country; and give priority to owners and operators under the greatest economic stress.

The amount of rental payments made to a “person” may not exceed $50,000 per year, which is in addition to payments that can be received under any other agricultural commodity program.

Under a CRP contract, the owner or operator must agree to:

1. implement a plan approved by the local conservation district to convert highly erodible crop land to less intensive use, including pasture, grass, legumes, forbs, shrubs or trees;
2. place the highly erodible land specified in the contract in reserve so as not to be used for agricultural purposes except as permitted by the Secretary of Agriculture;
3. establish vegetative cover on the land;
4. forfeit all rights to rental and cost sharing payments and refund any rental and cost sharing payments received under the contract, with interest, upon termination of the contract resulting from a violation of the terms of the contract;
5. refund to the Secretary of Agriculture or accept adjustments to the rental and cost sharing payments provided to the owner for violation of the terms of the contract which does not cause termination of the contract;
6. forfeit all rights to rental and cost sharing payments under the contract upon transfer of the land, unless the transferee of the land agrees to assume all obligations of the contract;
7. refund rental and cost sharing payments or accept adjustments in the rental and cost sharing payments, unless the transferee of the land agrees to assume all obligations of the contract;
8. not make any commercial use, such as harvesting or grazing, of the forage on the contract land, unless permitted by the Secretary of Agriculture in case of drought or other emergency;
9. not plant trees on the contract land unless permitted by the contract, except that customary forestry practices may be allowed on land converted to forestry use;
10. not adopt any practice specified in the contract which may defeat the purposes of the program; and
11. comply with any additional contract provisions.

Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa.  Member of the Iowa Bar.

Mr. POMEROY. I don't expect necessarily that you can speak to what might be under contemplation at the IRS, but I would like your attention to those recommendations, and as quickly as possible, because people literally have dozens, if not hundreds, of tax filings and a questioned status in their offices, not knowing how to treat this new development.

Mr. EVERSON. I had a discussion on this before the hearing today with some of my folks who were familiar with the meeting that I think you held last week on this.

Mr. POMEROY. Yes.

Mr. EVERSON. As we indicated in the early conversation, this is a discussion that has broad ramifications, particularly as the country moves to a model where there are more individuals who are self-employed or running small businesses. We need to tread very carefully as we look at this. I give you my commitment that we will look at this very carefully.

Mr. POMEROY. Mr. Commissioner, can we expect to have any guidance from the IRS prior to the filing date for this tax season?

Mr. EVERSON. I don't know the answer to that. I would imagine that would be quite expedited, since we're only a couple of weeks away from April 15th. I will ask that specific question. It is not one that we discussed or had an expectation of something that rapid in the conversation I had, in fact, earlier today on this subject. I will check.

Mr. POMEROY. To sharpen the point to you, by acknowledgement of the IRS, the letter ruling--which is private and nonbinding, but nonetheless stands with some authority about what the tax treatment might be in this area--was prepared without contemplation of retired farmers but the wording of it is broad enough to sweep them in. It leaves people in a very difficult position on whether to ignore it, as has been the treatment of this matter since 1988, or whether you change based on the IRS wording that was put out not in contemplation of this specific issue. So, some clarification I believe in this instance would be appropriate. Again, we're not asking the IRS not to--what we want them to do is lift the confusion by basically lifting the letter ruling as it applies to retired farmers, and then come forward with a more definitive statement with the contemplation of this particular set of circumstances, going forward for future guidance. I thank the Commissioner.

Chairman HOUGHTON. Thanks very much, Mr. Pomeroy. Well, thank you, Mr. Commissioner. We appreciate your testimony.

Mr. EVERSON. Thank you, sir.

Chairman HOUGHTON. Now we've got a time problem. I'm going to ask Mr. White, who is Director of Tax Issues for the GAO, and also Nancy Killefer, Chairman of the IRS Oversight Board, if you be willing to maybe squeeze in your testimony in maybe 3 minutes apiece in order that we can get through your testimony. Then when we come back from these three votes, we can get right into the questions. Is that all right with you, Ms. Killefer?

Ms. KILLEFER. Absolutely.

Chairman HOUGHTON. Good. Thanks very much. Okay, Mr. White.

Mr. WHITE. Mr. Chairman and Members of the Committee, we are pleased to be here. For several years, we have reported on the opposing trends in taxpayer service and enforcement that we've heard discussed already. IRS's 2005 budget addresses both enforcement and systems modernization.

One point I want to make about the budget request for 2005 is that this is not IRS's first request for additional enforcement staff. It follows similar requests in IRS's past five budgets. You can see what actually has happened in figure 1 on page 8 of my statement. Staffing in three key enforcement occupations--revenue agents, revenue officers and special agents--declined by over 21 percent between 1998 and 2003. These declines occurred, even though IRS's budget requests were almost fully funded and IRS did realize some savings. IRS funded other priorities, such as unbudgeted cost and improvements to taxpayer services.

Switching quickly to systems modernization, as you are aware, some projects have been completed but many of the projects that have not been completed are over cost and behind schedule. The point I want to make here is that this impacts taxpayers. The customer account data engine, for example, is intended to facilitate faster refund processing and better answers to taxpayer questions. IRS, in response to these problems, has reduced its modernization budget request to focus on fewer projects and is implementing action plans to correct deficiencies.

Turning to the 2004 filing season, IRS is continuing to improve most but not all taxpayer services, and we see this as a payoff from the completed modernization projects. I have some examples in my statement but I will skip most of those. Another point to make related to customer service and IRS's budget both has to do with electronic filing. Electronic filing is continuing to grow, but it is not growing at the rate that would meet either IRS's 80 percent goal but, in fact, is growing at a slower rate each year. This continues a trend that we have seen over time.

Electronic filing is important because it's a way to gain efficiencies. It's much cheaper to process electronically filed returns than to process paper filed returns, which is a very labor-intensive process. An example of the consequence of the growth of electronic filing that we've seen is that IRS has been able to reduce processing staff. In 2003, for example, about 1,000 full time equivalents in the processing area of IRS was the size of the decline there. So, it's a significant saving in that area.

Mr. Chairman, my three themes--declines in enforcement staff, systems modernization, and improved service--are related. Recent history causes us to question whether IRS will be able to increase enforcement staffing as much as proposed in the 2005 budget. IRS already expects some unbudgeted costs. If all IRS's planned savings are not realized, then funds for enforcement could be further reduced. One near term option for increasing enforcement staff is to reconsider the level and types of services IRS provides. For example, the improvements in phone and Internet service raise a question about whether IRS needs to operate as many walk-in sites. Longer term systems modernization, if successful, could generate efficiencies and increase e-filing which would allow IRS to do more with less.

I want to make a final point on enforcement staffing. As noted, many fear that declines could be reducing taxpayers' incentives to voluntarily comply. However, IRS currently does not have a measure of voluntary compliance. IRS is working to develop a measure, but won't have results until 2005. Those results could impact future IRS budgets. If compliance is stable or has improved, the pressure to increase IRS's enforcement staff might diminish in the future. If, however, compliance is down, the pressure on IRS's budget will likely increase in the future. Thank you, Mr. Chairman.

[The prepared statement of Mr. White follows:]

Chairman HOUGHTON. Thank you very much. We're just going to have to stop now. Miss Killefer, I'm sorry about this. We will just suspend the hearing until we come back from the votes. We'll be back as fast as we can. Thank you very much.

[Recess.]

Could we re-commence the hearing, please? Ms. Killefer, thanks very much.

Ms. KILLEFER. Mr. Chairman, thank you for inviting us here to testify. The Board believes that the IRS Budget is more than dollars or cents. It is really about the choices we as a Nation make about the future of our tax administration system, and how we help over 100 million American taxpayers deal with, unfortunately, an increasingly complex Tax Code and ensure that every American citizen pays his or her fair share of their taxes. We strongly believe that this is a critical time in our tax system's history, and it is a time to strengthen it, not merely to maintain it. As we all know, billions of dollars in uncollected taxes are left on the table because the IRS simply does not have the resources to do the job, and with each passing year, as the Board has done in its own research with the Roper Survey, we know that more Americans believe that it is more acceptable to cheat. This is particularly true of young Americans, and that is a very disturbing trend.

In crafting our budget to present to Congress, the Board addressed the concerns head on by reinvesting in the IRS to produce tangible increases in enforcement while maintaining the high level of customer service that we have achieved through the implementation of RRA 98. The Board is calling for a 10 percent increase in funding which should result in an increase of over 3,000 enforcement personnel, which would allow the IRS to improve its enforcement while maintaining customer service, and we also call for an increase in the budget for modernization versus the administration.

While we applaud the Administration, and particularly Secretary Snow, for requesting a funding increase for the IRS, we feel there is a fatal flaw in the budget and it comes because left uncorrected are the lack of funding for what we believe will be pay parity between the civilian and military budgets, an issue that you are grappling with here on the Hill, as well as unfunded costs in areas such as rent, postage, that have gone on for the 3 years preceding this. What this problem ends up with is the IRS has never been able to hire the FTEs that it projects. Each year for the past 4 years, and perhaps before, those increases have been eaten up by pay parity that was unfunded in the President's budget, as well as other unfunded liabilities. In an organization like the IRS that it 80 percent people, there is no choice but to hold back on hiring.

Our concern with the Administration's budget is that if you believe that pay parity will happen yet again, and that many of the increases that we know will already be there from GSA in terms of rent increases, et cetera, you will not be able to hire any of the additional people that the Administration recommends. We feel, as private sector members of the Board, that we cannot let this trend go on. It simply will lead to once again with increasing tax load from both more taxpayers filing as well as more schemes out there, that their enforcement will become hollow, and we think that is a terribly disturbing trend.

What we are recommending therefore is a 10-percent increase which would assume the funding of , if you will, a parity pay increase as well as full funding of rent increases that are already on the table from GSA, and other increases we anticipate, and then allow for the hiring of over 3,000 additional enforcement personnel, which we feel are badly needed, and which I think in fact the Commissioner and GAO absolutely support. One last point I would like to make from the Board's perspective is RRA 98 gave us, in fact demanded, that we submit a budget to you directly that represented our best judgment about the requirements of the IRS to fulfill its strategic mission.

From our collective expertise and familiarity with the private sector and best practices on the IRS's problems, we believe that these investments in enforcement pay for themselves many times over, not only in the revenue dollars that are directly collected through these enforcement activities, but by also reinforcing our voluntary tax system through the belief that every person is paying his or her fair share, and that is the fundamental strength of our tax system. Thank you.

[The prepared statement of Ms. Killefer follows:]

Chairman HOUGHTON. Let me ask Mr. White a question, and then we will come back to you, Ms. Killefer. Mr. White, the Commissioner showed us a chart showing the audit rates of those making over $100,000 and they are increasing. The GAO has done previous work on the ways the IRS assures compliance through other means, such as document matching. Do you think the IRS has taken the right steps to make sure all taxpayers are paying what they owe?

Mr. WHITE. I would make several points, Mr. Chairman. It is true that there are substitutes for certain types of audits. There may not be substitutes for the more complex face-to-face types of audits. Another point I would make though is that right now IRS does not know the size of the compliance problem. They do not have a current measure of the compliance rate. The last time they measured the compliance rate was using 1988 tax return data. So, they are in the process of developing a new measure, but it is not going to be available for at least another year, so we do not know the size of the problem.

In terms of steps that IRS can take to actually increase enforcement, there are several things they can do. One is to use their existing enforcement resources more efficiently. Their efforts to measure compliance should help them better target pockets of noncompliance, and therefore better allocate their existing resources. Right now they are sort of flying blind when it comes to allocating resources because it has been so long since they researched where noncompliance is. Another thing they need to do to use the existing enforcement resources more efficiently is make sure the business systems modernization is successful. They need to bring the new systems online. That will help.

Finally, something else they can do is free up resources from other parts of IRS and transfer those resources, reallocate those resources into enforcement work. One example is e-filing. I said in my statement that e-filing has now started to result in decreases in the number of processing staff at IRS. In 2003 they reduced the number of processing FTEs by about 1,000. They can also reconsider the level and types of services that they offer. Now the telephone service is so much improved, now that the Internet provides options that didn't exist even a couple of years ago, maybe it is time to raise the question of whether as many walk-in sites are needed at IRS. In fact, taxpayers are already making this decision. The number of taxpayers who use walk-in sites has been steadily declining at IRS. So, there are some opportunities to free resources from other parts of IRS and shift them into enforcement.

Chairman HOUGHTON. It seems almost impossible for me to believe that they do not know the size of the problem. Break that down a little bit.

Mr. WHITE. The last time they measured compliance, the rate at which taxpayers are paying what they know--this gets back to the measure of the tax gap which is the difference between what people ought to owe and what they are actually paying. The last time they estimated that compliance rate with a statistically valid approach was based on 1988 tax return data. Since then we have had tremendous changes in the economy. They now have their National Research Program to come up with a new measure of the compliance rate, but as I said, those results will not be available for another year.

Chairman HOUGHTON. What about the chart that the Commissioner used in terms of the enforcement resources that have been halted, and the effort remains below what is needed? There has got to be some relationship to the resources put in and to the people that are not complying or they don't think are complying.

Mr. WHITE. That is the fear that many people have, that because of the decline in those enforcement resources and what that has meant for their ability to conduct enforcement, that people's willingness to voluntarily comply may be going down. They have less incentive to comply than they did before, that they view IRS as less of a credible enforcement threat. The way I often think about this is from the point of view of honest taxpayers. Those taxpayers--and I think you raised this issue yourself--the system depends on trust. The confidence that honest taxpayers have that their friends, neighbors and business competitors are paying their fair share of the taxes, and if we ever lose that, then the compliance rate will suffer.

Chairman HOUGHTON. Ms. Killefer, I would like to go back to some of your statements. I suppose the law which created the Oversight Board gave you the proper authority and the resources to do your job. Is that right?

Ms. KILLEFER. In many ways, yes. I think we have learned over the course of the first three plus years of the Oversight Board we have a couple of things that were not foreseen. For example, as you all know, the nomination process is a lengthy one, and we currently have two vacant Board seats. We will have a couple more coming up. It is very difficult to conceive of the Board operating without a full membership as it was conceived. So, there are some things that we are learning as we go. Indeed, we were given the authority to submit a budget, but we have learned that we have become a footnote in the President's budget. Hence, we have started to issue our own report and appreciate the opportunity to testify here to be clear about what we think are the necessary resources.

Chairman HOUGHTON. I am sure you are very worried about the expense to revenue ratio. Whether this is going to turn around overnight or not, I have no idea. Probably not. The nonmilitary discretionary account, which is now about one-sixth of the overall budget, is getting squeezed all the time. I think it is a good idea. We are in a national crisis. We have to support our troops abroad. Hopefully it will not be as much in the future as it has been the last 2 years, but we have to do our bit here. If you look at a budget of an agency that is $10.7 billion, you have to believe that there is some opportunity for maneuvering, and I know it is not what you want, and I know you have suggested other resources, and I know there are other things as far as compliance that are important. Isn't there an opportunity with that size budget to do some of the things, particularly since we are in such a cost crunch in the country?

Ms. KILLEFER. Chairman, what I would say is from a private sector point of view it is unfortunate that the Federal budget views this as a cost center and fails to be able to recognize its revenue potential. If you had a company--and I know you have--and had the opportunity to invest in growth and revenue, would you do it? I know the answer is yes. That is what we are facing here. When you talk about the IRS, and it is 100,000 people, recognize that the sheer processing of returns, which has gone up every year and become more complex every year, and the answering of the phone calls, right, the very basic processing simply needs to get done. That is what has driven down the enforcement resources. It has not been a desire to do less enforcement. It has been the problem of with a fixed amount of resource--you have seen they have not gone up--the number of returns has gone up, the complexity of the returns has gone up, so you have an increasing workload with a fixed amount of resources, and what you have to do is process basic returns, answer the phone calls, put out the tax forms, and the discretionary becomes enforcement.

Chairman HOUGHTON. Yes, but there was a seismic shift in the structure of the IRS that took away from some of the enforcement capabilities, but now, getting back into balance, I would imagine that that would be lightened a bit.

Ms. KILLEFER. If you call it a seismic shift to take the phone service from less than 50 percent to now currently 80 percent, it was. If you consider that you want to go back to 50 percent so that you can fund enforcement? I think that is a promise that we would disagree with as a Board. We believe that--

Chairman HOUGHTON. That is not my process.

Ms. KILLEFER. Why did we put--

Chairman HOUGHTON. My question is this: you have $11.7 billion. Why can't you work something in terms of the things you think are important within that overall figure?

Ms. KILLEFER. Chairman, there have been productivity improvements at the IRS, in fact, completely in line with the financial sector of this country. So, they have achieved productivity. As Jim pointed out, we have gotten more electronic returns. The Brookhaven Center has shut down. We are shutting down another center. There will be another coming. Productivity improvements have occurred, but what you have here is an increasing workload at the same time, and we are off base--and I think a false base--of an unacceptable level of service, and we don't know whether it was the right level of enforcement. So, the premise that we started out with an adequate base and therefore can achieve productivity and redeploy, I think is a false premise. We were at an unacceptable level. I think if you go back and look over history, there are times that the IRS was funded at a much greater level, in the mid 1990s. It is simply, if you just run the workload numbers, you cannot do the work that needs to get done and support an enhancement of the enforcement efforts.

Chairman HOUGHTON. Mr. Pomeroy?

Mr. POMEROY. That was a very interesting exchange and I agree with both perspectives that were voiced. I think the Chairman raises a good point, that we want to capture all efficiencies and the savings flowing from them, and redirect them to agency priorities, and that would certainly be enforcement. At the same time I think you have been such an advocate, Ms. Killefer, I am making certain we understand enforcement takes funding. Failure to fund enforcement means people don't pay their taxes and you leave revenue uncollected, revenue that is owed under the law, revenue that most law-abiding taxpayers are paying, but some who are breaking the law are not paying. It is indeed a revenue center. Do you have any ball-park notion of for every dollar spent on enforcement, what you might collect in revenues?

Ms. KILLEFER. As Jim said, there are no recent calculations. The old numbers were approximately 10 or $11 per dollar spent, but those are very, very old, and I would not suggest that those are correct today.

Mr. POMEROY. When I was in the State legislature we enacted a program called Catch the Tax Cheater Program, and for every dollar expended we got $10 in revenue. I would believe, in fact, when we look at the demise of collections, driven by demise of audits, we might even do better than 10 to 1 in this environment. Mr. White, do you have any notions in that regard?

Mr. WHITE. We don't have any independent estimates. IRS has done some very crude guesstimates on it which suggest that you could bring in more than a dollar that you spend. They don't have a very good database for making those estimates, however.

Mr. POMEROY. I think that in helping Congress understand that funding IRS is in part a revenue center, not a cost center, some greater quantification of this would be helpful.

Ms. KILLEFER. Absolutely.

Mr. POMEROY. I hope we can work toward getting some better figure here. Let me turn to the back part of your testimony, Ms. Killefer, which talks about specifically enforcement activities requested but not collected. We spent an awful lot of time talking about abusive corporate tax shelters. I note that the funding requested by the Oversight Board was almost double what was funded by the Administration. Funding was reduced $23 million, 187 positions. Is that correct?

Ms. KILLEFER. That is correct.

Mr. POMEROY. Is it your belief that there will therefore be abusive corporate tax shelters that will not be caught, and there will be tax revenues owed but not paid because of these abusive corporate tax shelters and our somewhat limited ability to catch and deal with them?

Ms. KILLEFER. We do have that concern, and history would suggest that that is true.

Mr. POMEROY. There is another line item that is even more stark in terms of positions requested by the Oversight Board but not funded, and this is dismantling international and domestic terrorist financing. You request $12 million, 80 positions. Nothing was granted, no positions, no dollars to this request for dismantling international and domestic terrorist financing. Can you give us some background on that?

Ms. KILLEFER. The IRS I think traditionally over time has played an important role beyond sheer tax collection, be it the old Al Capone case. We feel that it really has the ability and the talent from its financial actuarial skills actually to play a great service to the country. So, we felt it was worthy to fund. I am not sure what the Administration is thinking. I am sure that they share our intent. I just think that that is the way the dollars fell out.

Mr. POMEROY. We have been working for some years to try and get at the financial underpinnings of international terrorism. Is the IRS without the capability to participate in that effort?

Ms. KILLEFER. I am not sure how they will actually end up allocating resources when they finally get their budget.

Mr. POMEROY. The Oversight Board came to the conclusion that we need to play a more robust role in attacking the international financing of terrorist, and 80 positions ought to be committed in this regard. None were allowed by the Administration.

Ms. KILLEFER. That is correct.

Mr. POMEROY. Thank you, Mr. Chairman.

Chairman HOUGHTON. Thanks, Mr. Pomeroy. Mr. Portman.

Mr. PORTMAN. Thank you, Mr. Chairman. I would like to hear the Administration's response to that 80 positions. I would imagine that they have allocated resources through some means, and I hope we can get that in writing from the Administration.

Ms. Killefer, I thank you very much for not just being here today, but for the work you do on the Board, and as you know, I think the Board is critically important, and when we created the Board we gave the Board a few very important responsibilities that were in the area of approval and not just review and oversight, and one was in preparing a budget which would go to the Secretary, to the President and then require it to be submitted to the Hill. This year your budget, as I read it, is about 5 percent greater than the Administration's request, last years, about 2.7 percent.

This is, frankly, what we expected to have happen. You indicated that back in the 1990s the IRS was funded better. I assume you mean that in relative terms because in the mid 1990s you referred to, we went from 7.4 billion down to 7.3 billion, down to 7.2 billion by 1997, and in 1998, when we issued our Restructuring and Reform Commission Report and then legislated, we went back up to 7.8 billion, and since then we have gone up. Earlier we said this proposal the Administration has before us is for a 4.8 percent budget increase. Remembering that there will be, in the congressional, budgeting process, I believe, a freeze on all non-security domestic discretionary spending, which includes the IRS, the Administration had less than a 1 percent increase, so the IRS did relatively well compared to other agencies and Departments.

Given what our deficit is and given where we are as a country right now, in fighting the war on terrorism, that is a fairly healthy increase. So, I just want to put that in some perspective to make sure we are not leaving the impression with those who might be listening that somehow we are terribly shortchanging the agency. In fact, in the Bush years, we have gone up almost 14 percent in spending for the IRS. It is tough. Every year this Subcommittee or at least some of its membership takes into account what the Oversight Board tells us, and our own independent analysis, and we fight with the appropriations process to try to be sure that there is adequate funding. The IRS is not always the most popular agency to fund. This year I think a 4.8-percent increase, again, is generous, and that is why we wrote a letter, the three of us, to the appropriators asking that that be fully funded. We are not suggesting how that is allocated between various enforcement and taxpayer service accounts, but we believe that at a minimum we ought to have this rather substantial increase in funding, again, relative to other agencies and Departments.

So, having said all that, I very much appreciate your budget and I appreciate the fact that you have laid out for us what you think the priorities are. I do think it is a little dangerous to get into saying, gee, because the Oversight Board has said specifically there ought to be 80 positions here, that if the budget of the Administration doesn't fund those, that that function somehow isn't accommodated--I don't know if it is or not--but that wasn't really the purpose of the Board, to get into that kind of micro management. It was the purpose to give us your unvarnished view of what you think the needs really are within a realistic framework, and I think you have done that. One quick question for you. The Oversight Board, as you know, is currently being reviewed as well, and as a strong supporter of the Board and someone who believes that it has met its intended purpose to provide oversight, do you think the Board itself is being given adequate support and adequate resources to do its job?

Ms. KILLEFER. That was a question that Chairman Houghton asked before, and I said we have learned through this first 3 plus years of the Board that there are some things that were not foreseen. As you know, having spent time with us, we actually are short two members and the nomination process has proved quite lengthy, and that has left us understaffed from a member standpoint. We also have some issues about continuity of our Board staff that concern us, and so we actually would suggest there may be some changes that we all want to make in the interest of ensuring the Board actually fulfills its intent over time, and having the strength of a full membership at all time and continuity in its staff support.

Mr. PORTMAN. That would be sensible since one of the main reasons for the Board was to provide continuity as well as expertise and accountability, and I think those are functions that have been performed very well. This hearing today is an example of that. I would just again say we need to keep it in perspective, that the Administration is proposing a substantial increase. The Commissioner, as you testified earlier, is focusing that increase where it needs to go right now, which is on enforcement, at the same time recognizing that we should never sacrifice the service gains we have made. We cannot allow this pendulum to swing, and that is where the Board provides an invaluable break on what might otherwise be the tendency in government to swing from one, in this case, enforcement, away from taxpayer service. They are consistent with one another I believe, and we will have that theory tested I suppose over the next couple of years as we try to do both. Thank you, Ms. Killefer.

Chairman HOUGHTON. Thank you, Mr. Portman. Mr. Pomeroy.

Mr. POMEROY. Ms. Killefer, I would like to come back to these positions in the international and domestic terrorist budget request. Can you tell us a little bit about the activities that you envisioned this corps doing? If you are not prepared to speak to it, I will certainly request some follow up writing regarding this matter, but it really does jump out as a pretty serious difference of opinion between the Oversight Board and the Administration. Can you give us information on it?

Ms. KILLEFER. Let me say that I don't know that it is as serious a disagreement as it would appear. I think what we reviewed as a Board in putting together the budget is where we felt there were initiatives that required increased resources. That was one of them you see among many in the enforcement arena. I am not sure the thinking that went on in the Administration as they tried to generate a budget that fit into the total budget, but they clearly brought down their request that both the IRS and we submitted. In doing that they made some choice. I am not sure that they are the ultimate choices that they will actually make when they receive a budget level. How they allocate resources post getting a budget among initiatives, I am not sure what they will do. I would be happy to provide you with detail around that initiative to give you some sense of why we approved it.

Mr. POMEROY. I would very much like that information, and I believe you have been kind in your characterization. You requested 80 positions. They did not give you any positions. This isn't just kind of differing at the edges of this proposal. It seems as though you believe that within the IRS structure and competencies, tracking the international flow of money to finance terrorism is something you would have very substantial enforcement powers to move out. I believe that most Americans think we need all hands on deck on this one, and if IRS can play a role along with the major criminal investigatory powers of this country, and whatever resources are being brought to bear, it would in all likelihood be a very helpful addition. So, I am going to want to pursue this and get some answers.

Ms. KILLEFER. We certainly do believe they can play a meaningful role in this, given their skills.

Mr. POMEROY. Then I would certainly like to know where specifically you see that and then engage the OMB in some discussions as to why they so completely disagreed and eliminated you from participating in this area. I thank the Chair and look forward to receiving the information from the witness. Thank you.

Chairman HOUGHTON. Mr. Portman.

Mr. PORTMAN. I should probably stop here, but I just have to say to my friend, Mr. Pomeroy, and to my friend, Nancy Killefer, I do think the Oversight Board has incredible expertise and specifically under law you are supposed to have expertise in management, which you do, and information technology, as Larry does, and in reorganization of large corporations and even small business expertise. We did not select you for your expertise on terrorism. So, I would hope that those who are listening, again, would not assume that this Oversight Board has the ability to decide how our government should be drying up resources to terrorists. That is not a function we looked for you to perform, and I am frankly disappointed that the Oversight Board is making recommendations about where they think terrorism ought to be approached within the IRS budget. That was not the idea. We do respect your budget, and I am again delighted to have it, but I would hope that we would understand that this Board--and this was a very controversial Board to set up--was put in place with some very specific constraints and very specifically looking for expertise in the areas where the IRS was most lacking, and that was in management, information technology and small business, and taxpayer sensitivity, and not, as important as it is, in fighting the war against terrorism. Thank you, Mr. Chairman.

Mr. POMEROY. You know the depth of my regard for my colleague, Rob Portman, and there has not been a legislator of the 435 of us more committed over the long haul to making sure the IRS is focusing on the right priorities and has the resources to do it, and he is in the weeds in technical competencies and he has worked it over time with great conscientiousness, and I admire his work in this area a great deal. I want to take a little issue with what he was just talking about in this area. Ms Killefer, you, as one Board Member, do have some background in international finance; is that correct?

Ms. KILLEFER. Yes, sir, some.

Mr. POMEROY. You are in fact a senior partner at McKenzie and Company, and indeed have a specific expertise within that company in international management consulting; is that correct?

Ms. KILLEFER. It is an international management consulting company.

Mr. POMEROY. You have held a variety of positions, public and private, relating not just to the flow of finance domestically, but internationally; is that correct?

Ms. KILLEFER. To some extend. I would say what--just to clarify for both of you--that what the Board does when it construct its budget--is work very closely with the IRS and look at a series of initiatives that we don't propose, that they propose to us as ones that would meet their mission. It is through that process that among other things this was one of their initiatives. So, we did not propose it, nor would we expect to propose initiatives to them.

Mr. POMEROY. Many illegal conspiracies have ultimately been brought down by investigators following the flow of money. Following the flow of money is something the IRS is pretty good at, isn't it?

Ms. KILLEFER. I would think so. There are other elements of government that do the same.

Mr. POMEROY. Undoubtedly, and there have been no discussions this afternoon about taking all other investigative areas here and stripping it from those agencies and putting it in the IRS. That is not what we are talking about at all, but we are talking about being able to tap some of the extraordinary institutional potential in the agency that through history has been in charge of basically following the money, finding out what is owed to our government, collecting it, including not just taxpayers at the H&R Block Office this afternoon, but very sophisticated international enterprises. That some of this in-house expertise, if augmented with appropriate resources, could have played a very interesting additional role perhaps in back-stopping these other agencies. So, as the Board, with all of its tremendous sophistication in international finance, evaluated this proposal from the IRS, it isn't as though you are without expertise, without competence to have an informed opinion on this matter, in my belief, and that is why I look forward very much to receiving this additional information from you. I thank the Chair. I yield back.

Chairman HOUGHTON. I feel like I have been at a tennis match here.

[Laughter.]

Mr. White, you and I ought to have our own session here. Anyway, I thank you very much for your testimony. I appreciate the work. You are great citizens. I think we will now move on to our next panel. Mr. Orwick, who is the President and Owner of the LFS Professional IRSs; Richard Shaw, Chair of the Tax Section, American Bar Association, Robert Zarzar, who is Chairman of the Tax Executive Committee at the American Institute of Certified Public Accountants, James Leimbach, Enrolled Agent, National Association of Enrolled Agents, and Timothy McCormally, Executive Director of the Tax Executives Institute. Now, Mr. Pomeroy, would you like to introduce the invited witness, Mr. Orwick?

Mr. POMEROY. I would be delighted. Allen Orwick is President and Owner of LFS Professional IRSs, a tax accounting and property management company located in Lakota, North Dakota, where he prepares income tax returns on more than 500 filers. He has done this for 23 years.

We have had some exposure, Mr. Chairman, to some of the fanciest firms out there in terms of financial consulting and tax preparation. In my view, none exceed the professional integrity that Mr. Orwick brings to bear on behalf of his clients. He is not trying to stretch the law. He is trying to understand it, and he is trying to, therefore, give his advice to his taxpayer clients in terms of what they owe and what they do not owe. There is a significant issue that has come up relative to a major part of his work, and that is servicing retired farmers, and so we will hear from him on this question in the course of this panel.

I thank the Chairman, but I most particularly thank Mr. Orwick. I would just note as an aside, he is also the mayor of Michigan, North Dakota. So, while he is in the depth of filing season, he is out here testifying, and, by the way, Michigan, North Dakota, is having significant flooding, which he is also dealing with at the same time. So, this is a man of many hats, but we are glad he is bringing his tax preparer hat to this table this afternoon. Thank you.

Chairman HOUGHTON. Well, Mr. Orwick, we are going to give you a chance to prove that you are as good as Mr. Pomeroy says you are.

[Laughter.]

So, thank you very much. Would you give your testimony?

Mr. ORWICK. Thank you, Mr. Chairman and Mr. Pomeroy. I appreciate the opportunity to be here today. I am not so sure that I can live up to that billing, but I will do my best. Just to revisit, I have a tax practice located in Lakota, North Dakota. It is the northeastern part of the State, very agriculturally involved, also a county that has an aged population. So, the various issues that Mr. Pomeroy alluded to earlier are big, big issues in our home area. Overall, I would say our tax season is going very well. The day-to-day workings of the complex tax law, of course, seem to put more and more hours on myself and my staff every year. If I were to wish for one thing, I guess it would be simplification, like everybody else.

We have had various contacts with State agencies and the IRS and feel very fortunate to work with such high-quality people, and the courtesy and help that they have given us throughout the season are appreciated. Since 1997, we have been very involved in the e-file program, and as of last Sunday, when I tallied it up, we had utilized the e-file program for 99.2 percent of the qualified tax returns. Of those that we did transmit, 98.4 percent were approved on the first transmission, which is something that we are very proud of. We are a big believer in the program and recommend use of the program to our peers.

In regard to the situation of the CRP, prior to the letter ruling that Mr. Pomeroy referred to earlier that was issued last May, it has been our understanding that CRP is to be reported as self-employment income for those who are actively farming, and rental income for those who are not. With this recent ruling, it has really thrown everybody into a frenzy as to whether or not that is the correct process or not. I participated in a meeting last Friday, put together by Congressman Pomeroy in Bismarck, North Dakota, and we had members of the IRS, myself, Dr. Harl, and our State Agriculture Commissioner there. During that meeting, there were a lot of different thoughts brought forward, but what we did notice is no resolution.

It is a huge item to a retired person, and it looks as though about 10 percent of my clientele could be adversely affected by this ruling if that is the case, with an average cost of $1,200 per taxpayer, which out of my firm alone is $60,000. This is money that the taxpayers did not count on paying when they walked into my office. It was something that I had to inform them of possibly being out there. My clients are very conservative, and they are law-abiding citizens, and they want to do what is right. The problem we have today is that we don't know what is right because of the situation with this recent ruling.

I would like to mention Dr. Harl's recommendations at that meeting, one of which was the withdrawal of CCA Letter Ruling 200325002 or reissue it and bring it into harmony with Private Letter Ruling 8822064 and giving us some time to go through and sort this matter out. I would hope that the IRS would look upon these recommendations and adopt them so that we can bring some certainty and closure to this matter. I would also like to mention that I support legislation that is being offered by Congressman Pomeroy and others to completely exempt CRP payments from self-employment tax. I want to thank you for the opportunity to be here today. I will answer any questions that you may have.

[The prepared statement of Mr. Orwick follows:]

Chairman HOUGHTON. Well, I thank you very much for that. Also, I thank you for coming in under your time limit. That is very helpful. Mr. Shaw?

Mr. SHAW. Good afternoon, Mr. Chairman and Mr. Pomeroy. Thank you. My name is Richard Shaw. I am Chair of the American Bar Association (ABA) Section of Taxation. This testimony is presented on behalf of the 400,000 members of the American Bar Association and the 20,000 members of the Section of Taxation. We appear before you today to specifically talk about one primary subject, and that is the subject of simplification. We want to emphasize it today. The ABA and the Section of Taxation have long been advocates of simplification of the Tax Code. Last month, the Board of Governors and the House of Delegates of the Bar Association adopted a resolution which treats simplification as one of 12 of the highest priority legislative areas where we believe emphasis needs to be placed. We believe that complexity is at the root of many of the significant obstacles to efficient and effective administration of the tax laws. Let's talk first about complexity creates controversy.

As the National Tax Advocate and others have well documented, the scope and complexity of the tax laws make it virtually certain that taxpayers will face procedural, technical, and bureaucratic obstacles in trying to meet their tax obligations. This not only creates problems on the front end, when they are trying to prepare their returns, but when errors appear it appears at the back end, where it results in complexity and litigation and controversy that should not have to take place. Second, let's consider the problem of fairness. Complexity has materially reduced the taxpayers' perceptions of fairness of the Federal tax system by creating disparate treatment of similarly placed and situated taxpayers. It is hard to imagine how taxpayers and Congress can see the IRS as an efficient, modern service or agency when the taxpayer cannot perceive the tax system as even being fair.

Finally, let's evaluate the manipulation. Tax law complexity creates opportunities for technical manipulation of the tax laws, often in ways not contemplated by Congress. Aggressive exploitation of ambiguities in the laws not only further aggravates the perception problem but it forces the IRS, the IRS, to divert resources from working with compliant taxpayers to having to interpret and aggressively avoid the problem of--or the ability to deal with aggressive noncompliant. We would prefer that they be able to deal with the voluntary taxpayers, but recognize the need for dealing with noncompliance as well.

What we are saying is that legislation on simplification is necessary. It results in difficult choices. The political realities of seeking a fiscal balance limits the ability to seek simplification. We know that. Simplification necessitates a willingness to embrace objective standards without dealing with passionate and political constituencies. Simplification requires that you avoid popular proposals and deal with realistic ones that avoid complexity. The code is replete with burdens where there are complexity, and these burdens are greater than the benefits that are obtained by engaging in simplification. Frequently, taxpayers have to engage in torturous struggles between a maze of cross-references and inconsistent definitions in order to examine an issue and then determine finally that it is not even relevant.

There is a problem of deadwood where we have many statutes that were fair and applicable when they were first enacted, but because of changes are no longer relevant. I want to draw attention to several just quick examples where we believe simplification is helpful. It is necessary and appropriate that we deal with a phase-out of tax benefits. The Joint Committee on Taxation has sought that they be phased out. The child definition creates problems. There are at least five different definitions. When the taxpayers find that one works, they tend to think that it works for all. This results in complexity and it interferes with efficiency of the system. We think that there is a need for the elimination of the alternative minimum tax. It has created complexity that is unnecessary. The capital gains provisions apply several definitions and notes. Schedule D is almost impossible to complete.

The foreign tax rules need to be modified. In a true sense, we believe that simplification must be dealt with at this time. We also touch on the fact that regulatory simplification should be dealt with. We recognize that Congress prepares and enacts the law. We also think that Congress needs to oversee the IRS in a way that will assure that there is more efficient administration that will provide guidance for taxpayers so that they are able to comply properly with the tax laws and satisfy their obligations.

I have cut my comments very short, but I would like to summarize by simply stating that our primary message is the need for Congress to devote its energy and its resources to promote changes in the tax laws that will result in greater simplification. It is difficult to expect taxpayers to have confidence in taxes imposed under current laws when even experienced tax return preparers consistently get different results on similar data because of the complexity of the tax laws. The integrity, the fairness, and the equity of the tax system required and do require a concerned effort to obtain simplification now and not 10 years from now.

[The prepared statement of Mr. Shaw follows:]

Chairman HOUGHTON. All right. Thank you very much, Mr. Shaw. I don't think anybody disagrees. We will get into this a little later. Could I ask the rest of you if you could stay within the 5 minutes? I sure would appreciate that. Mr. Zarzar?

Mr. ZARZAR. Thank you, Chairman Houghton and Ranking Member Pomeroy, for this opportunity to appear here today. The American Institute of Certified Public Accountants (AICPA) is the national, professional organization of certified public accountants comprised of more than 330,000 members. We believe that the 2004 filing season is progressing largely without any significant problems, and American taxpayers and practitioners generally are pleased with the IRS's performance. I would first like to commend Chairman Houghton for his sponsorship and active support of H.R. 22, the Individual and Small Business Tax Simplification Act of 2003. As Mr. Shaw has said, we firmly believe that the enactment of tax simplification measures is integral to the success of future filing seasons, and we encourage Congress to continue to make tax simplification a major legislative priority. As for the IRS budget and the Business Systems Modernization program, we urge Congress to support full funding of the IRS's fiscal year 2005 budget.

We note and appreciate the Administration's fiscal year 2005 request to increase the IRS's funding. We have long advocated funding levels that would allow the IRS to efficiently and effectively administer the tax laws and collect taxes. Giving the IRS the resources necessary to properly enforce the tax laws is vital to maintaining our voluntary compliance tax system. Last month, before this Subcommittee, Commissioner Everson reported on the difficulties the IRS has faced with implementation of its Business Systems Modernization program--testimony that was generally consistent with the conclusions found in the Oversight Board's December report. Despite these problems, we strongly urge Congress to stay the course in terms of support for appropriate funding for this modernization effort. This is an issue that must remain a central feature of the IRS's strategic plan for the next 5 years.

As for the IRS's e-filing goals, we support their long-range goals for electronic tax administration. We applaud the IRS's current success with e-filing for the 2004 season, following on its successes of last year. We also commend the IRS's efforts to phase in the electronic filing of business returns and its rollout of the "Electronic IRSs" section on the IRS website. During the last year, the IRS has taken positive steps to listen to the practitioner community about the myriad problems tax professionals still face when contemplating conversion of their firms to practices offer e-file services to their clients. We appreciate this effort on the IRS's part, and to this end, we look forward to serving as a positive e-file partner with the IRS.

Now, I do regret to inform you that there have been some information return problems this year along the whole line of complication rather than simplification. The 2003 Tax Act (P.L. 108-27) cut the rate to 15 percent for qualified dividends received by individuals. Unfortunately, compliance with the new 15-percent dividend tax rate has proved to be the biggest challenge for taxpayers and practitioners during the current filing season. Brokerage firms and mutual funds are having major difficulties determining when dividends are qualified dividends, which has resulted in large numbers of erroneous Forms 1099-DIV being mailed to taxpayers. This situation has caused havoc for many taxpayers and practitioners.

Many taxpayers filed their Forms 1040, only to receive an amended Form 1099-DIV after the fact from a financial institution. The taxpayer and preparer thus are faced with a dilemma as to whether an amended return should then be filed, including State amended returns, or whether an earlier filed return remains the realistic snapshot of the taxpayer's position for 2003 and wait for the IRS's matching program to satisfy the ultimate obligation of tax. The AICPA stands ready to work with Congress and the IRS to develop procedures to minimize the processing burdens placed on taxpayers and practitioners from such changes.

Finally, with respect to tax practitioners and their professional responsibility, the AICPA commends the IRS and Treasury for its efforts to address the professional responsibility standards of tax professionals generally, and particularly with respect to the eradication of abusive tax transactions. These are actions that we support. We have a long-standing track record of establishing professional standards for our CPA members. The AICPA has adopted and has in place a Code of Professional Conduct, as well as enforceable "Statements on Standards for Tax IRSs."

On the issue of return outsourcing, the AICPA's Professional Ethics Executive Committee appointed a task force in January 2004 to consider what changes, if any, should be made to our Code of Professional Conduct in connection with third-party-provider information. We are currently awaiting the task force's recommendations on this matter. Regardless of what decision a tax professional may make in this area, nevertheless, the public should understand that the practitioner remains fully responsible for the accuracy of a return and for ensuring confidentiality of client information. Mr. Chairman, I have completed my remarks and would be pleased to answer any questions you may have.

[The prepared statement of Mr. Zarzar follows:]

Chairman HOUGHTON. Thank you very much, Mr. Zarzar. Mr. Leimbach?

Mr. LEIMBACH. Mr. Chairman, I am deeply honored today to present this statement on behalf of the 10,000 members of the National Association of Enrolled Agents (NAEA), the professional society of Enrolled Agents. I am James Leimbach, and I became an Enrolled Agent in 1997 while on active duty in the United States Air Force. My wife, Kelly, and I jointly operate a private practice in Panama City, Florida, where we work with both individual and small business taxpayers in the preparation and electronic filing of their returns. I also represent taxpayers before the IRS.

With regards to filing season readiness, overall, filing season has run very smoothly. At the beginning of the season, however, we did experience processing problems in e-filing. Practitioners received a number of erroneous reject notices from overwhelmed e-filing centers. During this period, the IRS' Quick Alert e-mail system provided practitioners immediate notification of these problems, and it was invaluable. This information allowed us to plan around the problems as we were notified of them. Many practitioners also rely on an IRS CD-ROM or Volume 2 of Package X to get their updated forms and publications. It is particularly important for practitioners who live in areas where they do not have access to high-speed Internet service. Unfortunately, the products didn't arrive until as late as February 20th.

NAEA has long supported full funding of the IRS. We believe that a properly resources IRS can efficiently process tax returns, collect taxes, and resolve taxpayer problems. For far too long, IRS has been hamstrung by its legacy computer system. NAEA realizes that billions of dollars have been poured into the modernization effort. I am here today to tell you that it has not been in vain, as I am one of 14 NAEA members testing the new suite of e-services products allowing us to represent taxpayers electronically. In January of this year, the IRS reached a major milestone in the development of new electronic capabilities that will revolutionize the way we as tax practitioners will conduct future business with the IRS.

This new electronic capability, which I prefer to call "e-representation," will enable tax practitioners to quickly resolve their clients' IRS individual or business account problems via the Internet in a secure environment. It has taken the IRS 7 years to reach the point we are at today, and based on my experience in computer technology, I do not find that unusual in the least. The difficulty in integrating a 1960s-era mainframe with the Internet and doing so in an environment using highly complex encryption is enormous, costly, and worth every effort and every dime spent. This new e-services capability is truly going to revolutionize the way we conduct business with the IRS in resolving taxpayer problems.

Under the new suite of e-services products called Disclosure Authorization, Transcript Delivery System, and Electronic Account Resolution, I have the ability 24 hours a day, 7 days a week, to submit processing requests to the IRS' computer system. This access provides me instant processing of my power of attorney submittals and instant processing of my requests for crucial transcripts. It also allows me to submit proposals for problem resolution at any time I choose. When you combine the capabilities of Disclosure Authorization, Transcript Delivery System, and the Electronic Account Resolution, the end result is phenomenal e-representation capability. This will truly revolutionize the way we do business with the IRS.

Even though these products are undergoing testing and are not yet ready for nationwide deployment, NAEA has concerns about the future of this new capability. Our concerns are regarding Enrolled Agents that will be denied access due to the 100 e-file requirement established by the IRS; limitation on the types of issues that can be addressed electronically; granting full access of e-services to unenrolled tax preparers; potential results from premature nationwide deployment. Aside from these concerns, NAEA understands, respects, and supporting the need for more e-filing of tax returns. We also believe in leading by example. Therefore, we respectfully would like to make the following suggestion: The IRS needs to lead by example when promoting e-filing to the tax practitioner community. They can do so easily by requiring all IRS employees to e-file their personal and individual returns.

With regards to regulation of commercial preparers, I have included NAEA's recent statement before the IRS Oversight Board on the proposed regulation of commercial tax preparers. This is not my area of expertise, but NAEA would be pleased to provide a written response to any questions in this area. Mr. Chairman, it truly is a pleasure and an honor to be able to have shared with you our members' views, and if I may be able to answer any of your questions, I would be very delighted. Thank you.

[The prepared statement of Mr. Leimbach follows:]

Chairman HOUGHTON. Well, thanks very much, Mr. Leimbach. Mr. McCormally?

Mr. MCCORMALLY. Good afternoon, Mr. Chairman. I am Timothy McCormally, Executive Director of Tax Executives Institute (TEI), whose 5,400 members work for 2,800 of the largest companies in North America and Europe. Almost without exception, the companies employing TEI's members have been assigned to the IRS' Large and Mid-Size Business Division (LMSB). The largest 1,600 taxpayers within LMSB are subject to heightened scrutiny and ongoing audits as part of LMSB's Coordinated Industry Cases program. Our members cannot play the audit lottery because, for the most part, they are audited every year. From this perspective, TEI has long supported adequate funding for the IRS, particularly in respect of training and technology, and collaborative efforts between taxpayers and the IRS to enhance tax administration, and the proper balance between taxpayer service and compliance activities.

At the outset, I wish to echo the testimony of Mr. Shaw and the written statement of Mr. Zarzar, as well as the comments of the Commissioner and Mrs. Killefer, about how the complexity of the tax law strains the limited resources of taxpayers and the IRS and impairs the ability of the government to administer a fair and efficient tax system. While we are pleased that the Bush Administration has included several simplification provisions in its 2005 budget, we believe that much broader efforts must be undertaken. These include the repeal of both the individual and the corporate alternative minimum tax and the reform of the international provisions of the Tax Code. These changes are necessary to enhance taxpayers' ability to comply and the IRS' ability to perform efficient and effective audits.

Effective management of human resources is not a new challenge, but it takes on added importance as the government's workforce ages. Within LMSB, for example, 40 percent of all revenue agents will be eligible to retire in fiscal year 2006, and that number will rise to more than half just 2 years later. This development underscores one of the IRS' greatest challenges: the recruitment, retention, and training of qualified personnel. Nowhere is that need greater than within the LMSB Division, which is responsible for ensuring compliance by the country's largest and most complicated enterprises. The success of the agency--and LMSB in particular--depends on having an effective, efficient, well-trained, and motivated staff. Adequate funding is a prerequisite to achieving that goal.

Adequate funding is also required if the IRS is to maintain effective compliance strategies. LMSB has developed several important programs to streamline the compliance process and empower revenue agents and others to resolve issues and settle cases more quickly and efficiently. One recent effort deserves mention: a project to develop a focused audit planning process, which was rolled out to taxpayers and LMSB personnel last fall. TEI was pleased to participate not only in the design of the program but also in LMSB's training strategy with respect to it. A fuller explanation of the program is in our written statement.

Several other innovative procedures--such as the Advance Pricing Agreement program, Limited Issue Focused Examinations, and Pre-Filing Agreements--have also been used to improve the examination process and to promote currency and compliance. These initiatives should be encouraged, first, by providing ample training resources in connection with them, and then by ensuring that the IRS' renewed focus on enforcement does not mute their ongoing value. These procedures enable personnel to make decisions at a lower level, to resolve disputes fairly and more quickly, and thereby to preserve resources. Mr. Chairman, TEI commends the Subcommittee for holding this hearing, and we look forward to working with you, the staff, and the IRS to improve tax administration. I, like the other witnesses, would be pleased to respond to your questions.

[The prepared statement of Mr. McCormally follows:]

Chairman HOUGHTON. Well, I thank you very much. Mr. Pomeroy has a question. I have questions, but what I would like to do, because of the time here and because we have votes, is to submit them in writing to you gentlemen? Would that be all right? We just do have a crunch, and I am terribly sorry, but there was not anything we could do about it. It is out of our hands. Mr. Pomeroy, you probably want to ask a question. I will leave. I will leave the whole thing in your hands. Can I trust you?

Mr. POMEROY. You can.

[Laughter.]

Chairman HOUGHTON. Well, thank you very much. Gentlemen, I really appreciate your participation here today. Thanks very much.

Mr. POMEROY. [Presiding.] Mr. Chairman, let me just advise the panel what an odd thing it is, an unusual thing it is for a Member of the majority to leave the hearing still in process with the minority now to chair it. I assure you I will confine my comments only to the CRP issue, and after Mr. Orwick has traveled so far, I thank you so much for letting me get some information from him into the record. My apologies to the rest of the panel. I would like to explore some of these issues with you as well, but I believe under the circumstances I should best focus on CRP and Mr. Orwick's expertise in that area. If you would make one request of the IRS today relative to the existing confusion about the taxable status of CRP income for retired farmers, what would it be?

Mr. ORWICK. I think it would be the first of Dr. Harl's recommendations, which would be the withdrawal of CCA Letter Ruling 200325002 of May 29, 2003, or the reissuance with a narrowing of the ruling to harmonize it with Letter Ruling 8822064, March 7, 1998, that this would remove much of the current confusion.

Mr. POMEROY. There was a 1988 ruling that very clearly addressed the question of retired farmers and determined that CRP income was not subject to self-employment tax. Is that correct?

Mr. ORWICK. For retired individuals, yes.

Mr. POMEROY. For retired individuals. So, harmonizing the two letter rulings would simply be some clarification to indicate, as they orally indicated to us when we met with IRS representatives in North Dakota Friday, that this was not--that the subsequent letter ruling in 2003 was not written in contemplation of the retired farmer and should not have application for this tax reporting period to the retired farmer. Is that essentially what you would--

Mr. ORWICK. Yes, that is correct. My understanding of the meeting was the IRS' position was that each of these rulings were geared specifically to the people in question in each of those rulings and not to be used as a precedent, but as Dr. Harl indicated, without any other rulings to go by, by default we did need to use those to guide us in our decision-making process.

Mr. POMEROY. The Commissioner indicated this afternoon--and you heard him--that there could be a lot at issue here in light of types of income that may or may not involve SE tax, and it gets quite involved. I believe that that is a little over thinking on this particular question. The fact is, from 1988 on, the IRS has essentially had one position. People have relied upon that position. It was inadvertently placed in question by a letter ruling that the IRS now indicates they wrote without any contemplation of the retired farmer. So, some simple clarification of that letter ruling harmonizing with the earlier letter ruling would at least get us through this tax season, and we would welcome further clarification from the IRS in the area. Is that essentially the state of play?

Mr. ORWICK. Yes, that is very true. I think that it really puts the tax practitioners and taxpayers in an awful position the way that it is right now, because we have no idea what is our real guidance. Each client is having to step up to the plate and make the decision based on their own circumstances, and they are not tax professionals and not attorneys well versed in this area. We as practitioners can guide them as best we can with the facts and circumstances, but they really shouldn't be placed in a position to have to make that decision and lay awake at night wondering if the IRS is going to be knocking on their door with an audit or that there would be extra money to pay; or, as most of my clients are choosing to do, pay the extra tax because of their conservative nature and the fact that they want to be law-abiding citizens.

Mr. POMEROY. You indicated at the hearing or the meeting that we had in North Dakota, you are a conservative practitioner, and you have a very conscientious group of clients; and if they think they may owe it, they pay it. That is why this situation is really particularly unfair to them. It will have broad--I believe by far most retired farmers may not be aware of this letter ruling, will not be paying the self-employment tax. In light of the discussion in this area in our community, they will be aware of it. Maybe they will pay the tax. The thing to do is lift the uncertainty relative to this filing season and then deal with it in a more comprehensive and involved way with the kind of fact gathering that the IRS would appropriately do prior to issuing such further rules in this area. Is that right?

Mr. ORWICK. Yes, that would be a very prudent process.

Mr. POMEROY. Well, I want to thank all of the panel, and especially, again, in absentia, express my appreciation for the Chairman. There is only 5 minutes left in the vote, and I believe it is his indication that the hearing will end at this point in time, so I will do something I have never done before and gavel adjournment. Thank you.

[Whereupon, at 5:35 p.m., the hearing was adjourned.]
[Questions submitted by Chairman Houghton and Representative Ryan to Commissioner Everson, Mr. Orwick, Mr. Zarzar, and Mr. Leimbach, and their responses follow:]

Questions from Chairman Houghton to Mr. Leimbach

Question: As more and more Americans turn to tax preparers to prepare their returns, the role of practitioners in the tax system has become more important.  According to the National Taxpayer Advocate, as many as half of the 1.2 million tax preparers have no formal training and are not required to adhere to any professional standards. As you may know, the Advocate and others have discussed limited registration of paid preparers. What is your view of the proposal?

Answer: The members of the National Association of Enrolled Agents are dedicated to the integrity of the tax system and the roles professional responsibility and ethics play in preserving that integrity.  It therefore is disturbing to us that there is an increase in taxpayer belief that tax returns will be accepted regardless of the facts reported on them. 

The IRS has undergone major changes in the last several years.  Former Commissioner Rossotti’s reorganization of the IRS and the emphasis he placed on customer service may in part have been a catalyst in modifying taxpayer attitude.  Most agree that his initiatives were good, were consistent with the 1998 IRS Restructuring and Reform Act, and have produced a better IRS.  However, their implementation resulted in resources being shifted away from enforcement activities.  Other contributing factors include discontinuance of the Taxpayer Compliance Measurement Program (TCMP), ineffective technology, and tax law complexity.

Commissioner Everson has begun efforts to turn that around.  While he acknowledges that customer service plus enforcement equal compliance, he has announced that effective enforcement of the tax laws rather than further improving customer service will be the main focus of his administration.  In this connection, he implicated the tax practitioner community in the diminishment of compliance and challenged all practitioners to raise their ethical standards in order to avoid actions being taken against them by the government.  While much of this was done in regard to abusive tax schemes, it seems clear to NAEA and we believe to him that his efforts will not stop there. 

All who provide tax services must be cognizant of the strong enforcement component of tax compliance.  It has the possibility of touching every aspect of tax advice and return preparation. 

NAEA finds that commercial return preparers are an enigma in today’s tax practice world. We all seem to know there are problems in connection with services performed by paid preparers, but in many respects those problems are unknown and the product of anecdotal information and conjecture. We define commercial preparers as those 1) who prepare federal tax returns for a fee, 2) who are not required to possess any knowledge of tax law and procedure, and 3) who are subject to very limited oversight.  At the state level, only California and Oregon regulate commercial tax return preparers.

The number of commercial preparers is not known with any accuracy but, as your question suggests, estimates of upwards of 1 million individuals have been bandied about.  With 55% of returns having been prepared by someone other than the taxpayers in 2001 and perhaps even more in 2002 and 2003, it seems safe to conclude that the number of returns prepared by commercial preparers is considerable and growing.  Even if we had the numbers, we do not know the extent of training, if any, many of the commercial preparers have had and the manner in which they keep abreast of the changes in tax laws and procedures.  Perhaps of greatest concern is the belief the public is not aware of the fact that many commercial preparers have no credentials.  This may in part be the reason taxpayers “shop” for preparers who will prepare tax returns the way taxpayers wish them to be prepared (often unsigned by those preparers), to the detriment of responsible return preparers and the integrity of the tax system.

NAEA understands that tax return preparer penalties asserted in recent years have been minimal in number as related to the apparent potential for such penalties.  Those that have been imposed in large measure have not been collected.  We also know that attempts to implement recognition procedures in the electronic filing area, i.e. electronic filer originators (EROs), have been the subject of criticism due to systemic problems in background checks and the like as documented in the Treasury Inspector General for Tax Administration (TIGTA) report of June 2002.  Further, many of the problems in the Earned Income Tax Credit (EITC) program are attributable to paid preparer involvement.  Again, there does not seem to be a great deal of empirical data to support a conclusion as to the number of commercial preparers involved in the program and whether or not they do a consistently worse job than other preparers, even though there have been some informative and well-written white papers on the subject.

As you are aware, the National Taxpayer Advocate’s report to Congress for the year 2002 recommended that there be a program to register commercial return preparers.  It would be an extremely ambitious program and one that would be expensive to establish and run. The IRS disagreed with the recommendation citing, among other factors, the expense of the program and that the issue is one for states to address rather than the federal government.  NAEA believes there are problems both with the recommendation and the IRS response.  Consequently, we were pleased that her request for the year 2003 compromised the previous recommendation by recommending that there be a legislatively mandated task force established to study the situation and the many unknowns.

In spite of the above, NAEA supports Ms. Olson’s quest, if not her vehicles for achieving it.  If left unchecked, the perceived problems will continue to grow.  In this connection, we believe the IRS Advisory Council’s Wage & Investment and Small Business/Self Employed subgroup reports warrant favorable consideration.  In particular, the SB/SE subgroup’s belief that the IRS should begin working with outside stakeholders to develop a program after examining a number of the “unknowns” would be beneficial.

NAEA subscribes to the belief that ethics are the fabric that holds a profession together.  In the tax arena, Congress has identified those who qualify as federally authorized tax practitioners (FATPs), i.e. Enrolled Agents, Attorneys, and Certified Public Accountants.  All are licensed individuals whose professional practice is circumscribed by codes of professional conduct and continuing education requirements. 

With the above said, FATPs have dual loyalties.  One, of course, is to their clients.  The other is to the tax system itself.  NAEA thinks it safe to conclude that all FATPs share the goal of safeguarding the integrity of our tax system and would be willing to work to make that happen.  A possible beginning to assist the IRS in this respect is to form an independent private sector  task force comprised of representatives from the Enrolled Agent, attorney, and CPA organizations to consider the issue and make recommendations addressing them. NAEA would be pleased to head a practitioner organization steering committee to implement this.  Other organizations, individuals, academicians, and the like with similar goals would be invited to the extent that the numbers would be manageable.

We are eager to move off dead center in our support of overcoming the frustrations we all share with respect to the unknown factors relative to the issue and doing our part in establishing a program evidencing ethics as a vital part of our tax system’s integrity. However, our eagerness would be meaningful only if there is an intent by Congress to pursue the matter through legislation or another vehicle.

Question: In your written statements, all of you have emphasized the need to simplify the tax code. How did the tax code become so complex, and what should Congress do to simplify our tax Code?

Answer: Our current tax system tries to address every aspect of our economy and, to a large degree, social issues as well. The complexity resulting therefrom warrants simplification of the tax laws and their administration. The National Association of Enrolled Agents believes that incremental changes are the most effective means by which to accomplish tax simplification. For example, in the recent years, NAEA has requested simplification of the Alternative Minimum Tax (AMT), the definition of a child, particularly in the context of the Earned Income Tax Credit, and rationalization of phase-ins and phase-outs.

Question: Occasionally, we have heard opposition from practitioners to a tax simplification proposal that might alter or upset the practitioner’s chosen specialty of tax. Are your members willing to give up a lucrative practice that depends on a wrinkle in the tax code? How important is tax simplification to your membership and to the tax system as a whole?

Answer: The practice of the members of the National Association of Enrolled Agents would not be adversely affected by an incremental approach to simplifying the tax system.

Question: I understand that the IRS is in the process of launching a new program that will allow tax preparers to access certain information on behalf of the clients and will improve communication with the IRS. What is your impression of the new service so far? Are there any improvements the IRS should make?

Answer: The capabilities being referred to are Disclosure Authorization, Transcript Delivery System, and Electronic Account Resolution within the IRS’ e-services, secure web site. NAEA believes that these three (secure) capabilities are, without question, going to revolutionize the way tax practitioners conduct business with the IRS.  

The Disclosure Authorization (DA) capability allows tax practitioners the ability to submit an electronic Power of Attorney (POA) directly into the IRS’ Centralized Authorization File (CAF) computer system. The process of preparing a DA for a taxpayer takes approximately 3-5 minutes. Once the DA is prepared, the submittal and processing of the DA into CAF is instantaneous.

The DA capability will replace the current process of faxing (or mailing) a POA into the IRS’ IRS Centers for manual input into CAF. The normal wait time for the manual input into CAF is usually 2-3 days. The cost savings to the IRS will be truly significant when this capability becomes available this year once the final testing has been completed. The instantaneous processing of the DA into CAF allows tax practitioners immediate access to account information on the taxpayer(s) being represented via the Transcript Delivery System.

The Transcript Delivery System (TDS) is the true powerhouse of the three capabilities. With TDS, tax practitioners can access the specific account related information that is crucial to problem resolution for the taxpayer(s). The account information is delivered to tax practitioners instantly. It now takes a practitioner longer to print the account information transcripts than it does to actually fill out the request and receive them. The type of information that can be obtained is:

1. Account Transcript (Reflects a summary of the return and all subsequent information posted to the account.)
2. Return Transcript (Contains most of the lines from an original return, including the various forms and schedules submitted with the return. The transcript contains both the "per return" and "per computer" entries from IRS databases.)
3. Record of Account (Merger of both Account Transcript and Return Transcript)
4. Verification of Non-Filing (This transcript is used in circumstances where a taxpayer may need a letter from the IRS indicating that he or she did NOT file a tax return. A good example would be where a taxpayer has applied for a state-backed mortgage subsidy bond.)
5. Wage and Income Transcript (W-2, 1099-DIV, 1099-MISC, etc. Practitioners can also select “All Documents” to retrieve every wage and income document reported to the IRS)

Prior to TDS the practitioner either had to drive to the local IRS office and obtain transcripts which took a total of one hour, or contact the IRS’ Practitioner Priority IRS and request transcripts to be faxed to me. The general turnaround time for receipt of the faxed transcripts was anywhere from one hour to one day.

TDS is an utterly amazing capability for tax practitioners and will have a major impact on the practitioner’s ability to better serve their clients.

Once the DA and TDS capabilities have provided the necessary service to the tax practitioner, the final step is in the electronic (secure) correspondence with the IRS for problem resolution. The secure Internet interaction with the IRS is achieved via the Electronic Account Resolution (EAR) capability.

EAR provides practitioners the following:

1. Account Problems Inquiry: This type of inquiry will allow users to address account related issues (not in ACS or Under Reporter) for resolution. A good example would be abatement of penalties due to reasonable cause.
2. Notice Inquiry: This inquiry will allow users to respond to IRS Notices with the exception of those that are outside the scope of EAR such as a CP2000, Notice of Underreported Income.
3. Complex Refund Inquiry: The Complex Refund inquiry will allow users to address refunds that were issued via direct deposit or by paper check and have either been destroyed, lost, not received, or stolen. It is also possible to inquire about refunds that have been offset by the Financial Management System (FMS) or have been applied to other tax debt owed to the IRS.
4. Payment Inquiry: The Payment Tracer will allow you to inquire on behalf of an individual or business, payments made to the IRS but not yet posted or to verify the posting of a payment on the account. A good example would be 1040-ES payments.
5. Installment Agreement Inquiry: The Installment Agreement provided in EAR is limited to Guaranteed Installment Agreements (under $10,000) and Streamlined Installment Agreements (under $25,000). Installment Agreements for amounts over $25,000 cannot be processed through EAR at the present time. In addition, the only payment method available is through Direct Debit. In addition to submitting a new Installment Agreement, you can revise an existing one or reinstate a previous Installment Agreement, which are two features that will be very useful.
6. Follow Up Inquiry: The Follow Up Inquiry will allow users to address previously submitted EAR inquiries that require additional information for the original submittal (i.e. not enough room in comments area), or in responding to a CSR’s request for additional information.
7. Multiple Inquiry: The Multiple Inquiries function allows tax practitioners to address simultaneously the first five types of inquiries above on behalf of an individual or business.

The current turnaround for an IRS response to a proposed problem resolution is generally one month, many times much longer. With EAR, the IRS’ response will be within three business days.

The combination of DA, TDS, and EAR is just plain phenomenal capability in IRS representation. The products will be the first of its kind and certainly, enhancements will be needed since many of the desired representation aspects will not be included in the initial release. Two excellent examples for future inclusion in EAR would be the ability to address collection related issues and those handled by the under reporter IRS entities.

 The IRS has already solicited the Enrolled Agents and CPAs that have been testing the products for their input for future enhancements. NAEA’s biggest concern for future enhancements is whether or not adequate funding will be available. It is crucial that Congress ensure that adequate funding for this new capability and the future enhancements will be there when needed.

Question: One of the things that make the tax system complex is that the IRS does not always provide a clear answer to the tax treatment of a common transaction. Is the IRS doing enough to publish clear and concise guidance to taxpayers? Would increasing the resources available to the IRS in this area help to make the tax system more transparent?

Answer: The IRS has made progress in its effort to publish clear and concise guidance to taxpayers. Part of such progress is making information available on the Internet and CDs.  The problem in trying to publish clear and concise guidance is that the tax issue itself is complex and can only be simplified to a point. For example, taxpayers with children are faced with numerous different definitions of a child for 1) Dependent, 2) Child Tax Credit, 3) Earned Income Credit, 4) Credit for Child and Dependent Care Expenses, 5) Adoption Credit. Having one definition versus numerous definitions for a child is a long-standing problem that has been addressed repeatedly without success.

Increasing the number of IRS personnel working the Customer IRS telephone lines and answering questions from the public, especially during the tax season would be a sound objective. Bright line guidance for IRS employees and the public is agoal worth pursuing. All of this would require appropriate training.

Question: We have discussed the IRS budget with the government panelists.  What is your view of the budget, as practitioners?  Where do you believe the IRS should allocate its resources?

Answer: The National Association of Enrolled Agents always has supported full funding for the IRS.  In addition to the training discussed above, we believe the IRS should focus its resources on modernizing antiquated computer systems, expanding the new electronic capabilities such as DA, TDS, and EAR, and increasing enforcement, especially with respect to non-filers.

Question: I imagine you have heard about the delays in Business Systems Modernization program. Can you explain why it is important to you, as practitioners, to complete this important program? What benefits do you see, and what services should the IRS provide in the future?

Answer: The Business Systems Modernization effort is crucial for the future administration of our tax system. The effective administration of our tax system depends, to an enormous degree on having computer systems that can process the workload. A 1960s-era mainframe cannot be expected to handle the demands placed upon it fifty years later. The volume of taxpayers now and in the future is just beyond the computer processing power built in the 1960s.

Question: The IRS has hired a new director of the Office of Professional Responsibility, and it is beginning to coordinate the efforts of the various working divisions to interact with practitioners. What is your initial impression of the IRS’s efforts in this area, and what should be done in the future?

Answer: NAEA is very pleased that IRS is finally able to address the resource and modernization needs of the Office of Professional Responsibility (OPR). As practitioners, we look forward to seeing progress in having OPR address long-standing issues involving tax professionals. In doing so, we hope that the OPR will be sensitive to the independence of this office in fulfilling its quasi-judicial role. We believe it is too early to assess the success of its initiatives.

Question: What is your assessment of the state of the tax system today, compared to six years ago, when Congress enacted the IRS Restructuring and Reform Act?

Answer: The IRS Restructuring and Reform Act resulted in a tremendous cultural shift at IRS. During the process (which is ongoing), practitioners found that IRS employees were placed in new positions without adequate training. On the front lines, they did not know where to send taxpayers for proper resolution or assistance and the negative impact it had on the morale of the IRS employees is still evident today. The IRS failed in the proper planning and execution of the reorganization and it still plagues the IRS today. This is not to imply the RRA was wrong. NAEA believes that the same shift in culture affecting IRS employees also has affected taxpayers and practitioners.

Questions from Chairman Houghton to Mr. Orwick

Question: As more and more Americans turn to tax prepares to prepare their returns,   the role of practitioners in the tax system has become more important.  According to the National Taxpayer Advocate, as many as half of the 1.2 million tax prepares have no formal training and are not required to adhere to any professional standards.  As you may know, the Advocate and others have discussed limited registration of paid prepares.  What is your view of the proposal?

Answer: I do not oppose limited registration of paid prepares if those whom do questionable work are “weeded” out of the business of preparing tax returns.  This registration should have some sort of grandfather clause included for qualified prepares.

Question: In your written statements, all of you have emphasized the need to simplify the tax code.  How did the tax code become so complex, and what should Congress do to simplify the tax Code?

Answer: I started preparing tax returns in 1980.  Since that time every new tax law has added some degree of complication.  IRS rulings such as Rev. Rul. 2000-4 regarding depreciation and those of which I spoke on the taxation of CRP income for retired taxpayers, adds to the confusion and frustration of taxpayers and practitioners.  The alternative minimum tax has also become a burden for many average taxpayers; this was not the original intent when it became part the tax Code many years ago.  When Congress passes tax legislation, it is very important that their intent be clear, so the IRS knows how to interpret and enforce the law.  This alone would “simplify” the current tax system.

Question: Occasionally, we have heard opposition from practitioners to a tax simplification proposal that might alter or upset the practitioner’s chosen specialty of tax.  Are your members willing to give up a lucrative practice that depends on a wrinkle in the tax code?  How important is tax simplification to your membership and to the tax system as a whole?

Answer: Since I do not represent any particular organization I can only speak for myself.  I believe that simplification is the cornerstone to the success of our current tax system.  If we as practitioners or the taxpayers themselves cannot comply with the law because it is to complicated the system no longer works.  As to altering or upsetting my particular practice with simplification, I feel that we have a broad base of clients whom even in a more “simple” tax system would continue to require the professional services we offer.  However, simplification would allow my staff and myself to work a normal workweek rather than eighteen hours a day, seven days a week for the tax season.

Question: I understand that the IRS is in the process of launching a new program that will allow tax prepares to access certain information on behalf of clients and will improve communication with the IRS.  What is your impression of the new service so far?  Are there any improvements the IRS should make?

Answer: I have had limited exposure to the current system and do not feel that this exposure has yet given me an opportunity to make an educated comment on it’s effectiveness.  However, I was part of a pilot program a few years ago dealing with the same issues and found the system a fantastic tool in resolving my clients’ account problems with the IRS.

Question: One of the things that makes the tax system complex is that the IRS does not always provide a clear answer to the tax treatment of a common transaction.  Is the IRS doing enough to publish clear and concise guidance to taxpayers?  Would increasing the resources available to the IRS in this area help to make the tax system more transparent?

Answer: Yes, I believe it would.  Also the passage of clear and concise tax legislation would aid the IRS in reaching their goals.

Question: We have discussed the IRS budget with the government panelists.  What is your view of the budget, as practitioners?  Where do you believe the IRS should allocate its resources?

Answer: As with anything, the more funds that are available the easier it is to do a better job.  I feel the IRS is currently doing a good job, additional programs designed to build a team effort between the IRS, taxpayers and practitioners would be a positive place to apply additional funding.

Question: I imagine you have heard about the delays in the Business Systems Modernization program.  Can you explain why it is important to you, as practitioners, to complete this important program?  What benefits do you see, and what services should the IRS provide in the future.

Answer: I do not feel that I have enough facts to comment on this issue.

Question: The IRS has hired a new director of the Office of Professional Accountability, and it is beginning to coordinate the efforts of the various working divisions to interact with practitioners.  What is your initial impression of the IRS’s efforts in this area, and what should be done in the future?

Answer: I believe that all advances in this area are very positive steps and I commend them for their efforts.  I have not personally been exposed to this program, so I do not at this time have an initial impression of the IRS’s efforts in this area.

Question: What is your assessments of the state of the tax system today, compared to six years ago, when Congress enacted the IRS Restructuring and Reform Act?

Answer: I believe that the IRS has become more customer service orientated.  This along with movement towards electronic filing and other advancements of technology have been very positive steps.  On the downside, I believe the tax legislation passed during this period along with the interpretation of it and previous laws by the IRS has made working with the current tax system more complicated and cumbersome.

Questions from Chairman Houghton to Mr. Zarzar

Question: As you may know, the Advocate and others have discussed limited registration of paid preparers.  What is your view of the proposal?

Answer: National Taxpayer Advocate Nina Olson, as part of the Advocate’s 2003 Annual Report to Congress, calls for the establishment of a “registration, examination, certification, and enforcement program for federal tax return preparers.”

The legislative intent of the tax return preparer registration proposal is to raise the professional standards for unenrolled preparers.  Providing meaningful guidance to practitioners in the performance of their professional responsibilities is an objective we strongly support, as reflected by the AICPA’s Code of Professional Conduct and our Statements on Standards for Tax IRSs.  However, we are concerned that this registration initiative has not undergone sufficient review regarding the level of financial resources required for proper administration of the program.  No budgetary commitment to this program is reflected in the Administration’s proposed IRS budget for fiscal year 2005.

In conjunction with any review of the proposal, we also recommend that the IRS and Congress study how the current Electronic Return Originator (ERO) application process might overlap or duplicate even a “limited” registration process for tax return preparers.  Under the current ERO application process, IRS conducts a background check of all principals and responsible officials affiliated with a tax return preparer’s firm.  This background check includes:  (1) an FBI criminal background review; (2) a credit history check; and (3) an IRS records check with respect to the preparer and the firm’s adherence to tax return and tax payment compliance requirements, including a review of any prior non-compliance under the IRS e-file program.

Question: In your written statement, all of you have emphasized the need to simplify the tax code.  How did the tax code become so complex, and what should Congress do to simplify the tax code?

Answer: In our testimony, the AICPA reaffirmed its support of efforts to reduce complexity in existing tax law and to curtail incremental complexity in the future.  While we acknowledge that an absolutely simple tax system is not feasible in today’s complex business and economic environment, we believe it is possible to design a simpler tax system.

We believe that the problem of undue complexity has arisen in part because of the dominance of other legislative goals (such as revenue enhancement, rate reduction, economic incentives and social policy) over the goal of simplification.  As a starting point, lawmakers need to balance the goal of tax simplification with these competing objectives.  Incremental additional complexity can be curtailed by following basic guiding principles for tax law simplification.[1]  For example, as legislation and administrative guidance is drafted, legislators and regulators should:  (1) seek the simplest approaches; (2) minimize both compliance and administrative burdens; (3) avoid inconsistent concepts and definitions; and (4) avoid enacting provisions that apply to only a few or for only a short period of time.

Congress must then undertake meaningful tax simplification to existing law.  Considerable consensus has developed in recent years identifying desirable proposals that would simplify the law for a large number of taxpayers.  For example, the AICPA provided lengthy comments on the 2001 Recommendations of the Staff of the Joint Committee on Taxation to Simplify the Federal Tax System.[2]  In addition, in February 2000, the AICPA sent to Congress a package of tax simplification recommendations the Institute hammered out in a historic joint initiative with the Tax Executives Institute and the American Bar Association Section of Taxation.[3]  Among the recommendations were:  (1) repeal of the alternative minimum tax; (2) harmonization of family-status definitions; (3) streamlining education tax incentives; and (4) eliminating or making uniform the numerous phase-outs contained in the Code.

These changes alone would make the Code more consistent, rational, fair, and transparent – particularly for low- and middle-income taxpayers.  While there are revenue costs associated with simplification reforms, it is also important to recognize that there are significant compliance burdens that will be eliminated by such reforms.

We note with pleasure Chairman Houghton’s introduction of nine separate tax simplification bills on April 2, 2004, many of which address our top complexity concerns.

Question: Occasionally, we have heard opposition from practitioners to a tax simplification proposal that might alter or upset the practitioner’s chosen specialty in tax.  Are your members willing to give up a lucrative practice that depends on a wrinkle in the tax code?  How important is tax simplification to your membership and to the tax system as a whole?

Answer: The AICPA has surveyed its membership on the topic of tax law simplification.  This has resulted in our firm belief that it is essential to simplify the tax code in order to preserve our voluntary compliance tax system and, as a consequence, preserve a viable tax practice for our membership.  As a consequence, the AICPA has actively supported many Congressional tax simplification efforts and has offered Congress many specific recommendations over the years.

Tax advisers spend considerable time assisting clients with compliance problems; time that they believe would be better spent on activities such as personal financial or strategic business planning.

Question: I understand that the IRS is in the process of launching a new program that will allow tax preparers to access certain information on behalf of clients and will improve communication with the IRS.  What is your impression of the new service so far?  Are there any improvements the IRS should make?

Answer: The IRS has taken a number of positive steps during the last year to listen to the practitioner community about the myriad of problems tax professionals still face when contemplating offering e-file services to their clients.  This includes the IRS’s efforts to phase-in the electronic filing of business returns and its rollout of the “Electronic IRSs” section on the IRS Website, including a suite of Web-based products for practitioners to do business with the IRS electronically.  Electronic IRSs would enable practitioners who e-file more than 100 “accepted” individual tax returns in a season to (1) submit many commonly used IRS contact forms electronically and receive an acknowledgement of acceptance from the IRS; (2) make electronic inquiries about individual and business tax account problems and issues; and (3) request tax return transcripts and account transcripts.  We support the new e-services, but we encourage the IRS to eliminate the 100 return threshold, allowing all practitioners to benefit and contribute to the growth of e-filing and account resolution.

Question: Is the IRS doing enough to publish clear and concise guidance to taxpayers?  Would increasing the resources available to the IRS in this area make the tax system more transparent?

Answer: All IRS guidance must be effective, clear, timely, and designed to promote a uniform understanding and consistent application of the tax laws.  In this context, we support any initiative designed to improve the quality of published IRS guidance.  The IRS has made great strides in recent years, and we look forward to increased efficiency and timeliness in the future.  Allocating appropriate resources to increase the volume of guidance published will make the tax system more transparent.

Question: What is your view of the IRS budget, as practitioners?  Where do you believe the IRS should allocate its resources?

Answer: We applaud Congressional efforts to provide full funding for the IRS’s fiscal year 2005 budget.  The AICPA has long advocated funding levels which would allow the IRS to efficiently and effectively administer the tax laws and collect taxes.  We support the objective of the Administration’s budget proposal which focuses on increasing staffing and providing more resources for enforcement.  In addition, we believe the budget should strive to provide a positive balance among:  (1) improving taxpayer service; (2) enhancing enforcement of the tax law; and (3) modernizing the IRS through its people, processes, and technology.

Question: Can you explain why it is important to you, as practitioners, to complete the Business Systems Modernization program?  What benefits do you see, and what services should the IRS provide in the future?

Answer: The IRS Oversight Board’s December 2003 Business Systems Modernization  and the IRS have detailed continuing delays in implementing the customer account data engine designed to replace the IRS Master File of taxpayer records.

Despite these problems, we urge Congress to stay the course in supporting appropriate funding for the modernization effort that must remain a central feature of the IRS’s strategic plan for the next five years.  The Business System Modernization goals are critical to the future of the IRS, taxpayers, and the effectiveness of our tax system..

Question: The IRS has hired a new director of the Office of Professional Responsibility and it is beginning to coordinate the efforts of various working divisions to interact with practitioners.  What is your initial impression of the IRS’s efforts in this area, and what should be done in the future?

Answer: The AICPA is encouraged by Commissioner Everson’s commitment to upgrade the Office of Professional Responsibility, and his appointment of Cono Namorato as the office’s new Director.  These efforts should greatly enhance the IRS’s ability to address professional responsibility standards for all tax professionals and help eradicate abusive transactions.

We also commend Treasury and the IRS for their commitment to issue final regulations under Circular 230 over the next several months to address:  (1) “best practices” for tax advisors (which we believe should be aspirational in nature); and (2) tax shelter opinions.  These regulations should help to “raise the bar” of professionalism for tax advisors, as well as the quality of written tax opinions.  The final regulations should clearly address the need for restoring integrity and confidence in the tax system, and we are proud to join with the Treasury and the IRS to ensure that tax practitioners have a role in that restoration.

Question: What is your assessment of the state of the tax system today, compared to six years ago, when Congress enacted the IRS Restructuring and Reform Act?

Answer: The IRS Restructuring and Reform Act has resulted in:  (1) improved taxpayer service; (2) greater equity in the administration of the tax law; and (3) higher productivity of the IRS’s workforce.  Nevertheless, we recognize that further improvements can and should be made – improvements that can result in an even higher level of service for America’s taxpayers.  We support Commissioner Everson’s push to increase staffing in the compliance area and to ensure a proper balance between service and enforcement within the context of the IRS budget initiatives for fiscal year 2005 and the IRS’s strategic plan for the next five years.

[1] See AICPA comments on 2001 Recommendations of the Staff of the Joint Committee on Taxation to Simplify the Federal Tax System, February 2002.

[2] See AICPA, American Bar Association Section of Taxation and Tax Executives Institute Tax Simplification Recommendations, February 25, 2000.

[3] Id.

Questions from Chairman Houghton to Mr. McCormally

Question: As more and more Americans turn to tax preparers to prepare their returns, the role of practitioners in the tax system has become more important.  According to the National Taxpayer Advocate, as many as half of the 1.2 million tax preparers have no formal training and are not required to adhere to any professional standards.  As you may know, the Advocate and others have discussed limited registration of paid preparers.  What is your view of the proposal?

In your written statements, all of you have emphasized the need to simplify the tax code.   How did the tax code become so complex, and what should Congress do to simplify the tax Code?

Occasionally, we have heard opposition from practitioners to a tax simplification proposal that might alter or upset the practitioner’s chosen specialty of tax.  Are your members willing to give up a lucrative practice that depends on a wrinkle in the tax code?   How important is tax simplification to your membership and to the tax system as a whole?

I understand that the IRS is in the process of launching a new program that will allow tax preparers to access certain information on behalf of clients and will improve communication with the IRS.  What is your impression of the new service so far?  Are there any improvements the IRS should make?

One of the things that makes the tax system complex is that the IRS does not always provide a clear answer to the tax treatment of a common transaction.  Is the IRS doing enough to publish clear and concise guidance to taxpayers?  Would increasing the resources available to the IRS in this area help to make the tax system more transparent?

We have discussed the IRS budget with the government panelists.  What is your view of the budget, as practitioners?  Where do you believe the IRS should allocate its resources?

I imagine you have heard about the delays in the Business Systems Modernization program.  Can you explain why it is important to you, as practitioners, to complete this important program?  What benefits do you see, and what services should the IRS provide in the future?  

The IRS has hired a new director of the Office of Professional Accountability, and it is beginning to coordinate the efforts of the various working divisions to interact with practitioners.  What is your initial impression of the IRS’s efforts in this area, and what should be done in the future?

What is your assessment of the state of the tax system today, compared to six years ago, when Congress enacted the IRS Restructuring and Reform Act?

Answer: On behalf of Tax Executives Institute, I am pleased to respond to your follow-up questions to the Oversight Subcommittee’s hearing on the 2004 IRS filing season and IRS budget for FY 2005. TEI appreciates the opportunity to express our views.

In your April 5, 2004, letter, you asked about the effect of the complexity of the Internal Revenue Code on tax administration. The IRS National Taxpayer Advocate (NTA) has consistently identified the complexity of the tax laws as the number one problem facing taxpayers. In her 2003 annual report, Nina Olson ranked the alternative minimum tax (AMT) for individuals as the number one problem, noting that according to IRS estimates, taxpayers spent more than 29 million hours in 2000 completing and filing AMT tax forms, or roughly 63 hours per taxpayer who actually pays the AMT. “The AMT is extremely and unnecessarily complex,” the report concludes, “and results in inconsistent and unintended impact on taxpayers.” Your recent proposal (H.R. 4131) to gradually raise the AMT exemption amount and repeal the individual AMT after 2013 is a good first step in reducing complexity.

The corporate AMT, however, suffers from the same policy and administrative deficiencies as the individual AMT: It creates enormous compliance burdens. TEI strongly believes that taxpayers should not be required to compute their taxes twice or to keep two sets of books. In addition, the AMT taxes corporations when they can least afford it — when they are struggling to survive in a down economy. The AMT represented poor public policy when it was enacted, and ensnares taxpayers who do no more than engage in activities that Congress independently determined should be encouraged. The AMT should be repealed for all taxpayers, individuals and corporations.

Everyone — Congress, the U.S. Department of Treasury, the IRS, tax professionals, and taxpayers — bears responsibility for the current complex state of the law. More than five years ago, TEI joined with the AICPA and ABA Tax Section to draw attention to the problem and to seek solutions. Mr. Chairman, you have been a strong supporter of these efforts, and, indeed, during your 17 years in Congress, you have been a strong champion for making the tax law simpler. TEI commends you and this Subcommittee for highlighting this issue.

TEI wishes you well on your retirement at the end of this year and pledges to continue seeking changes that will make the tax law simpler for all of us.

If you have any questions, please do not hesitate to contact me or Fred F. Murray, TEI’s General Counsel and Director of Tax Affairs, at 202.638.5601.

Questions from Representative Paul Ryan to Commissioner Everson

Question: My question is in regards to child tax credit overpayments as a result of the child tax credit advance payments that were sent out last year. 

A constituent shared with me that they approached the IRS with the following scenario:  In the case of divorced parents, the individual ex-spouses may alternate tax years in which they claim the personal exemptions and the child tax credit.  One parent, for example, may have claimed the child tax credit in 2002 and received the child tax credit advance payment in 2003.  This parent, however, will not claim the child tax credit for tax year 2003 because it is the turn of the other parent to claim the child tax credit.  The constituent asked the IRS if the parent who received the child tax credit advanced payment in 2003 would have to repay the advance in some way to the IRS?  The constituent also asked if the parent who will claim the child tax credit for 2003 would have to reduce the $1,000 per child credit by the amount of the advance payment received by the other parent?

The IRS indicated to the constituent that if the advance payment exceeds the total of the child tax credit and the additional child tax credit, the taxpayer does not have to repay the difference.  This is true even if the taxpayer isn't eligible for the credit in 2003.  In addition, the IRS told the constituent that a taxpayer takes into account only his or her advance payment, not the amount received by someone else, even if that person had claimed the qualifying children the previous year.  Therefore, in the constituent's situation, no repayment would need to be made and the other parent would claim the full credit allowable without subtracting the advance payment amount.

My question is, first, is this true?  Second, if this is in fact true, what does IRS estimate these child tax credit overpayments will amount to for tax year 2003?

Answer: In the scenario described, your constituent was given the correct answer.  The divorced parent claiming the child for 2003 may claim the full credit without regard to the advance child tax credit payment received by the other divorced parent.  The parent that is not claiming the child for 2003 but received the advanced child tax credit payment is not required to repay the credit to the IRS.        

IRS does not have a way to calculate the amount of overpaid ACTC to parents that have alternating support agreements. 

Question: The Federal tax refund offset program, which is referred to as the Treasury Offset Program (TOP), allows government agencies to submit to the IRS claims for delinquent debts up to ten years old.  The State of Wisconsin is currently participating in this program for the purpose of recovering state-owed debts.  Local municipalities, however, are not permitted to participate in TOP to include debts owed to local and municipal agencies. 

Do you believe that the current system could accommodate local municipalities to participate in TOP?  If so, what is needed to allow local municipalities to participate in TOP?  If you do not believe the current system could accommodate local municipalities, why?

Answer: Although the IRS participates in the TOP, the Treasury bureau responsible for the operation of TOP is the Financial Management IRS (FMS).  Therefore, we referred your question to FMS for a response.  FMS’s response is below.

State debt currently collected through TOP is limited to delinquent child support obligations and delinquent state income taxes, which may include delinquent local income taxes administered by the chief tax administration agency of the state.  Legislation would be required to expand the program to include debts owed to local and municipal agencies. 

FMS receives information about state debt from the U.S. Department of Health and Human IRSs for delinquent child support obligations and from a single point within each state for state/local income tax debt.  TOP could not accommodate debt owed to local and municipal agencies because to do so would require telecommunications connections with hundreds of end-points and extensive systems modifications to accommodate hundreds of connections per state.  Additionally, we do not currently have the resources required to manage and troubleshoot a program to collect large volumes of debt owed to local and municipal agencies nor to handle debtor inquiries, transfer funds to hundreds of end-points, and train thousands of new users. 

To accommodate debt owed to local and municipal agencies, the Financial Management IRS would need to forego other priority projects and increase development, operational and program staff.  Such a project would require a significant development effort and modification to debt systems with no substantial benefit to the Federal Government.  Even if these challenges could be met, Treasury might be reluctant to support expansion of the program to collect debts that do not have a Federal component or a Federal/State partnership interest.

[Submission for the record follows:]

Scorse, Gerald E., New York, NY, statement