Mr. Chairman and members of the subcommittee, I am Judith Akin, Enrolled Agent. I am the immediate past chair of the IRS Information Reporting Program Advisory Committee and I am an officer and member of the Board of Directors of the National Association of Enrolled Agents. I have been an EA for more than 25 years and maintain a private practice in Oklahoma City, Oklahoma where I work with individual and small business taxpayers.

Today I am representing NAEA whose more than 10,000 members are tax professionals licensed by the U.S. Department of the Treasury to represent taxpayers before all administrative levels of the Internal Revenue Service. I am pleased to have this opportunity to testify before you on the subject of penalty reform.

As you know, Enrolled Agents were created in 1884 to ensure ethical and professional representation of claims brought to the Treasury Department. Members of NAEA ascribe to a Code of Ethics and Rules of Professional Conduct and adhere to annual Continuing Professional Education standards, which exceed IRS requirements. Like attorneys and Certified Public

Accountants, we are governed by Treasury Circular 230 in our practice before the Internal Revenue Service. We are the only tax professionals who are tested by the IRS on our knowledge of tax law. Since we collectively work with millions of taxpayers and small businesses each year, Enrolled Agents are uniquely positioned to observe and comment on the average American taxpayer's experience with our system of tax administration.

The Need for Penalty Reform

Since our testimony before the Commission on Restructuring the IRS in 1997, NAEA members have frequently spoken out on the need for penalty reform. We were pleased to see this issue addressed by the Joint Committee on Taxation and the Treasury in recent reports to Congress. Portions of the National Taxpayer Advocate's Report add to the discourse. However, we would not wish you to think that reforms are not already underway. We are pleased to note that a major "fairness" issue has been resolved. Full credit is now being given for Social Security and self-employment taxes paid in. In the past, if a taxpayer failed to file a tax return for more than three years, even if there was a refund due and all taxes were paid in timely, the taxpayer was not credited by the Social Security Administration for the FICA and SE taxes paid in. Yet the IRS insisted on collecting these same taxes. The procedure is now that, if the government is paid the taxes, it credits the taxpayer's account. We are very pleased that the procedure has changed.

IRS problem solving days continue to provide a safety valve for resolution of some long-standing cases. We applaud IRS' consistent effort in this area. At the end of the day, we believe they are doing the right thing in making their best people available to help get cases resolved and closed, thus reducing penalties and interest imposed on taxpayers.

Corporate Tax Shelters

We realize that the issue of corporate tax shelters is not before us today and was addressed at a hearing in November. We would respectfully urge the members of this subcommittee to understand the impact of these devices on the compliance of average taxpayers. Our tax system is based on voluntary assessment. If average taxpayers believe that those who faithfully pay their taxes are foolish, then you will see a commensurate increase in noncompliance.

You may recall that one impetus for the Tax Reform Act of 1986 was that large corporations were "zeroing out" on their taxes. Middle class taxpayers realized they were paying more in taxes than major corporations. Were the tax breaks of the time legal? Yes, but they undermined our tax system. Its perceived fairness is critical to its success. Speaking as someone from the heartland, I urge you to maintain taxpayer confidence in the integrity of our tax system.

Response to the National Taxpayer Advocate's Report

While the National Taxpayer Advocate's Report covers a variety of topics, I would like to comment on several that concern penalty issues.

Problem #5: Penalty Administration

Consistency in imposing penalties and consistency in abating them is an issue that needs the continued attention of appropriate IRS personnel. We would agree with our colleagues at the Tax Executives Institute that this is a problem needing prompt attention in order to maintain confidence in the fairness of the system. The coordinated review recommended by TEI is one we would endorse.

Problem #8: Innocent Spouse

We are pleased that on January 18, 2000 IRS issued final guidance for taxpayers seeking equitable relief from federal tax liaiblity under IRC Sections 6015(f) and 66(c) pursuant to the Tax Restructuring and Reform Act of 1998. These claims for innocent spouse relief are among the most difficult and time-consuming for practitioners to deal with and we welcome IRS guidance in resolving them.

Problem #10: Misapplication of Payments

NAEA concurs with the National Taxpayer Advocate that this is a continuing problem but not a severe one based on our considerable experience with the Electronic Federal Tax Payment System. Our direct experience is that mistakes are few and that they are, for the most part, quickly corrected. We remain optimistic that as IRS personnel, taxpayers and practitioners become more accustomed to this and other new methods of payment, errors will be even fewer than they are now and will be quickly resolved.

Problem #15: Compliance Burden on Small Business

We would agree that the IRS has made significant strides in terms of reaching out to the small business community to help educate and thereby reduce the compliance burden on this sector of the taxpaying public. The Small Business CD-ROM developed by the Office of Public Liaison and Small Business Affairs is an excellent tool that can help small business owners maximize the assistance available through the IRS. Another excellent program is the Federal Tax Deposit School that is run much like "traffic school" which a business owner must attend when he/she has run afoul of the deposit rules. It is being replicated around the country with Enrolled Agents working with IRS employees to ensure that small business gets the information early, understands the importance of tax withholding, and has the opportunity to get back into compliance and remain there.

We are also very pleased with IRS' recent decision to permit taxpayers to designate the payment of federal tax deposits so as to minimize penalties. Taken together, these are very positive steps leading to greater fairness in the system.

Problem #18: Understanding Federal Tax Deposit Problems

NAEA concurs with the National Taxpayer Advocate that this area is in need of revision. At present, many of the rules are overly complex and subject to change which the small business community, in particular, is unable to keep up with. We are also concerned about the impact of frequent changes upon the newest and smallest businesses, those that do not yet have the resources to hire professional assistance for tax and accounting work.

Dispute Mitigation

NAEA concurs with the National Taxpayer Advocate that penalty administration contributes to significant problems facing taxpayers. It would be extremely helpful if penalty abatement could be consistently available, particularly in those areas where taxpayers have made innocent mistakes. The cases NAEA has brought to the subcommittee should provide some understanding of the dimensions of this problem in that affects not only small businesses but also elderly taxpayers and small, community-based nonprofit organizations.

Case Studies

More than half of NAEA's members are online. As a result, NAEA regularly surveys its members for their views and experience on various issues. The survey on penalty reform generated scores of replies. They break down into several areas: those affecting small business, those affecting senior citizens, and those affecting small nonprofits. We examined these reports from our Members through the prism of 1) voluntary compliance; 2) fairness in operation; 3) whether a deterrent to undesirable behavior; and 4) whether the penalties were capable of effective and efficient administration by the IRS.

A. Small Business

It is a frequent assertion that small business is the least compliant part of the taxpayer community. However, as frontline tax practitioners, we find that noncompliance is often due to a lack of information and understanding of the tax code. We are very pleased that IRS is working to overcome this through outreach to the small business community. However, there remains much work to be done as the following anecdotes from our members indicate.

*A retail store owner in New Hampshire with an impeccable record of making timely -- even early -- deposits of payroll taxes stretching back 20 years, was not aware that effective 1/1/99 he would be required to make semi-weekly deposits. By the time the error was caught, the penalty due was $2,000, even though he was still making timely deposits each month.

* A young businessman in Virginia was advised to set up his small company, in which he was the sole person involved, as an S Corporation but did not know he was supposed to pay himself a salary. A couple of years went by and this individual did not withhold taxes on the amounts he withdrew from the corporation. An accountant, upon finding this error, went back through the records and grossed up his pay, filed the necessary payroll tax reports, and told the client how much in tax he had to pay. The client agreed this was reasonable and began paying the back taxes in installments and kept current with the reporting. The IRS came in and assessed the 100% penalty on the back taxes, refusing to abate any of the penalties and interest. The young man was forced into bankruptcy. This was a clear example of a person who was trying to do the right thing and was not trying to "beat the government." A reasonable penalty and interest charge in this situation would have been warranted but not the 100% penalty.

* In 1983, a small businessman in Texas, faced with his wife leaving him and his son being sent to prison for murder, became a non-filer. He had had his tax return prepared but in the midst of the family tragedy, neglected to sign and send it in. When contacted by the IRS in 1990, he filed his returns from 1986 forward but, wanting to be completely honest, he volunteered to file for 1983, 1984 and 1985. The years he volunteered to file were then chosen for audit. He was assessed $19,000 in additional income and self-employment taxes and $75,000 in penalties and interest. IRS refused to accept an offer in compromise. He was forced into bankruptcy. When he sold his business he owed $31,000 in income tax. The funds from selling the business were put into bankruptcy and the court would not release the funds to pay the tax. When the funds were finally released, IRS assessed him penalties and interest for not paying his taxes on time.

* A cabinetmaker in California tried to get back in business after declaring bankruptcy in the early 1990s. Faced with cash flow problems, he made payroll deposits late. Penalties and interest on his account now total 52.6% of his tax liability, although he has made every effort to get current. When asked about penalty abatement, IRS declined, even though the taxpayer has kept his account current and recently made a $3,000 lump sum payment.

* A client who did her own payroll did not do the "look back" on tax deposit frequency. The four-quarter deposits in that "look back" totaled $50,005, $5 over the amount that required her to pay semi-monthly. IRS has discontinued sending notices and thus she continued her monthly deposits in 1999. The penalty for first quarter was in excess of $500, with the same true for the second quarter. She sought professional help and the penalties were finally abated but the process was quite time consuming and required assistance from a tax professional.

* Taxpayer died last December 25 after a lengthy illness. His wife was unable to get the 941 (payroll tax deposit) taxes paid on time. IRS said she would have to pay the penalties and interest first, in order to be considered for the abatement. If she could pay the penalties and interest, she would, obviously, not have to request any assistance. Because of the penalties, she cannot pay the taxes owed and it keeps growing faster than she can pay.

B. Small Nonprofits

Understanding of the tax laws as they apply to nonprofits is a perennial issue for those of us who work with small nonprofit organizations. Often, community-based organizations have volunteer leadership, which changes from year to year. Frequently we find they have no permanent staff, no records, or if they have them, they are very spotty and incomplete. Sometimes the leader is a visionary who is focused upon the mission of the organization and fails to think about taxes at all. There is a widely held view at the grassroots level that nonprofits are exempt from all taxes. Imagine the surprise when a tax notice is received.

* A social club in Alabama was penalized $440 for late filing of the Form 990EZ. It was due May 15, 1998 and was filed 22 days late.

* A small nonprofit received a penalty for late filing totaling $1,640 when the administrator, in attempting to obtain an extension to file the return, used the guidelines for the individual extension. He sent in the request but neglected to give a "reason" for the request. When IRS notified the nonprofit that the extension was not accepted, the nonprofit quickly sent in the return so that it was only 2 weeks late. However the penalty was assessed anyway.

* Two payroll tax checks were inadvertently buried on the desk of the pastor of a small church. The payments were mailed in but, of course, were late. IRS assessed a penalty. Abatement was requested on the grounds that payroll tax deposits had not been late in over 5 years and that although the circumstances may not be "reasonable cause" in nature they were certainly not a case of "willful neglect." Penalty abatement denied.

* The pastor of a small church in Florida applied for and received recognition as a not for profit more than a dozen years ago. The pastor believed the organization did not need to file any tax returns because of its nonprofit status. IRS wiped the client from its records because a return has never been filed. When the church sought an EA to put together financial records for a bank loan, they were asked for copies of their tax return. In the words of the EA, they hadn't a clue. The pastor decided to file all returns that had never been filed. Meanwhile, IRS could find no record of their being approved as a not for profit but fortunately, the taxpayer had held onto that document so it was sent to IRS. Information is being reconstructed for tax years 1995-1998. IRS has assessed a penalty of $5,000 for 1995 but has yet to bill for the other years. True, the client was negligent but it could be argued that so was the IRS for not following up when the nonprofit did not file originally.

C. Individual Taxpayers

We received many comments about taxpayers -- particularly senior citizens -- being caught up in penalties where they truly did not understand the situation and were caught unaware. Steps need to be taken immediately to lessen the impact on taxpayers who are completely in the dark about the penalties and interest they face if they try to come back into compliance after an innocent mistake.

Furthermore, as our society moves toward self-managed retirement plans such as IRAs and 401(k)s, there will be many more opportunities for individuals to inadvertently run afoul of the system with disastrous consequences. Some examples of the problems senior citizens face are cited below:

*A senior citizen was drawing out his IRA, using the minimum distribution. Last November his wife was sick with pneumonia and she was hospitalized for 9 days. With his stress, he forgot, and the bank neglected to remind him, to take out his minimum distribution of $1,692. When he realized his mistake, he withdrew it on February 1, 1999. When he did the return on March 6th, the EA had to prepare a Form 5329 and he paid the $846 (50%) penalty. Without the penalty, he owed $15. As directed in Publication 590, a letter was included explaining the situation but apparently it was never read. Nothing was heard from the IRS for 6 months. About 3 weeks ago his EA followed up with a Power of Attorney, letter and copies of all documents. The most aggravating thing about this is he is a retired person who is trying to comply with the tax law and gets hit with a 50% penalty. If he had committed civil fraud and willfully understated his taxes by the same $1,692, his penalty would have been 25% or $423.

*Taxpayer is a widow in her late seventies who is still working as a secretary in a federal agency. She has a small IRA in the agency's credit union. In August, the credit union sent her a form stating that because she was past 70-l/2 years of age, she must withdraw a certain amount. If she agreed to the withdrawal, she merely had to check a box and return the form. She suffered a heart attack and was hospitalized for several weeks. Consequently she failed to return the form. The penalty for failing to make the required withdrawals is 50%. A request that penalty be waived has been made, but this is an example of the type of circumstance affecting potentially millions of taxpayers of ordinary means.

* Taxpayers, age 78 and 76 years old, have an outstanding tax liability from 1967 and 1968. Thirty years later, it's still open as the IRS has threatened action on these retired people and had repeated statute extensions signed. For tax year 1967, original debt was assessed at $27,015.25 in 1975. Current debt is now at $236,255.26 after more than $40,000 has already been paid on the debt. For 1968, liability was assessed at $9,813.28 as of 1975; $14,000 was paid in 1975 with a current balance due of $13,130.07. Both the 1967 and 1968 returns were filed timely. They are paying off the debt at the rate of $150 to $300 per month with no hope of ever paying it off. Each payment made shows an equal amount of interest assessed each month so no progress is ever made and then the additional interest that they couldn't pay is incurred. This couple has few assets: a 1987 Chevy, a little life insurance. They owe $15,000 in credit card bills; they pay $900 per month for medical care and are in very poor health. They have lived with this situation hanging over their heads all these years.

Increasingly complicated estimated tax rules are making it difficult, if not impossible, for taxpayers to stay in compliance. Just one example of several that were sent in:

*Taxpayer's liability for the 1998 1040 was $9,000 which was satisfied with estimated payments of $5,800 made before the submission of the return and $3,200 paid with the submission of the return. IRS null and voided her Form 4868 Request for Automatic Extension of Time to File, charging a penalty of $676. The interest tab was $106.99. The taxpayer managed to find herself in this situation despite having overpaid (paid in advance) her estimated tax, even through the 4th quarter.

We are finding that once taxpayers fall behind, they may never be able to catch up. A typical example:

*In 1989, a low wage individual went to work for a company. He did not realize taxes were not being withheld. He was given a 1099-MISC at year-end but had no money to pay taxes. His 1989 tax debt is now $17,262 of which $1,598 is penalty and $9,079 -- one-third more than the tax owed -- is interest. Given his spotty work history, he owes from 1990 and also 1997 and 1998. Most low-income taxpayers do not question employers. They want the work and just don't understand when employers hand them a 1099-MISC instead of a W-2 at the end of the year. This is particularly true for low-income workers who are often very naive about employment taxes and who are not in a position of strength to bargain with a prospective employer.

NAEA Recommendations

1. Review of Penalty Administration

As we have previously testified, the problem with penalties often originates here in Congress.

We are very pleased that these hearings are being held and hope that they will be done on a regular basis in the future, much as the IRS budget and filing season readiness hearings are. The reports by the Joint Committee on Taxation and Treasury, along with portions of the National Taxpayer Advocate's Report provide very useful guidance on areas in need of attention.

2. Tax Penalties Should Not be Used for Revenue Raising

There are too many penalties for too many infractions and no one could reasonably expect taxpayers to comprehend their applicability. We think the current code's proliferation of penalties has accomplished nothing but create taxpayer perceptions of a system run amok which acts like a hidden tax rate. This feeling is reinforced by the fact that, in the past, various committees scored penalties for revenue raising purposes. Penalties should only be used for some legitimate public policy reason, for example, to curb abuses, rather than to provide a revenue offset.

3. Payment and Abatement Should Be Separate Considerations

As some of our earlier examples indicate, we believe that insisting that tax and interest be paid before a request to abate a penalty for reasonable cause can be considered should be eliminated. Payment of tax and abatement of penalties should be separate considerations and the facts and circumstances of each case should be weighed.

4. Trust Fund Recovery Penalty

This penalty should be assessed against officers, rather than against just those who were responsible. Once the actual outstanding taxes have been paid to protect the employees benefits, the penalties and interest should be stopped or limited to a maximum amount. In addition, IRS needs to ensure that proper procedures are in place. To prevent future loss of taxes, interest and penalties by IRS, a new law should be considered which would allow the IRS and State Agency be notified of ALL bankruptcies in which an outstanding IRS account is on file.

5. Eliminate or Restrict the Failure to Pay Penalty

Too often Enrolled Agents are called upon to seek abatement of this penalty. It should only be imposed in cases of egregious fraud or negligence. Again, facts and circumstances of each case should be taken into consideration.

6. Simplify the FTD deposit rules and the Related Penalties

Too often we are called upon to straighten out problems when common sense should prevail. The facts and circumstances of each case should be considered. We are heartened by IRS' recent decision on application of federal tax deposit payments. It's a step in the right direction.

7. Offer to Eliminate or Reduce Penalties

Enrolled Agents, as a rule, strive to return taxpayers to compliance and search for ways to enable them to stay that way. It would be very helpful if IRS would look to the facts and circumstances of cases and offer to eliminate or reduce penalties. Several comments from our Members noted that rather than encouraging taxpayers to come into compliance, the severity of penalties can force a taxpayer to continue to not file and/or pay his or her taxes.

Perhaps a two-tier system could be implemented so that if the taxpayer comes forward and files his/her return voluntarily, the penalty would be waived or at least greatly reduced. If the IRS must come to the taxpayer, then the penalty would be higher.

In addition, it would be helpful if no penalties, only interest, were charged for a taxpayer or paid preparer who makes an honest mistake. Given the complexity of our tax laws, penalties should only be applied where there is a clear and deliberate effort on the part of the taxpayer or paid preparer to cheat the government.

8. Standardize the Forms 1099

The current system frequently hammers individuals who make a simple mistake such as overlooking an interest or dividend payment. This is particularly true for the elderly who have great difficulty following the law and keeping track of these payments. This confusion could be dramatically reduced if there were standard Forms 1099, which would be required to be used by every information reporter with no substitutions allowed. We are seeing an ever-increasing number of interest and dividend statements that look much more like a letter than a reporting document. There is no reason why, with today's modern computer systems, all information reporters cannot have and use identical forms. This is also true for W-2s.

9. Eliminate Frivolous Penalties

Many clients are being affected by the Failure to File the Information Return, Form 1065, when there are fewer than 10 partners. Practitioners in the know use PL 95-600 to get the penalty abated but the mere fact that this Public Law exists and IRS continues to ignore the Committee's directives causes clients grief and worry. IRS employees need to recognize that there is no "assessable penalty" on a partnership with fewer than 10 partners and all partners reporting their distributive share on their individual tax returns.

The $100 minimum penalty for returns filed more than 60 days late is sometimes excessive. For example, taxpayer had a 1998 tax liability of $197. He had withholding of $88 and a payment of $109 was filed when the return was submitted in early August. IRS assessed a late filing penalty of $100, late payment penalty of $2.72 and interest. Combining the late filing and late payment penalties would make things simpler, fairer and easier for the taxpayer to comprehend.

10. Eliminate the Daily Compounding of Interest on Penalties

The compounding factor does not help collect the taxes any faster and creates just that much more that the taxpayer cannot pay. Again, perhaps a facts and circumstances approach could be used to eliminate daily compounding of interest on penalties when taxpayers have made an innocent mistake.

11. Continue Education Outreach to Taxpayers

It is important that IRS continue its outreach to taxpayers. We believe IRS is doing an excellent job with respect to individual and small business taxpayers. We are very concerned about the lack of information for small nonprofits. This area needs immediate attention.

12. Provide Adequate Training for IRS Employees

There is always tension between having a consistent national standard and having the ability to make judgments on a case by case basis. NAEA does not wish to make a recommendation which would be impossible for IRS personnel to carry out. However, the hardship cases we have described necessitate IRS personnel having the ability to mitigate penalties where there is no intent to cheat the government. Perhaps a well-defined national standard coupled with adequate training as well as the ability to exercise judgment in difficult cases would benefit both the IRS and taxpayers.

Conclusion

I would like to thank you, Mr. Chairman and the members of the Oversight Subcommittee, for the invitation to share our members' views with you today. I will be happy to respond to your questions and comments about our recommendations.

[THE ATTACHED REPORT: "REPORT TO THE CONGRESS ON PENALTY AND INTEREST PROVISIONS OF THE INTERNAL REVENUE CODE," DATED OCTOBER 1999, IS BEING RETAINED IN THE COMMITTEE FILES. THE REPORT CAN ALSO BE VIEWED ELECTRONICALLY FROM TREASURY'S WEBSITE AT "http://www.treas.gov/taxpolicy/library/intpenal.pdf".]