Mr. Chairman and members of this distinguished Subcommittee:

The American Institute of Certified Public Accountants ("AICPA") offers you these comments on the penalty and interest provisions in the Internal Revenue Code ("Code"). The AICPA is the national, professional organization of certified public accountants comprised of more than 330,000 members. Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. They provide services to individuals, not-for-profit organizations, small and medium-size businesses, as well as America's major businesses, including multi-national corporations. Many serve businesses as employees. It is from this broad base of experience that we offer our comments.

INTRODUCTION

The AICPA worked with Members of Congress, the Internal Revenue Service, and other tax practitioners and business groups in 1989 in connection with the last major reform of the federal tax penalty provisions. The result of those efforts was the Improved Penalty Administration and Compliance Tax Act of 1989 ("IMPACT"). Since then, questions have been raised regarding the appropriate administration of the interest and penalty provisions, such as the use of penalties as a bargaining tool by the IRS. Also since that time, a number of revisions to the interest and penalty provisions have been made or proposed. We believe there once again is a need to take a comprehensive look at the interest and penalty provisions and make needed reforms to ensure the provisions are appropriately and fairly applied and are designed to accomplish their purpose. We encourage you to do so.

We offer you our assistance with such an undertaking, and, as an initial step, provide you with our comments on: the Joint Committee on Taxation's Study of Present-Law Penalty and Interest Provisions as Required by Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters) (JCS-3-99), July 22, 1999; the Department of the Treasury's study, entitled Penalty and Interest Provisions of the Internal Revenue Code, released October 25, 1999; and the penalty and interest reform provisions in the National Taxpayer Advocate's 1999 Annual Report to Congress, released January 4, 2000.

Our comments regarding penalties are based on our continued belief in the philosophy embraced by IMPACT, that the purpose of penalties is to encourage compliance, not to raise revenue. We urge Congress not to alter that philosophy. We also urge Congress to adhere to the philosophy that interest is not to be imposed as a penalty, but rather is solely compensation for the use of money.

Our comments are based on considering the penalty and interest regime in its entirety. Individual comments and suggestions should not be accepted or rejected in a piecemeal fashion since the appropriateness of one provision often depends on the status of another.

PENALTY PROVISIONS

1. Accuracy-Related and Preparer Penalties

Note: The following discussion relates only to non-tax shelter items.

Standards for Taxpayers and Preparers

Both the JCT staff and Treasury propose modifications to the standards that must be satisfied with respect to a tax return position in order to avoid the accuracy-related penalty applicable to taxpayers under section 6662 for the substantial understatement of tax and the preparer penalty under section 6694(a) for understatement of a taxpayer's liability due to an unrealistic position. Under present law, to avoid the substantial understatement penalty, a taxpayer must have "substantial authority" for an undisclosed position and a "reasonable basis" for a disclosed position; for a tax return preparer to avoid the preparer penalty, an undisclosed position must have a "realistic possibility of being sustained on the merits" and a disclosed position must not be "frivolous."

Both the JCT staff and Treasury recommend that the same standards apply to taxpayers and tax return preparers. We do not object to that recommendation, but request that in making such a change, Congress clarify in the statutory language that the imposition of a penalty against a taxpayer and the imposition of a penalty against the taxpayer's return preparer must be based on separate determinations. The imposition of a penalty against one is not evidence that the imposition of a penalty against the other is appropriate. For example, a taxpayer may pay a penalty for personal reasons, such as to avoid expending additional time and money to contest the issue even though the taxpayer might have been successful if the matter had been pursued; an automatic imposition of a penalty against the return preparer in such a case clearly would be inappropriate. An independent review of the applicable authorities and of the facts, including who had knowledge of specific facts, must be considered in determining whether the imposition of a penalty against a particular party is appropriate.

Standards for Disclosed Positions

Under current law, to avoid a substantial understatement penalty with respect to a disclosed position, a taxpayer must have a "reasonable basis" for a return position; for a tax return preparer to avoid a preparer penalty with respect to a disclosed position, the position must not have been "frivolous." The JCT staff recommends raising the minimum standard for taxpayers and tax return preparers regarding disclosed positions such that, to avoid a penalty for a disclosed position, there must be at least "substantial authority." Treasury recommends raising the minimum standards for taxpayers and tax return preparers regarding disclosed positions such that, to avoid a penalty for a disclosed position, there must be at least a "realistic possibility of being sustained on the merits."

We have serious concerns about raising the standard for taxpayers and tax return preparers above the "reasonable basis" standard currently applicable to taxpayers. We are particularly troubled by the JCT staff's proposal to establish "substantial authority" as the minimum standard for disclosed positions. Such a high standard may be unworkable. While taxpayers and tax return preparers may be able to ascertain whether "substantial authority" exists with regard to some issues, that is not true in all cases. The Federal tax law is forever changing, and, as a result, there may be virtually no guidance issued at the time a return is filed, and, therefore, virtually no authority with respect to the proper tax treatment of an item. Further, even if there is some authority, given the exceedingly complex nature of the tax law, it may nevertheless be extremely difficult for taxpayers and preparers to know the probable correctness of many return positions. It is not only unrealistic, in many cases it is impossible, to ensure such a high degree of accuracy as is required by a "substantial authority" standard or even the "realistic possibility of being sustained on the merits" standard without forcing taxpayers to avoid otherwise meritorious positions on the return.

While taxpayers may be able to ascertain whether "substantial authority" or "realistic possibility of being sustained on the merits" exists with regard to some issues, that certainly is not true in all cases. This problem is compounded by the fact that the IRS has failed to adhere to a provision added to the Internal Revenue Code in 1989 to assist taxpayers and preparers in determining whether "substantial authority" is present for a position. IMPACT created section 6662(d)(2)(D) of the Code, requiring the IRS to publish, not less frequently than annually, a list of positions for which the IRS believes there is no "substantial authority" and which affect a significant number of taxpayers. To date, the IRS has never issued any such list for any year. If the IRS is unable itself to determine which positions lack "substantial authority," it is unreasonable to adopt this threshold as the minimum reporting standard for return positions by taxpayers and tax return preparers.

In its 1989 civil tax penalty study, the IRS acknowledged the practical limits on the probable correctness of returns. In the Commissioner's Study of Civil Penalties, 1989, at VIII-11, the IRS noted:

While not in and of themselves determinative of the correct standard of behavior, a variety of factors limit the ability of taxpayers to report positions disclosing a liability that is probably correct. Perhaps the most significant limitation is the ambiguity inherent in applying a complex and changing set of tax rules to an infinite variety of factual situations, which may themselves be of ambiguous import. These complexities may result in failure to recognize issues, incorrect conclusions as to the probability that a particular position will prevail, and differences of opinion regarding probability that are not resolvable short of the courthouse. The complexity of modern financial affairs, when coupled with the legal requirement to file a return by a statutory deadline and the costs of making the best possible assessment of each individual issue may also provide practical limits on the pursuit of a theoretically perfect return.

For these reasons, we believe the standard for disclosed positions should be the "reasonable basis" standard currently applicable to taxpayers.

Standards for Undisclosed Positions

Under current law, to avoid the substantial understatement penalty with respect to an undisclosed position, a taxpayer must have "substantial authority;" for a tax return preparer to avoid a preparer penalty with respect to an undisclosed position, the position must have a "realistic possibility of being sustained on the merits." The JCT staff recommends that, for an undisclosed position, the taxpayer and the tax return preparer must reasonably believe that the tax treatment is "more likely than not" the correct tax treatment under the Code. In contrast, Treasury does not propose raising the standard for undisclosed positions above the "substantial authority" standard that currently applies to taxpayers; it would apply that standard to both taxpayers and tax return preparers.

We agree with Treasury that the "substantial authority" standard is the more appropriate threshold standard for undisclosed positions, rather than the higher "more likely than not" standard recommended by the JCT staff. Currently, the only authorities that can be relied upon to constitute "substantial authority" are those issued by the government itself or the judiciary. Acceptable authorities include: the Internal Revenue Code and other statutory provisions, regulations, court decisions, and administrative pronouncements (e.g. revenue rulings, revenue procedures, proposed regulations, private letter rulings, technical advice memoranda, actions on decisions, information releases, notices, and other similar documents published by Treasury or the IRS). In addition, the list of authorities includes General Explanations of tax legislation prepared by the Joint Committee on Taxation (the "Blue Book"). Conclusions in treatises, legal periodicals, legal opinions or opinions of other tax professionals do not qualify under present IRS rules.

Taxpayers and preparers who take positions relying on the government's own rules and pronouncements should be able to feel comfortable that their positions are sufficiently accurate so as to free them from the possibility of penalties. A "more likely than not" standard for undisclosed positions would mean disclosure would be required even though the "substantial authority" threshold is satisfied with respect to a position. Having taxpayers disclose items on their returns which comport with the government's own list of authorities would unnecessarily increase compliance costs for taxpayers and burden for the IRS. Further, such an approach would literally inundate the IRS with countless inconsequential disclosures, weakening the overall effectiveness of the disclosure regime. Thus, we believe the standard for undisclosed positions should be "substantial authority."

Reasonable Cause Exception

The JCT staff recommends repeal of the reasonable cause exception to the substantial understatement penalty. We disagree, believing that the exception is necessary to provide flexibility needed to waive the penalty in appropriate situations.

Amount of Preparer Penalty

The JCT staff recommends increasing the amount of tax return preparer penalties. For first-tier violations, i.e., preparation of a return with a position that does not meet the minimum preparer standards, the JCT staff recommends changing the preparer penalty from a flat $250 per occurrence to the greater of $250 or 50% of the tax preparer's fee. For second-tier violations, i.e., understatements that result from willful or reckless disregard of the rules or regulations, the JCT staff recommends increasing the amount from a flat $1,000 per occurrence to the greater of $1,000 or 100% of the preparer's fee.

Treasury also recommends increasing the tax return preparer penalties. Treasury recommends that consideration be given to a fee-based or other approach that more closely correlates the preparer penalty to the amount of the underlying understatement of tax rather than the flat dollar penalty amount under current law.

We support retaining the two-tier flat dollar penalty under current law. We base our recommendation on the lack of empirical evidence indicating that the flat dollar amount is not effective. In our opinion, deterrence for preparers results not from a dollar penalty, but rather from the possible adverse impact on the preparer's ability to practice and on his/her reputation for integrity and ethical behavior.

2. Failure to File Penalty

Rate

The current law contains a failure to file penalty of 5% of the net tax due, for each month (or portion thereof) the return remains unfiled, up to a maximum of 25%. The JCT staff proposes no change to the current provision. Treasury recommends that the penalty be restructured to eliminate front-loading; it proposes doing this by lowering the penalty rate in the initial months and providing for the increase in the rate, up to the 25% maximum, over a longer period of time. The example Treasury presented was charging a rate of 0.5% per month for the first 6 months and 1% per month thereafter, up to the 25% maximum. Treasury recommends retaining the current rule for fraudulent failure to file.

We agree with Treasury's reasoning that the front-loading of the failure to file penalty in the first five months of a filing delinquency does not provide a continuing incentive to correct filing failures and imposes additional financial burdens on taxpayers whose filing lapse may be coupled with payment difficulties, thus, possibly impeding prompt compliance. We also agree with Treasury that the current structure seems especially harsh given the fact, by merely requesting one, a taxpayer is entitled to an automatic extension for most or all of those five months. (An individual taxpayer is entitled to an automatic four-month extension; a corporate taxpayer is entitled to an automatic six-month extension.)

Given the significance to the tax system of taxpayers fulfilling their filing obligations, the failure to file penalty should be structured to provide a strong incentive for timely compliance, and a continuing incentive to promptly correct any failure to file.

Service Charge

Under current law, since the late filing penalty is a percentage of the net tax due, no penalty applies with respect to a late-filed return if the return reflects a refund due or no tax due. Treasury recommends imposing a new de minimis service charge for late returns that have a refund or no tax due, at least in situations where the IRS has already contacted the taxpayer regarding the failure to file the return.

We do not support this recommendation. We view such an approach as unjustified. Such an approach is particularly inequitable in situations where the taxpayer has a refund due, since the IRS has had interest-free use of the taxpayer's money.

Safe Harbor

Treasury recommends adoption of a provision that would permit the IRS to take into account a taxpayer's compliance history in determining if there is reasonable cause for abatement of the failure to file penalty. Treasury does not support providing automatic relief from the failure to file penalty based on safe harbor rules, however.

Although we agree with Treasury that a taxpayer's compliance history should be considered in determining the appropriateness of a penalty, we recommend a more expansive simplification of the penalty abatement provisions. To reduce the burden on both taxpayers and the Service resulting from the imposition of many inappropriate penalties, we recommend that safe harbor provisions be established for a variety of penalties (particularly those that are mechanical in nature, such as the failure to file, failure to pay and failure to deposit penalties) that would be deemed to represent reasonable cause. The object of these safe harbors would be to minimize the assessment and subsequent abatement of many penalties. Safe harbor provisions could take the form of:

• No penalty assessment for an initial occurrence; however, the taxpayer should receive a notice that a subsequent error would result in a penalty;
• Automatic non-assertion of a penalty based upon a record of a certain number of periods of compliance; and/or
• Voluntary attendance at an educational seminar on the issue in question, as the basis for non-assertion or abatement.

Such safe harbors would encourage and create vested interests in compliance, since a history of compliance would result in relief. Additionally, the likelihood of future abatements would diminish if the taxpayer has a history of non-compliance. Furthermore, a system of automatic abatement would reduce the time spent by both the Service and taxpayers on proposing an assessment, initiating and responding to correspondence, and on the subsequent abatement. The ability to abate a penalty for a reasonable cause other than those used for automatic abatements would continue; however, reasonable cause abatements requiring independent evaluation should be reduced.

3. Failure to Pay Penalty

Retention or Repeal

Current law contains a failure to pay penalty equal to 0.5% per month (or fraction thereof), up to a maximum of 25%. This penalty was created in 1969 to respond to the belief that the then-applicable interest rate (a flat 6%) on underpayments was not sufficient to encourage timely payment of tax and to discourage the use of the government as a low-cost lender.

The JCT staff recommends repealing the penalty for failure to pay taxes, noting the repeal would be consistent with a policy initiative begun by RRA'98, in which the rate of the penalty for failure to pay was reduced. The National Taxpayer Advocate also recommends a repeal of the penalty. Treasury acknowledges that the initial intent of the penalty was to address the fact that the interest rate on underpayments did not take into account the then market rate; nevertheless, it recommends retaining the failure to pay penalty, but with a restructured rate, as noted below.

We believe that, since the rate of interest on underpayments is now tied to the market rate of interest, this penalty, as a substitute for interest, should be repealed. If the penalty is not repealed, we recommend adoption of the mitigation and waiver provisions noted below.

Expansion of Mitigation of Penalty for Months During Period of Installment Agreement

Under current law, the failure to pay penalty for individuals with respect to a timely filed return is reduced from .5% to .25% for any month in which an installment agreement is in effect. This mitigation provision does not apply to halve the penalty in any case in which a final notice has been issued (at which time the penalty increases to 1% per month).

The National Taxpayer Advocate recommends that this mitigation provision be expanded to include reducing the penalty rate from 1% to .5% in situations (1) when a final notice is issued in error or as the result of an administrative practice and (2) when a final notice has been issued, for any month in which an installment agreement is in effect. We agree with the recommendation.

Waiver of Penalty When an Installment Agreement is in Effect

The National Taxpayer Advocate also recommends that the failure to pay penalty be waived for any month in which an approved installment agreement is in effect, even if the 1% per month penalty rate otherwise applies. Under the recommendation, however, the failure to pay penalty would be reinstated for the entire period if the taxpayer defaulted prior to completing the agreement. We agree with thatrecommendation.

Rate

Treasury recommends restructuring the calculation of the failure to pay penalty. The penalty would equal 0.5% per month for the first 6 months and 1% per month thereafter, up to the maximum of 25%. The penalty would be reduced to 0.25% per month during the first 6 months and 0.5% per month thereafter if the taxpayer makes and adheres to a payment agreement. As under current law, a higher rate would apply once the IRS takes action to enforce collection.

As noted above, we recommend repealing the failure to pay penalty rather than revising the rate.

Service Charge

The JCT staff recommends imposing an annual 5% late payment service charge on taxpayers that do not enter into an installment agreement within 4 months after assessment. The service charge would be imposed on the balance remaining unpaid at the end of the 4-month period.

We do not support establishment of a service charge for failure to enter into an installment agreement. We believe that such a service charge will penalize taxpayers who already are struggling to pay their tax obligations.

Related Installment Agreement Issues

Waiver of Fee. The JCT staff recommends waiving the installment agreement fee for taxpayers that agree to the automated withdrawal of each installment payment.

We support the JCT staff's recommendation. We believe that waiving the fee for taxpayers that enter into agreements to pay tax via an automated system of withdrawal will provide an incentive to enter into these agreements and better ensure payment of taxes. We have heard that some states that offer automated withdrawal payment plans have shown high rates of adherence to installment agreements. We believe that adoption of this provision will similarly facilitate a higher rate of adherence to installment agreements for the Federal government.

Installment Agreement Interest Rate. Treasury recommends providing the IRS with the authority to use a fixed rather that a floating interest rate on installment agreements in order to facilitate adherence to such agreements and to avoid possible balloon payments.

We support Treasury's recommendation to simplify the installment interest rate calculation.

4. Estimated Tax Penalty

Status as Penalty or Interest

The JCT staff recommends repealing the individual and corporate estimated tax penalties and replacing them with interest charges. The National Taxpayer Advocate also recommends eliminating the penalty and allowing interest to be automatically asserted, or as an alternative, he calls for simplification of the estimated tax penalty computations. Treasury recommends retaining the individual and corporate estimated tax penalties as penalties.

We support the recommendation of the JCT staff and the National Taxpayer Advocate for converting the estimated tax penalties for individuals and corporations into interest provisions. The conversion of the estimated tax penalties into interest charges would result in a more accurate characterization since the penalties are essentially fees for the use of money.

Deductibility of Interest

The JCT staff recommends that interest on underpayments of estimated tax by individual taxpayers be nondeductible personal interest, whereas interest paid on underpayments of estimated tax by corporate taxpayers be deductible. We recommend that deficiency interest be deductible by individual taxpayers to the extent the deficiency to which the interest relates is attributable to the taxpayer's trade or business or investment activities.

$1,000 Threshold for Individuals

The JCT staff recommends increasing to $2,000 the threshold below which individuals are not subject to the estimated tax penalty. Currently the threshold amount is $1,000 after reduction for withheld taxes. The JCT staff also recommends that the calculation of the threshold be modified to take into account certain estimated tax payments, i.e., estimated taxes paid in four equal installments on or before their due date. Accordingly, for qualifying individual taxpayers, no interest on underdeposits of estimated tax would be imposed if the tax shown on the tax return, reduced by withholding and certain estimated tax payments, is less than $2,000.

Treasury recommends retaining the current $1,000 threshold, but allowing estimated tax payments to be considered under a proposed simplified averaging method in determining whether the threshold is satisfied.

We support increasing to $2,000 the threshold below which individuals are not subject to the estimated tax penalty. We also support allowing estimated tax payments to be considered under a simplified averaging method in determining if the threshold is satisfied. Both recommendations should simplify the computations required to calculate estimated tax payments and the interest (JCT) or penalty (Treasury) on underpayments.

Safe Harbors

The JCT staff recommends repealing the modified safe harbor that is applicable to individual taxpayers whose adjusted gross income for the preceding taxable year exceeded $150,000. Under the JCT staff's proposal, all taxpayers making estimated payments based on the prior year's tax would do so based on 100% of the prior year's tax.

We support this JCT staff recommendation for simplification of the safe harbor provisions.

Rate

The JCT staff recommends applying only one interest rate per underpayment period - the rate applicable on the first day of the quarter in which the payment is due. Currently, if interest rates change while an underpayment is outstanding, separate calculations are required for the periods before and after the interest rate change. Having only one interest rate apply per underpayment period would end the potential for multiple interest calculations occurring within one estimated tax underpayment period.

We support this JCT staff recommendation for simplification of the computations.

Underpayment Balances

The JCT staff recommends changing the definition of "underpayment" to allow existing underpayment balances to be used in underpayment calculations for succeeding estimated payment periods, i.e., making underpayment balances cumulative. Under the proposal, taxpayers would no longer be required to track each outstanding underpayment balance until the earlier of the date paid or the following April 15^th.

We support this JCT staff recommendation for simplification of the computations.

Leap Year Issue

The JCT staff recommends establishment of a 365-day year for estimated tax penalty calculation purposes. Current IRS procedures require separate calculations when outstanding underpayment balances extend from a leap year through a non-leap year.

We support this JCT staff recommendation for simplification of the computations.

First-Time Offender

Treasury recommends providing a reasonable cause waiver of the estimated tax penalty for individuals that are first-time payers of estimated tax. The proposed waiver would be available only if the balance due is below a certain amount and is paid with a timely-filed return. Current law does not provide a general reasonable cause waiver for failure to pay estimated tax for individuals.

Although we do not support Treasury's position on retaining the estimated tax penalty, if the penalty is continued, we do support the recommendation for a reasonable cause waiver of the penalty for individuals that are first-time offenders.

Penalty Waiver

Treasury recommends waiving the estimated tax penalty if the penalty is below a certain de minimis amount - e.g., $10 to $20. There is no current statutory authority permitting the IRS to waive estimated tax penalties below a de minimis amount.

Although we do not support Treasury's position on retaining the estimated tax penalty, if the penalty is continued, we support the recommendation for establishing a de minimis waiver, but recommend a higher de minimis amount.

Safe Harbor for Corporations

We recommend increasing the taxable income cut off point from $1 million to $10 million for defining a "large corporation" for purposes of the Section 6655(d)(1)(B)(ii) safe harbor.

5. Failure to Deposit Penalty

Recently Enacted Provisions

Both the JCT staff and Treasury recommend that no major changes be made to the failure to deposit penalty provisions, to allow time for recent changes in these rules to be implemented and evaluated.

We support the recommendations that no major changes be made to the new rules until the provisions have been in effect long enough to be evaluated, but we encourage the introduction of any minor changes that add to the simplification of the failure to deposit penalty.

Deposit Schedule

The JCT staff recommends that Treasury consider revisions to the deposit regulations, particularly the change in deposit schedule, to change in a later calendar quarter.

We support the JCT staff's recommendation as a simplification of the failure to deposit provisions.

Penalty for Wrong Method of Deposit

Treasury recommends that it be provided with the authority to reduce the penalty for use of the wrong deposit method from 10% to 2%. Currently, taxpayers who use the wrong deposit method may be subject to the penalty rate of 10% and, thus, may be treated as harshly as if they did not make the deposit at all.

We support Treasury's recommendation; the lower rate would not be unduly harsh and would accomplish the same objective of encouraging payment by the proper method.

Systemic Problems of Payroll Services

The JCT staff and Treasury recommend that the IRS work with payroll services to resolve systemic errors, rather that deal with individual employers on a case by case basis.

We support the JCT staff and Treasury's recommendations. Such an approach could greatly simplify the resolution of such problems.

6. Pension Benefit Penalties

The JCT staff recommends consolidating the IRS and ERISA penalties for failure to file timely and complete Form 5500, and reducing from three to one the number of governmental agencies authorized to assess, waive, and reduce penalties for failure to file Form 5500. The JCT staff recommends designating the IRS as the agency responsible for enforcement of reporting. The JCT staff also recommends repealing the separate penalties for failure to file Schedules SSA and B and for failure to provide notification of changes in plan status. The JCT staff recommends treating these situations as a failure to file a complete Form 5500.

Treasury recommends consolidating the penalty for failure to file Form 5500 into a single penalty that will not exceed a specified dollar amount per day or a monetary cap per return. Treasury proposes that the single penalty would be waived upon a showing of reasonable cause. Welfare and fringe benefit plans would be subject to a similar single penalty under Treasury's proposal. Treasury recommends designating the Department of Labor as the agency responsible for enforcement of reporting. The Department of Labor's DFVC voluntary compliance program would continue to provide relief from late filing or failure to file penalties for Form 5500 under the proposed single penalty.

Although we do not have comments on the specific recommendations, we do encourage proposals such as these that promote simplification.

7. Uniformity of Administration

Statistical Information

The JCT staff and Treasury recommend that the IRS improve its method of providing statistical information on abatements and the reasons and criteria for abatements. We support this recommendation.

Supervisory Review

The JCT staff and Treasury recommend improving the supervisory review of the imposition and abatement of penalties. We support this recommendation on the theory that such improved review would promote equitable treatment of taxpayers.

Abatement

The JCT staff recommends consideration by the IRS of establishing a penalty oversight committee similar to the Transfer Pricing Penalty Oversight Committee.

We support the JCT staff's recommendation as a means to promote equitable treatment of taxpayers. Previously, the AICPA has recommended the creation of a database regarding the imposition and abatement of penalties and the establishment of a coordinator of penalty administration to promote consistent application.

INTEREST PROVISIONS

Determining the amount of interest owed to or by taxpayers in connection with their Federal tax liabilities is governed by a rather complicated set of interest and procedural provisions in the Internal Revenue Code. We believe simplification of the interest regime is in order and commend the JCT staff for proposing the establishment of a single interest rate applicable to both underpayments and overpayments of all taxpayers and the abatement of interest in various instances. We agree that these proposals will greatly simplify interest computations and are disappointed that Treasury essentially recommends maintaining the current interest regime, including interest rate differentials for corporate taxpayers. We think the recommendations made by the JCT staff, coupled with our proposed modifications, will result in a fairer, simpler, more administrable interest regime. We also believe that the JCT staff's interest simplification recommendations, with our modifications, should be adopted in their entirety because the benefits of each component necessarily depends upon the enactment of the others.

Like both the JCT staff and Treasury, we believe the Internal Revenue Code's interest provisions should provide for compensation to the government for the time that the taxpayer has use of the government's tax dollars and to the taxpayer for the time the government has use of the taxpayer's money. Interest is fundamentally a charge or compensation for the use or forbearance of another's money - it is not a penalty. The interest provisions should not be used to financially punish taxpayers.

1. Interest Rate

The JCT staff recommends providing one interest rate for overpayments and underpayments for both individuals and corporations, equal to the short-term applicable federal rate ("AFR") plus 5 percentage points. Treasury recommends a uniform interest rate in the range of AFR plus 2 to 5 percentage points except in the case of large corporate overpayments or underpayments, for which Treasury recommends retaining the current rate differential, including "hot interest."

We strongly believe that adopting a single rate for underpayments and overpayments of all taxpayers will substantially reduce the administrative difficulties and financial inequities associated with the numerous differentials contained in the current regime. We, therefore, support the JCT staff's single rate recommendation.

Establishing one rate for every taxpayer necessarily entails blending the various market rates applicable to all taxpayers; however, we are concerned that the JCT staff's proposal may establish an excessively high interest rate. At current market rates, raising the overpayment and underpayment rates to AFR+5 percentage points would result in a 10 percent rate; that would be the highest rate of interest for ordinary underpayments in more than a decade. Individual taxpayers would see their underpayment rate jump from 8% to 10% and the minimum rate that would apply to corporate taxpayers would be equal to the current "hot interest" rate. We concur with Treasury that the appropriate rate should be in the range of the AFR plus 2 to 5 percentage points and should reflect typical market rates.

2. Interest Abatement

Additional Causes for Abatement

The JCT staff recommends that the IRS be granted the authority to abate interest: (1) where necessary to avoid gross injustice; (2) for periods attributable to any unreasonable IRS error or delay, whether or not related to managerial or ministerial acts; (3) in situations where the taxpayer is repaying an excessive refund based on IRS calculations, without regard to the size of the refund; and, (4) to the extent the interest is attributable to taxpayer reliance on a written statement of the IRS. Treasury agrees to abatement of interest when the taxpayer has reasonably relied on erroneous written advice from the IRS, but does not recommend further legislative expansion of abatement of interest, arguing that current law provides sufficient relief. The National Taxpayer Advocate recommends abatement when the taxpayer is experiencing significant hardship.

We support the recommendations of the JCT staff and the National Taxpayer Advocate and strongly encourage their adoption. Further, because the IRS has been reluctant in the past to grant relief in this area, we request that the terms "gross injustice," "unreasonable" and "significant hardship" be adequately defined to provide the IRS with clear standards for implementation.

Application of Abatement Attributable to Errors and Delays to Nondeficiency Federal Taxes

The current law provision allowing abatement based on errors or delays by the IRS is limited to interest on income, estate, gift, generation skipping, and certain excise taxes. The National Taxpayer Advocate recommends that the abatement provision be expanded to apply to interest on employment taxes, the remainder of excise taxes, and certain other taxes. We agree with that recommendation.

3. Suspension of Interest Where IRS Fails to Contact Taxpayer

Neither Treasury nor the JCT staff make any recommendations with regard to the interest suspension provision, enacted as part of the Internal Revenue Service Restructuring and Reform Act of 1998, that suspends the accrual of deficiency interest for individual taxpayers in all cases where the IRS fails to notify the taxpayer within 18 months (1 year beginning in 2004), specifically stating the taxpayer's liability and the basis for that liability. Under use of money principles, interest is charged solely as compensation for the use of another's money. While there may be some situations in which use of money principles should give way to more compelling objectives, such as in the abatement context, we believe such an automatic suspension provision is an unnecessary feature for a single-rate interest regime with broad interest abatement authorities. An expanded interest abatement provision should provide adequate relief for those taxpayers subjected to excessive interest charges. We, therefore, recommend that this provision be repealed and that any resulting savings to the government be applied to lowering the proposed single-rate amount.

4. Interest Netting

Treasury argues that, given the recent enactment of global interest netting, it is premature to adjust interest rates to eliminate all interest differentials. On the other hand, the JCT staff notes that establishing a single rate of interest will simplify tax administration and "limit" the need for interest netting on a going-forward basis. We believe that restoring interest rate harmony will mitigate (but not eliminate) the need for interest netting in most cases, because the rate at which interest is paid by a taxpayer to the IRS with respect to any underpayment of tax will be the same rate paid by the IRS to a taxpayer who overpays a tax liability. Unfortunately, the Internal Revenue Code contains several special rules providing for interest-free periods whereby taxpayers and the government are given grace periods to take certain actions without accruing additional interest charges. For example, the government is given 45 days to process refund claims and taxpayers are afforded 21 calendar days to pay demand notices (10 business days if the amount exceeds $100,000). Thus, even with the single-rate interest regime advocated by JCT staff, there would continue to be some situations where taxpayers could be charged interest on periods of underpayment that run concurrently with a non-interest bearing overpayment period for the taxpayer.

We support JCT's proposed single rate regime but believe that interest netting still would be appropriate in some circumstances, to ensure that taxpayers are not charged interest on amounts where no true liability actually exists. Extending interest netting to interest-free periods would be consistent with use of money principles and would not harm the government since during these periods of time, neither the taxpayer nor the government are actually indebted to one another. In our judgment, taxpayers do not object to interest-free periods; they recognize the importance of administrative convenience, to allow the government sufficient time to process claims for refund. Taxpayers, however, do resent the imposition of interest on equivalent outstanding amounts under the pretext that a true liability exists where none does. Absent netting, the problem will become more acute if the interest rates are equalized at a higher level, as the JCT staff is proposing.

The JCT report states that limiting the availability of netting to situations in which the taxpayer both owes and is owed interest for the same period preserves the integrity of the rule requiring the suspension of interest where the IRS fails to contact an individual taxpayer. The JCT staff seems to be saying that taxpayers should be required to pay interest during some periods of mutual indebtedness when they clearly are not indebted to their government in order to preserve the concept of suspending interest for taxpayers who have admittedly underpaid their taxes. Logic dictates that taxpayers who owe tax should pay interest and those who owe no tax should not pay interest.

In summary, we believe that a new single-rate interest regime should contain an interest netting component whereby taxpayers can identify periods of mutual indebtedness involving interest-free periods and request the IRS to have their interest charges recalculated in accordance with procedures similar to those set forth in Rev. Proc. 99-19.

5. Interest and Look-Back Rules

The JCT staff recommends that the single interest rate also apply to the Code sections that reference the underpayment or overpayment rate under present law. The Treasury report does not address this issue. There are several provisions that allow taxpayers to re-determine their tax liability based on facts determined after the filing date of the return without requiring an amended return to be filed--the so-called "look-back" provisions. As we indicated above, we believe that a single interest rate should be applicable to the underpayments and overpayments of all taxpayers, but question the amount of the rate increase proposed by JCT. We are concerned that, in the context of these sections, under JCT staff's proposed rate structure, most taxpayers would face a significant increase in the amount of interest.

6. Exclusion of Individual Overpayment Interest from Income/Denial of Deduction

In an attempt to equalize rates on an after-tax basis for individual taxpayers and corporations, the JCT staff recommends that overpayment interest paid by the IRS to individuals be excludable from income. While acknowledging that the same rate and same tax treatment with regard to deficiency interest would provide equivalent effective interest rates for individual and corporate taxpayers, Treasury does not propose an exclusion for interest and believes a deduction for deficiency interest for individuals is not warranted.

While JCT's recommendation is one way to provide equivalent effective interest rates on underpayments and overpayments for individuals, the proposal is incomplete because it fails to clarify the deductibility of deficiency interest attributable to trade or business or investment activities of a non-corporate taxpayer. Section 163(h)(2) provides that, in the case of a taxpayer other than a corporation, no deduction shall be allowed for personal interest paid or accrued during the taxable year. The term "personal interest" does not include interest paid or accrued on indebtedness properly allocable to a trade or business. Temporary regulations section 1.163-9T(b)(2)(i)(A) provides, however, that interest relating to taxes is personal interest regardless of the source of the income generating the tax liability. This interpretation of the statute has generated considerable litigation and two different standards for the deductibility of interest on deficiencies incurred in a trade or business--a corporation filing a Form 1120 is clearly entitled to deduct deficiency interest while an individual operating an unincorporated trade or business reporting income on a Form 1040 return is denied the interest deduction. We believe section 163(h) should be modified to allow every taxpayer a deduction for interest attributable to a deficiency attributable to trade or business activities, regardless of the form in which the businesses is operated, or to investment activities.

7. Dispute Reserve Accounts

The JCT staff recommends that taxpayers be allowed to deposit amounts in a "dispute reserve account," a special interest-bearing account within the U.S. Treasury. These accounts are intended to help taxpayers better manage their exposure to underpayment interest without requiring them to surrender access to their funds or requiring them to make a potentially indefinite-term investment in a non-interest bearing account. The Treasury report does not contain similar relief.

We have some concerns about how the dispute reserve account system will operate. For example, will the IRS be permitted to use the offset provisions against amounts deposited into these accounts? Nevertheless, we believe the JCT staff's recommendation blends the good features of several current-law approaches to avoid deficiency interest charges and merits serious consideration.

8. Interest-Free Periods

Treasury recommends that, when administratively feasible, the 45-day rule restricting overpayment interest on refunds should be applied, in the case of early-filed returns, to the date the return was received, rather than the last day prescribed for filing the return. The JCT report does not recommend any changes with regard to these so-called rules of convenience.

Under the Code, taxpayers are given a 21-day interest-free grace period to pay tax liabilities (10 business days if the underpayment is in excess of $100,000) while the government is given 45-days to make tax refunds. In addition, overpayment interest accrues on an overpayment from the later of the due date of the return or the date the payment is made, until a date not more than 30 days before the date of the refund check.

Nuances associated with these special rules contribute to the complexity of interest computations. We believe that in the context of comprehensive interest reform, consideration should be given to reviewing and adjusting the application of these rules. The lengths of the grace periods were established years ago and may no longer reflect the actual length of time it takes to complete the assigned task (e.g., transmit data, issue refund checks, remit payment). On the surface, it seems patently unfair to give the IRS 45 days from the due date of a return to process a refund check while allowing some taxpayers only 10 business days to respond to an IRS bill. We believe that these rules should be updated, with a view toward simplification.

9. Application of Compound Interest Only to the Underlying Tax

The National Taxpayer Advocate recommends that compound interest apply only to the tax liability and that simple interest apply to penalties and/or additions to tax.

We disagree with that recommendation. Interest computations already are extremely complex; this proposal would add to that complexity. Further, such an approach would be inconsistent with the use of money principles on which interest is based.

10. Limitation on the Total Amount of Interest that Can Accumulate

The National Taxpayer Advocate recommends that the total amount of interest that can accumulate on a liability should be limited to 200% of the underlying tax liability.

We disagree with that recommendation as being inconsistent with the use of money principles on which interest is based.

STANDARDS APPLICABLE TO IRS

1. Standards

The JCT staff recommends that standards similar to those that apply to tax practitioners should be imposed on IRS employees.

We support the JCT staff's recommendation, but urge that sanctions be specified to encourage enforcement. As a matter of fairness and consistency, we recommend that, under current law, the IRS require revenue agents to have concluded that there is at least a "realistic possibility of success" before proposing an adjustment against a taxpayer. (If, as is proposed, the standards for tax return preparers are raised, the standard for IRS revenue agents should be raised similarly.) One method of ensuring that a position contained in a Revenue Agent Report has satisfied the standard could be to require that each Report be signed, evidencing supervisory approval, by an individual at the group manager or higher level, attesting to the fact that the proposed adjustments set forth therein meet the applicable standard. Implementing a policy such as this would be consistent with tax administration principles for the IRS set forth in Rev. Proc. 64-22, 1964-1 C.B. 689. Rev. Proc. 64-22 requires that the Service apply and administer the law in a reasonable and practical manner, and that issues only be raised by examining officers when they have merit, and never arbitrarily or for trading purposes.

2. Awards of Costs and Fees

Section 7430 of the Code currently requires the IRS to pay the reasonable administrative and litigation expenses of a taxpayer in certain circumstances if the IRS does not show that its position was "substantially justified." Such awards are not available, however, to taxpayers having a net worth above a certain dollar amount.

We recommend that recovery of such expenses under section 7430 be available to all taxpayers, regardless of their net worth. The IRS should be held accountable to all taxpayers and responsible for reimbursing a taxpayer for expenses it unduly causes the taxpayer to incur.

3. Monitoring and Reporting

The JCT staff recommends that the IRS be required to publish annually, information regarding payments made under section 7430 for taxpayers' administrative and litigation expenses and the administrative issues that resulted in the making of those payments.

Treasury recommends that, on an ongoing basis, the IRS undertake review of cases involving awards of attorney's fees and cases where penalties have not been judicially sustained, in order to enhance quality review of the administrative process.

We support the JCT staff's recommendation.

COMMUNICATIONS BETWEEN IRS AND TAXPAYERS

1. Communications with Individuals

The JCT staff recommends that the IRS place a higher priority on improving the processes by which the names and addresses of individual taxpayers are updated in the IRS's records.

Treasury recommends that on an ongoing basis the IRS improve the quality of its notices and communications to taxpayers regarding the basis for penalty and interest assessments and the abatement procedures. Treasury also recommends that the IRS institute procedures to reduce the burdensome nature of the current abatement process.

We support these recommendations.

2. Method of Communicating

The JCT staff recommends consideration by the IRS of the use of e-mail and fax instead of regular mail for communicating with taxpayers. The JCT staff also recommends that the IRS consider proposing legislation to provide for use of an alternative delivery system where current law requires use of regular mail.

We support the JCT staff's recommendations.

CONCLUSION

As stated earlier, we believe there is a need for a comprehensive review of the penalty and interest provisions in the Code and reforms to those provisions to ensure they are appropriately and fairly applied and are designed to accomplish their purpose. We welcome the opportunity to work with you now and in the future on such an undertaking.