Re: Comments to the Proposed and Temporary Regulations Relating to the Compromise of Tax Liability

Dear Sir or Madam:

These comments address the proposed and temporary regulations (REG-116991-98; T.D. 8829) that reflect changes made by the Internal Revenue Service Restructuring and Reform Act of 1998 (the "RRA") to § 7122 of the Internal Revenue Code of 1986, as amended (the "Code"). We appreciate the opportunity to comment on these regulations and hereby request that a public hearing be scheduled with respect to the regulations.

In the RRA of 1998, Congress amended Code § 7122 and directed the Secretary to prescribe guidelines to determine whether an offer-in-compromise should be accepted. See Code § 7122(c)(1) as added by section 3462(a) of RRA 1998. In the Conference Report of RRA 1998, Congress expressed its intent "that the IRS [in formulating these rules] take into account factors such as equity, hardship, and public policy where a compromise of an individual taxpayer’s income tax liability would promote effective tax administration." H. Conf. Rep. No. 599, 105^th Cong., 2d Sess. 289 (1998).

Consideration of factors such as equity and public policy represents a significant expansion of the traditional grounds for compromising cases, which formerly were limited to doubt as to liability and collectibility. The legislative history also specified that the IRS should utilize this new authority "to resolve longstanding cases by forgoing penalties and interest which have accumulated as a result of delay in determining the taxpayer’s liability." Id.

As acknowledged in the preamble, the proposed regulations do not fully incorporate the Congressional mandate of encouraging offers-in-compromise in longstanding cases in which penalties and interest have accumulated as a result of delay. See Preamble to the Proposed Regulations (REG-116991-98) 64 Fed. Reg. 39107 (July 21, 1999). Indeed, the Preamble encourages commentators to identify situations in which the Secretary’s authority to compromise should be used because "IRS delay in determining the tax liability has resulted in the accumulation of significant interest and penalties." Id. We would also suggest that the proposed regulations, while taking a strong first step toward incorporating the new standards, need to elaborate on the equitable and public policy grounds for compromising certain taxpayer liabilities.

For the reasons set forth below, we believe that the Secretary should use this expanded offer-in-compromise authority in cases where an individual taxpayer's liability results from factors beyond his control and the accumulation of interest and penalties is disproportionate to the taxpayer's tax liability. One situation where this is likely to happen is where the Tax Matters Partner ("TMP") in a TEFRA partnership fraudulently sells shares to investors in a sham business and the investors are effectively prevented from reducing their exposure to interest and penalties. ^/

Delays Resulting from Partnership Audits. Because there is an inherent delay in the TEFRA process before individual partners are notified of any tax liability resulting from audit, interest charges on any deficiency will generally be very substantial. In a TEFRA audit, the IRS cannot contact individual partners with respect to a "deficiency" on their individual return prior to completion of the partnership-level proceedings (at most, a notice partner will receive notice of the beginning of the TEFRA audit and the final partnership administrative adjustments). See Code §§ 6223, 6225. Moreover, the contact for "payment" will occur at least 5 months to a year after the partnership adjustments are finally determined. Code §§ 6225, 6229(d). In addition, TEFRA audits often take years to complete due to the complexity of the issues and facts that must be resolved in examination and subsequent appeals.

The impact of the delay inherent in a TEFRA audit is exacerbated when it is accompanied by the Service's decision not to remove or enjoin a conflicted Tax Matters Partner (TMP), such as a tax shelter promoter who has perpetrated a fraud on the investors. During that time, the TMP has the authority to extend deadlines and statutes of limitations without the knowledge or consent of other partners. This problem has arisen in at least three published cases involving tax shelters in which innocent investors were adversely affected. See Transpac Drilling Venture v. Commissioner, 147 F.3d 221 (2d Cir. 1998); Shorthorn Genetic Engineering 1982-2, Ltd. et. al., Walter J. Hoyt III, Tax Matters Partner v. Commissioner, T.C. Memo. 1996-515; and River City Ranches #4, J.V., Walter J. Hoyt III, Tax Matters Partner, et al., v. Commissioner, T.C. Memo. 1999-209. In the above-cited cases where Walter J. Hoyt was the TMP, he was being investigated by the IRS and other government agencies for his criminal conduct relating to the partnerships, while at the same time continuing to represent the partnerships in the IRS audit and ensuing litigation. The investors were not notified of the criminal investigations. The TEFRA process of providing the investors constructive notice and opportunity to be heard through a TMP with a significant conflict of interest becomes fraught with potential for abuse and accrual of extraordinary liabilities. The investors effectively lose the ability to control the administration of their tax case when the Service and the TMP know of a conflict of interest, but the investors do not.

In the TEFRA partnership audit context, therefore, individual taxpayers that are partners in the audited partnership can find themselves in exceptional circumstances where factors such as equity, hardship and public policy should prompt the Secretary to utilize the compromise authority granted by Congress in Code § 7122. Clearly, it would be short-sighted to impose a rule that would make the Government an insurer of individual taxpayer liabilities attributable to a tax shelter promoter's misdeeds. However, where the Service's actions (or failure to act) may have contributed to the problem and the taxpayers involved could not have known that a tax liability was being generated, expanded offer-in-compromise authority is warranted for the interest and penalty portion of the final liability.

No Relief Under the Interest Abatement Authority. Code § 6404(e) grants the Secretary the authority to abate interest on tax deficiencies under certain circumstances in which such interest was attributable in whole or in part to "unreasonable errors or delay" by the IRS. Since 1986, § 6404(e) has provided that interest could be abated for so-called "ministerial acts" by IRS personnel that resulted in a delay of a tax assessment after the taxpayer and the IRS completed efforts to resolve the matter. The "ministerial acts" limitation often results in a finding that the IRS need not abate interest -- even in longstanding tax disputes. See, e.g., Lee v. Commissioner, 113 T.C. No. 10 (Aug. 18, 1999).

In 1996, as part of the Taxpayer Bill of Rights, Congress expanded IRS authority to abate interest to include "managerial acts." However, recently issued IRS regulations have construed the term narrowly and have eliminated, in certain cases, the benefit to taxpayers intended by Congress. See Treas. Reg. § 301.6404-2(b)(1) (Dec. 17, 1998). Thus, in the above-described circumstances involving a conflicted TMP, the IRS would not necessarily exercise its authority under § 6404(e) to abate interest.

In any event, abatement under Code § 6404(e) is limited to errors or delays occurring after the IRS has initially contacted the taxpayer regarding a "tax deficiency or payment." No exceptions are provided for the application of the interest abatement rules to partnerships that are subject to the TEFRA audit rules. In TEFRA partnership cases, the limitation of interest abatement to the time after the taxpayer is contacted by the IRS as to a "tax deficiency or payment" results in an injustice because partners typically are not informed of their individual deficiency or payment until the case is several years old. Moreover, after the partnership tax liability is final, the IRS may spend considerable time arriving at what may ultimately prove to be erroneous computational adjustments to the individual taxpayer return. Even those delays do not appear to trigger abatement as a remedy, because they occurred prior to the "initial" contact with the taxpayer as to "payment" or "deficiency." Therefore, the relief provided by Code § 6404(e) does not address the "exceptional circumstances" to which investors in this type of partnership may be subjected.

We acknowledge that the Taxpayer Relief Act of 1997 added a provision that requires the suspension of interest when a partner settles his TEFRA partnership case for the period during which the IRS fails to issue a notice and demand for payment if it failed to give such notice within 30 days of the settlement. See Code § 6601(c). This provision clearly does not address unreasonable delays that may occur during a TEFRA audit; it only addresses delays after notice of deficiency and settlement.

In a recently issued study on the interest and penalty provisions, the Joint Committee on Taxation has recommended the Secretary be granted the authority to abate interest for a period that is attributable to unreasonable IRS errors or delays, whether or not related to managerial or ministerial acts.^/ The Joint Committee on Taxation Study has also recommended that the Secretary be given the authority to abate interest if a gross injustice would otherwise result if interest were to be charged.

Although present law does not provide IRS with the authority to abate interest on those two expanded grounds, the Secretary's new offer-in-compromise authority does allow IRS delay and equity to be taken into account. However, if such grounds are not fully spelled out in the offer-in-compromise regulations, Congressional intent will be frustrated and it will be necessary to directly amend the interest abatement statute.

Policy Rationale for Abating Interest in the Offer-in-Compromise Context. Public policy militates against imposition of interest penalties against taxpayers known by the IRS to be victims of fraud. Interest is a charge for the use of money. Interest assessments imply that the taxpayer has had the use of money that belonged to the Service, or conversely, that the taxpayer has benefited from the use of the money. In the case where a taxpayer has been defrauded of the very same amounts that the IRS claims were improperly refunded, it is inequitable to impose substantial interest penalties on the fraud victim. See River City Ranches #4, T.C. Memo. 1999-209; Shorthorn Genetic Engineering, T.C. Memo 1996-515. ^/ The inequity is particularly poignant where the IRS declines to take action within their authority to prevent the taxpayer from being defrauded of money that the IRS ultimately claims belongs to the government, thereby increasing the likelihood of very large interest accruals.

Recommended Change. Section 301.7122-1T(b)(4)(ii) of the temporary and proposed regulations provides that a compromise may be entered into to promote effective tax administration when, regardless of the taxpayer’s financial circumstances, "exceptional circumstances exist such that collection of the full liability will be detrimental to voluntary compliance by taxpayers." The regulations should further specify that such exceptional circumstances may exist where the taxpayer's liability is due largely to factors beyond the taxpayer's control and there have been significant delays in resolving the taxpayer's liability resulting in significant accumulations of penalty and interest charges.

The regulations provide only two examples of such "exceptional circumstances." Although these examples are extremely helpful, the first involves a taxpayer that suffered a serious illness and was unable to manage his financial affairs during such time. The second example involves a case where a taxpayer relied on incorrect advice from the IRS in an informal e-mail response concerning the rollover period for an IRA account. See Temp. Reg. § 301.7122-1T(b)(4)(iv)(E). The regulations also include a helpful example under the "economic hardship" category involving a business that suffers an embezzlement loss related to its employment tax liabilities. See Temp. Reg. § 301.7122-1T(b)(4)(iv)(D)(Ex. 4).

An example that addresses the exceptional circumstances faced by a defrauded investor that is assessed with substantial penalties and interest resulting from TEFRA partnership audit should be added to the final regulations. We suggest the following:

Example 3. Taxpayer invested in a limited partnership that he reasonably believed was conducting a legitimate business. In Year 1, the partnership became subject to a TEFRA Internal Revenue Service examination. While the audit was pending, the Tax Matters Partner was under civil and criminal investigation for fraud relating to the partnerships. Taxpayer was not notified of these investigations. The Tax Matters Partner continued to have the authority to and did extend statutes of limitations and enter into agreements with the IRS for personal reasons, which were in conflict with the interests of the partnership’s investors. As a result of the length of the case, and the IRS’s decision not to exercise its authority to remove the Tax Matters Partner or enjoin his promotion of the partnerships, by the time that Taxpayer was notified of his liability from the partnership audit in Year 15, very substantial interest and penalties had accrued. Taxpayer’s overall federal tax compliance history does not weigh against compromise.

Because of the exceptional circumstances that can arise from the certain partnerships under the TEFRA audit process, we recommend that the final regulations under Code Section 7122 be changed to include an example of the appropriate use of the Secretary’s authority to compromise penalties and interest with respect to the liability of individual partners who have not taken any deliberate actions to avoid the payment of taxes and whose interest liabilities have accumulated because of IRS delay and inaction.

Sincerely,
Kathleen M. Nilles

KMN/mpc:efs

cc: Jonathan C. Talisman, Treasury Department
Rita Cavanagh, Treasury Department
Timothy C. Hanford, Ways and Means Committee
Bruce Strauss, Senate Finance Committee
Anita L. Horn, Senate Finance Committee

C01/316972.1
11/24/99