Chapter 3

Options to Enhance Voluntary Compliance

A key part of IRS' tax-exempt bond oversight strategy, as in other areas, is
enhancing voluntary compliance. Although IRS can take administrative and
enforcement actions to encourage compliance, as discussed in chapters 1
and 2, Congress can enhance IRS' ability to deter tax-exempt bond abuse by
providing appropriate incentives in the law to promote voluntary
compliance. IRS does not know the extent of current noncompliance in the
tax-exempt bond market, but it is reasonable to assume that some degree
of noncompliance exists. For example, despite limited enforcement efforts
in the nearly $800 billion tax-exempt bond market given IRS' limited
resources across a range of priorities, IRS has found some cases of
noncompliance. However, Congress has not adopted a penalty structure
for tax-exempt bonds that IRS can use to encourage compliance.
Consequently, if noncompliance is discovered, the basic sanction available
to IRS is to tax the interest that bondholders receive on the bonds;
however, this sanction does not target those found to be responsible for
the noncompliance and is disproportionately severe for many types of
noncompliance with tax law.

The IRC generally prohibits IRS from disclosing federal taxpayer
information, including information about its enforcement activities related
to tax-exempt bonds. However, tax-exempt bond market forces can
encourage compliance if information is available to support judgments
about tax-related compliance risks. Market participants would tend to
avoid doing business with noncompliant parties or would require a higher
return on investments to compensate for increased risks. Although the
disclosure prohibitions are based on concerns that cannot be ignored,
such as respect for citizens' privacy, some of these concerns may be less
applicable to the governmental bodies that issue bonds. Moreover,
although any changes in disclosure restrictions for tax-exempt bonds
would have to be carefully considered, it may be possible to alleviate some
concerns through the design of a disclosure provision limiting what could
be disclosed.

House report language accompanying the Omnibus Reconciliation Act of
1989 clarified that IRS can use the penalty for promoting abusive tax
shelters found in IRC Section 6700 for tax-exempt bonds. This penalty
would target those responsible for noncompliance if they were involved in
providing the bond as an abusive shelter of income from taxes. However,
it has not yet been tested by IRS in a tax-exempt bond case. It also does not
apply to all types of noncompliance.

Options to Enhance Voluntary Compliance

Penalties to Promote
Compliance

Simplifying the laws and regulations applying to tax-exempt bonds, perhaps by restricting complex requirements to complex transactions, may also promote compliance by making the requirements more readily understandable and less burdensome. However, these requirements are likely to remain relatively complex because of continuing congressional concerns with the ways tax-exempt bonds have been used. Therefore, IRS will need to encourage voluntary compliance through such means as education of participants in the tax-exempt bond market, clear regulations, and well-designed enforcement efforts.

Congress promotes voluntary compliance with the tax law by providing incentives as well as sanctions and penalties in the IRC. IRS policy emphasizes penalties as an important mechanism to encourage voluntary compliance. If penalties are to encourage voluntary compliance, they must be targeted to the individual(s) responsible for the noncompliant behavior and known to them. In addition, IRS must be willing to impose the penalty, the penalty must be readily administrable, and it must be both of appropriate magnitude to the severity of the noncompliant behavior and of sufficient magnitude to deter noncompliance. However, because Congress has never adopted a penalty structure for tax-exempt bonds, the basic sanction available to IRS when a bond does not meet IRC requirements is to tax the bondholders' interest on the bond.

As in other tax areas, IRS relies on voluntary compliance in the tax-exempt bond industry. However, what makes this reliance unusual for tax-exempt bonds is that the tax liability for noncompliance does not fall to those whom IRS relies on to voluntarily comply, such as issuers (state and local governments, special authorities, and districts) and the specialists that issuers rely on to provide legal, financial, and other services (bond counsels, underwriters, and others). Instead, that liability falls to the bondholders, whose interest earned on bonds they thought were tax exempt is taxed when noncompliance is discovered. Thus, the incentive to comply is different from that in areas of tax law in which the abuser is directly liable for the abuse.

Historically, IRS has been reluctant to impose the sanction of taxing bondholders' interest because it is a severe sanction that is not directed at the parties responsible for the noncompliant behavior. In addition, this sanction is difficult to administer because IRS has to identify the individual investors, notify them that the interest is now taxable, collect the taxes due, and potentially bring individual suits against them if they do not pay

Options to Enhance Voluntary Compliance

the taxes. With the growth of tax-exempt mutual funds, hundreds or thousands of investors may own small portions of a given tax-exempt bond and their proportional ownership of a particular bond may be very small and difficult to verify.

Rather than taxing the interest on a bond, IRS' practice has been to use closing agreements when it determines that bond transactions do not comply with the tax laws. Under the approximately 70 agreements since 1981, issuers almost always paid IRS an agreed-upon amount and the bondholders' interest remained tax exempt. However, in a 1991 memorandum, IRS officials concluded that closing agreements typically resulted in settlements that represented only a small fraction of the arbitrage profits earned, which in turn were often of much smaller amounts than lost tax revenues. Because they typically are much smaller than the arbitrage gained, closing agreements provided little incentive to comply. According to an IRS Official, Examination no longer wants to use closing agreements to settle tax-exempt bond cases because closing agreements are not designed to promote voluntary compliance.

Apart from these concerns, the ability of closing agreements to deter abuse is limited for other reasons. Because they are not prescribed penalties and each agreement is the result of individual negotiations, their terms are not defined. In addition, because of prohibitions in the IRC, their terms cannot be disclosed by IRS. Those in the tax-exempt bond industry typically would learn of closing agreements resulting from issuers' noncompliant bonds if the issuers publicly discussed them. Thus, unlike the consequences of a prescribed penalty, industry participants cannot know in advance the consequences that will result if noncompliance is discovered by IRS. We believe that this combined with IRS' reactive use of its limited resources to oversee compliance, the relatively small amounts paid by those who reached closing agreements with IRS, and the reluctance of IRS to use the available sanction of taxing bondholders' interest, constrains the deterrent effect of IRS' Oversight.

As of May 1992, IRS had decided to consider taxation for a number of bonds that it judged highly abusive. Almost all of these bonds were issued in 1985 or 1986, were identified for IRS by external sources, and were allegedly issued to avoid the requirements of the Tax Reform Act of 1986. According to a December 1992 press article, in a court motion by IRS in response to a lawsuit filed by a bondholder to prevent IRS from collecting taxes on interest earned on bonds IRS contended were not tax exempt, IRS indicated that it is examining or challenging the tax-exempt status of more

Options to Enhance Voluntary Compliance

コ

than 30 bond issues nationwide. Nevertheless, officials have recognized
that taxation is administratively complex and that the investors who
would be required to pay the taxes were not likely to be those responsible
for the abuses. To prioritize its cases, as of May 1992, IRS had adopted
thresholds for determining which bondholders should be notified that
their interest was taxable. Although this effort to tax some bonds may
convince issuers that IRS is willing to take further action and thus may help
motivate issuers to reach closing agreements with IRS in the future, the
other limitations of closing agreements in promoting compliance will not
be fully overcome.

House report language accompanying the Omnibus Budget Reconciliation Act of 1989 clarified that IRC section 6700, which contains the penalty for promoting abusive tax shelters, applies to parties involved in the organization or sale of tax-exempt bonds. Section 6700 may provide IRS with a more appropriate penalty for tax-exempt bond abuses than taxing bondholders' interest or reaching closing agreements with issuers because it has attributes that may encourage voluntary compliance. That is, it (1) is set by statute and therefore industry participants can know in advance the consequences of noncompliance, (2) was adjusted by Congress in the 1989 act to more closely align the penalty with the severity of the noncompliant behavior by applying it to each sale of an interest in an abusive tax shelter, and (3) is targeted to those responsible for the noncompliance.

Language changes in the Omnibus Budget Reconciliation Act of 1989 were
made to clarify that the section 6700 penalty applies not just to the overall
activity of promoting abusive tax shelters but rather to each individual sale
of an interest in a shelter. Because of these changes, instead of being
penalized one time for creating an abusive tax shelter, a shelter promoter
would be penalized for each time an individual bought into the shelter. The
1989 act also revised the amount of the penalty under section 6700. Before
the 1989 act, the IRC penalty imposed for promoting abusive tax shelters
was "equal to the greater of $1,000 or 20 percent of the gross income
derived or to be derived by such person from such activity." As revised by
the 1989 act, the penalty equals $1,000 or, if the person establishes that it is
lesser, 100 percent of the gross income derived (or to be derived) by such
person from each such activity. The effective date of the legislative
changes to this penalty was January 1, 1990.

Although this penalty would target those responsible for the noncompliance if IRS used it for tax-exempt bond abuses, it is not clear whether the penalty can be used to effectively encourage compliance in

Options to Enhance Voluntary Compliance

the tax-exempt bond industry because IRS has not applied it in a tax-exempt bond case. To use the penalty, IRS must prove that those parties considered responsible intentionally promoted a bond through which investors could improperly shelter income and avoid paying taxes. To date, IRS largely has been wrapping up cases from 1985 and 1986. Even if this penalty is appropriate for certain types of tax-exempt bond abuses that amount to promoting abusive tax shelters, IRS Still lacks appropriate penalties for other forms of noncompliance such as failure to file tax-exempt bond information returns.

In an April 20, 1990, response to the Chairman, Committee on Ways and Means, House of Representatives, regarding simplification of the IRC, the staff of the Joint Committee on Taxation recommended that a statutory penalty system be developed as an alternative to, or in combination with, loss of tax exemption for selected violations of the IRC's tax-exempt bond rules. The staff's letter stated, “In general, the only sanction for violation of any of the numerous Code requirements applicable to tax-exempt bonds is loss of tax exemption. Even for many of the most serious violations, loss of tax exemption is directed toward the wrong party-the investor holding the bonds rather than the issuer of the bonds." The letter also stated that for more minor violations, loss of tax exemption was too severe a sanction and that IRS avoided imposing it in practice.

The Government Finance Officers Association-an association representing local government finance officials-and other groups also have taken the position that taxing bondholders is inappropriate because they are not the parties responsible for the noncompliance. A statement submitted on behalf of the Government Finance Officers Association and several other organizations to the House Ways and Means Committee in 1990 said that although section 6700 represents an important first step to reforming tax-exempt bond-related penalty provisions, they supported further reexamination of penalty provisions.

IRS is considering alternative penalties in a somewhat analogous area. That is, when a tax-exempt organization, such as a charity, fails to meet applicable requirements, IRS can revoke its tax-exempt status. As with the tax-exempt bond sanction, IRS has been reluctant to use this sanction because of its relative severity. According to IRS' Director of Exempt Organizations' Technical Division, Exempt Organizations will be using alternative penalties that would be more appropriate, including tax shelter penalties.