At least from this practitioner’s perspective, in the earlier days of IRS bond audits, there were substantial inconsistencies in IRS practices. Different documents were requested by the examining agents, different tax-exemption requirements were reviewed, and different positions were taken with respect to those requirements. And this was the case taking into consideration the various audit programs that the IRS has conducted over the years – even within a particular program these inconsistencies were apparent. The IRS Tax Exempt Bonds group has made great progress in reducing these inconsistencies, which has significantly increased the quality and fairness of audits. One area, however, that has suffered from an over-emphasis on consistency is the IRS’s refusal to waive rebate penalties where an issuer’s underpayment of rebate is found – whether by the IRS or by the issuer – in connection with an examination of the bonds.
Where an issuer fails to timely pay its full rebate payment, IRC section 148 provides an alternative to declaring the bonds taxable – a penalty equal to 50% of the late rebate payment for governmental or 501(c)(3) bonds. The Code then specifically authorizes Treasury to waive all or any portion of this penalty. This authority has been implemented through regulations (Treas. Reg. 1.148-3(h)(3)):
The penalty is automatically waived if the rebate amount that the issuer failed to pay plus interest is paid within 180 days after discovery of the failure, unless, the Commissioner determines that the failure was due to willful neglect, or the issue is under examination by the Commissioner at any time during the period beginning on the date the failure first occurred and ending on the date 90 days after the receipt of the rebate amount. Generally, extensions of this 180-day period and waivers of the penalty in other cases will be granted by the Commissioner only in unusual circumstances.
In short, the penalty is automatically waived if payment is made within 180 days of discovery unless the failure was due to willful neglect or the bonds are under audit, and otherwise only in unusual circumstances. It is not clear what “unusual circumstances” means but it is clear I’ve never seen those unusual circumstances because in each case where I’ve had this issue, a request for penalty waiver has been summarily refused. Further, IRS agents have consistently said that they have been directed not to waive the rebate penalty when the underpayment comes to light in an audit, apparently without consideration of the circumstances.
It is further worth noting that, for an issuer to be subject to the “unusual circumstances” standard for waiver, the underpayment need not be discovered by the examining Agent or by the issuer as a result of a document request or question raised by the Agent. That very tough waiver standard is a result of mere timing: the standard applies if the issue is under audit at any time from the due date of the rebate payment until 90 days after the late payment is made. It is also interesting to recognize that, after receiving a late rebate payment from an issuer that is not under audit, if the IRS should then happen to open an audit within 90 days to consider whether willful neglect existed or merely by coincidence having nothing to do with the rebate payment, then the penalty waiver is automatically subjected to the unusual circumstances standard. Hopefully a more lenient approach would be taken in this post-payment audit, or is that circumstance also a victim of consistency?
The logic of categorically refusing to waive the rebate penalty in an audit is baffling. Tax penalties should be designed and implemented to encourage compliance (and not, e.g., to raise revenue). The IRS itself acknowledges in the Internal Revenue Manual that the purpose of penalties is to “enhance voluntary compliance by taxpayers,” and states that “the Service will design, administer, and evaluate penalty programs based on how those programs can most efficiently encourage voluntary compliance.” IRM 18.104.22.168.1 (06-29-2004). Given this goal, it is hard to see the relevance of the audit. Instead, the inquiry should focus on the issuer’s efforts to comply with the rebate requirement. If the issuer made a good faith or strong or . . . (pick your standard) effort to comply with this complex requirement, the existence or non-existence of an audit should be irrelevant. This is apparently not a novel thought as the rebate penalty is the only penalty we’ve been able to uncover whose waiver is dependent upon the error not being discovered on audit. (Thanks goes to our very able summer associate, Emily Mikes, for slogging through the tax penalties in search of other penalties whose waiver is affected by an audit.)
It is especially harsh to refuse consideration of the issuer’s effort to comply with a requirement as complicated as rebate. By contrast, in the case of the return preparer penalty for understatement of a tax liability, one of the specifically listed factors warranting waiver of the penalty is that the “error resulted from a provision that was complex, uncommon, or highly technical, and a competent tax return preparer . . . reasonably could have made the error.” Treas. Reg. 1.6694-2(e)(1). No one would argue that the rebate requirement fails to meet this “complex, uncommon, or highly technical” standard. Further, this leniency for complex requirements is provided to tax return preparers – professionals who make their living this way. The rebate requirement applies to bond issuers, most of which have limited staff, many responsibilities and good faith but limited opportunities to master the rebate requirements. They are certainly as deserving of leniency as tax professionals.
In summary, then, a change in the rebate penalty regulation to eliminate consideration of the existence of an audit is in order. And, recognizing the hurdles of changing a regulation, I would respectfully request that the IRS exercise its reasonable discretion to interpret “unusual circumstances” more broadly to more effectively implement the purpose of the rebate penalty.