In the IRS instructions for 1099's, it states:

Box 2. Early Withdrawal Penalty
Enter interest or principal forfeited because of an early withdrawal of time deposits, such as an early withdrawal from a certificate of deposit (CD), that is deductible from gross income by the recipient. Do not reduce the amount reported in box 1 by the amount of the forfeiture.

but
Box 4. Federal Income Tax Withheld
Enter backup withholding. For example, if a recipient does not furnish its TIN to you in the manner required, you must backup withhold on payments required to be reported in box 1 (which may be reduced by the amount reported in box 2), box 3, and box 8 on this form.

For Box 4, what is it referring to when it states: "which may be reduced by the amount reported in Box 2". Box 2 states not to reduce the amount of the forfeiture. Are the instructions stating for Box 4, to reduce it by the penalty? If the customer is deducting the penalty based on Box 2, wouldn't reducing Box 4 be double dipping?

It means you take Box 1 and if you feel like it, you can subtract Box 2, 3, and 8 prior to imposing the backup withholding percentage.

LOL !! That is exactly how it reads, if you want to...but this is the IRS and their instructions...that can't be correct??

About the only thing a bank might see is an early withdrawal penalty. If you have customers on which you both have to backup withhold on and that comes in and does an early withdrawal of a CD, then I would be examining this customer a little more carefully for a potential SAR. As I previously indicated, most banks exit the relationship as soon as possible or offer to move everything to a non-interest bearing account..

What I do not still understand is why a bank would "choose" to substract an early withdrawal penalty from the amount reported related to Federal Income Tax Withheld. One is unrelated to the other.

Because from the customer's perspective, the early withdrawal penalty is normally tax deductible. So you may withhold either on the total in Box 1 or Box 1 minus Box 2.