Is your exempt organization mired in a seemingly endless dispute with the IRS? Are you looking for a new path to arrive at a quick, quiet and cost-effective resolution of your IRS dispute? If the answer to either question is “Yes”, then take five minutes and read some fresh thinking on why and when to use Alternative Dispute Resolution techniques with the IRS.

The Enforcement Environment

The Internal Revenue Service, in part due to inquiries from the Senate Finance Committee and the vigilance of its ranking member Senator Charles Grassley (R-IA), has ramped up its oversight and enforcement activities of exempt organizations. It is doing so in the face of some staggering numbers. In 1998 there were 650,000 tax-exempt organizations; today the number has doubled to 1.2 million recognized by the IRS as exempt. Revenues of these organizations have also doubled during the same period, from $990 billion to almost $2.0 trillion. The IRS response of increased oversight and enforcement is being undertaken while staff levels have remained virtually constant.

The IRS has also engaged taxpayer groups in broad-based compliance checks by issuing “voluntary” questionnaires to pre-selected organizations within the focus group. Four hundred and eighty-seven tax exempt hospitals responded to a May 2006 questionnaire about how the hospital provides and reports benefits to the community. A 33-page compliance questionnaire was sent to 400 colleges and universities in September 2008; a response date was recently extended to February 6, 2009, due to the amount of information requested. Other compliance initiatives have been conducted with community foundations, credit counseling organizations, and also with public charities seeking information about executive compensation and tax exempt bonds.

What is the likely impact of this information overload and increased enforcement activity on the IRS? On taxpayers? Given its finite and flat resources, can the IRS reasonably be expected to process all the information provided through the revamped and expanded Form 990 and these other sources and use it to create an effective and balanced service and enforcement offering to its TEGE custoers? We assume that the IRS strategy is that all the new information will allow it to select and conduct examinations in a much smarter and more targeted fashion.

Yet, the current environment is clearly a strained one. Examinations are often protracted and costly, and many cases go unresolved and wind their way up to the IRS Appeals office. When they arrive at Appeals, there is a backlog that is growing almost exponentially.  

At the end of fiscal year 2007, Appeals had a total case inventory of 51,502. In fiscal year 2008 just ended, Appeals received 116,000 new cases and closed 106,000. Fiscal year 2009 is expected to continue on an upward path. Yet, the number of Appeals Officers assigned to handle these cases has not grown.

Practitioners with cases at Appeals are experiencing significant delays in moving them along. Appeals has about 10 officers dedicated to hearing TEGE cases and the number of cases pending is in the range of 700. While cycle time data is not available for TEGE cases, for LMSB the cycle time for large corporate taxpayers (Coordinated Industry Cases) to get a case through the Appeals Division during 2007 was 718 days. To this must be added the years the case takes to wend its way through exam.

The bottom line of all of this is that many non-profit organizations, including public charities and private foundations, find that they are caught in a twilight zone of a seemingly endless IRS examination and Appeals review process. They are effectively “forced” to extend the statute of limitations again and again to avoid a death-wish of the IRS issuing a notice of revocation/notice of deficiency that assumes the absolute worst case scenario. If they refuse, it then becomes the exempt organization’s burden to prove the likely exaggerated and assumed facts to be incorrect, a time-consuming, costly and very public process. Most clients are advised by counsel to extend the statute of limitations, thus allowing the IRS to keep the case open indefinitely.

ADR—A New Path to Resolution

There is another path to closure—one that is commonly and successfully used in the commercial world to resolve disputes. That is Alternative Dispute Resolution which takes the form of either non-binding mediation or binding arbitration. It has proven to be the overwhelming tool of choice to resolve commercial disputes because it is quick, quiet and cost-effective. ADR is just beginning to take off in the tax world and the IRS has recently approved several programs that are available to taxpayers and at the same time can provide a reasonable alternative to ease the burden at an already overloaded Federal agency.

The IRS Restructuring and Reform Act of 1998 mandated that the IRS develop non-binding mediation and binding arbitration programs. Since then the Service has recognized six different ADR programs and four of those are available to the exempt organization community:

  • Fast Track Settlement (Announcement 2006-61 and News Release IR-2007-200). Available to both SBSE and TEGE taxpayers, this is still a pilot program and operates in 8 major geographic areas. It can involve both legal and factual issues and can be invoked while the case is still in the Examination Division. A specially trained “independent” Appeals officer mediates the unresolved issues. There is a 60 day time limit on the entire process. The result is not binding, and the parties may proceed through the regular Appeals process if Fast Track does not resolve the case.
  • Appeals Mediation (Rev. Proc. 2002-44). This is available for legal and factual issues after the regular Appeals process has concluded without resolution. The parties can utilize either a single IRS mediator or an IRS mediator plus a true independent third-party “neutral” as co-mediators. The parties must agree on the chosen mediator(s) and the taxpayer pays for the co-mediator. The result is not binding, and the parties can proceed to litigation if they are still unable to resolve their differences.
  • Appeals Arbitration (Rev. Proc. 2006-44). This tool is available only after the regular Appeals process has concluded without agreement. It is available for factual issues only, and the arbitrator’s award is final and binding. The arbitrator is selected by the parties and is either a specially trained Appeals officer or an independent neutral arbitrator.
  • Tax Exempt Bond Mediation Dispute Resolution (Announcement 2006-36 and Announcement 2006-43). This is designed to resolve disputes between the bond issuer and the IRS over any proposed adverse ruling about the treatment of tax exempt interest. An Appeals officer mediates the dispute but again the issuer can at its expense bring in an independent co-mediator.

The authors believe that the first Program, Fast Track Settlement, is likely to be the most popular because it allows for mediation intervention at an early stage—when the case is still at the exam stage. Both legal and factual issues can be submitted to the procedure and the Appeals mediator can make recommendations using his settlement authority taking into account litigation hazards. And, the process has a quick timeline—60 days.

The types of exempt organization issues that could be mediated, or decided by an arbitrator, include messy or factually complex issues, matters involving a “battle of the experts” such as valuation determinations or unreasonable compensation. Unrelated Business Income Tax (UBIT) disputes could be mediated or arbitrated. Cases that may lead to an unfavorable precedent for either or both parties could also be candidates for ADR. Litigation hazards are also to be considered by the parties in evaluating whether ADR is a good choice. Many times, bad facts result in bad law and one or both parties may want to keep the case out of the public domain.

ADR can provide both the IRS and the taxpayer with a flexible, creative, and more efficient process to resolve their disputes starting when in Exam, Appeals and even to cases docketed in court. The potential advantages for the taxpayer include confidentiality of the proceeding, a faster resolution, more control over the outcome of the case, and better management of legal fees and other costs (including interest on any deficiencies). The advantages for the IRS include better and more efficient utilization of staff, ability to avoid unfavorable precedents resulting from litigation, and the ability to manage an ever-growing case inventory without the addition of personnel.

A No-Loser Strategy

In the commercial world of conflict resolution, ADR is often described by its protagonists as a “win-win” or a “non-zero-sum” proposition. That is so because it has proven over and over to be fast, efficient and cost-effective. Equally important, the process and the result often have the effect of moving the parties’ relationship away from confrontation toward a more collaborative one going forward.

The authors believe that ADR in the exempt organization world can likewise provide a win-win scenario for both the IRS and taxpayers.  

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.