The IRS collects 92% of federal government receipts. However, the number of IRS Revenue Agents conducting examinations is the lowest in nine years and the number of Revenue Officers collecting unpaid taxes is the lowest in ten years. Notwithstanding, the President’s Fiscal Year 2015 IRS budget proposal claims the IRS should collect an additional $2.1 billion in enforcement revenue through various programs directed at enhancing the IRS’ ability to detect, resolve, and prevent tax avoidance. The IRS supports its request for additional funding by asserting that enforcement and related compliance programs generate a $4 to $1 return ratio. The agency utilizes its enforcement tools to help shrink the “tax gap”: the difference between the amount of tax that taxpayers should pay (according to the IRS) and the amount taxpayers pay on a voluntary basis, which is currently estimated to be $450 billion. What does this mean for KTS clients? With increased and more efficient enforcement activity, all companies and high-net worth individuals may deal with the IRS in 2015—directly or indirectly. Based on the limited funding and understaffing, IRS personnel may have to make decisions more quickly regarding which issues to pursue that will generate the greatest return. With that background, the following is a list of 15 tips to help taxpayers and advisors deal with (or possibly avoid) the IRS in 2015 as the IRS focuses on enforcement to shrink the tax gap:
1. Hot Audit Issues For 2015
For 2015, the IRS reportedly plans to focus enforcement activity primarily on international tax provisions, high-income individuals (especially those with foreign accounts or a family office), and employment tax issues for all businesses (including exempt organizations). All tax controversy considerations for these areas should start in the planning stages – not upon the start of an IRS audit.
2. International Tax Planning & Enforcement
The IRS continues its laser focus on international enforcement, including offshore asset disclosures, transfer pricing, CFC and PFIC rules, FTCs, and other cross-border issues. As Foreign Account Tax Compliance Act (“FATCA”) and other global anti-tax avoidance regimes gather steam, U.S. businesses and individuals with foreign operations or investments must appreciate their compliance and disclosure obligations. The penalties for compliance failure are onerous, and the chances of being pursued for
non-compliance have increased dramatically.
As of July 1, 2014, U.S. businesses must comply with FATCA’s new withholding and documentation obligations, triggered by payments to foreign persons and requiring review of cross-border payment streams with foreign affiliates, customers, or counterparties. Individuals do not escape the focus. Thanks to FATCA, in 2015 other countries will report information to the IRS regarding financial investments held by U.S. citizens and residents in that country. That information combined with IRS steppedup
enforcement make it of paramount importance for U.S. taxpayers to understand their responsibilities.
3. An IRS Notice Is Never An FYI
An IRS inquiry can evolve into a major problem if one or more of the following occurs after receipt of an IRS notice (during an examination or otherwise): (i) the IRS delivers the notice to someone in the organization other than to the group in charge of IRS matters and the notice is untimely processed or ignored (i.e., “I will forward this later” or “not my department”); (ii) someone unfamiliar with the straightforward tax issue deals directly with the IRS (“that’s not my department, but I’ll get to the bottom of it…”); or, most alarming, (iii) a real IRS or tax problem exists and the individual familiar with the issue deals with the IRS without any outside representation (“IRS, let me explain EXACTLY what happened … ”). The first contact with the IRS can dictate the result or the extent of IRS inquiry. Careful attention should be paid to the selection of who actually speaks to the IRS on behalf of the taxpayer.
4. Responding To An IDR (Information & Document Request)
The IRS issues informal Information Document Requests (“IDRs”) to collect documents and information during examinations. Once a document is turned over, an admission is put in writing, a spreadsheet is created at the IRS examiner’s request, or a recorded interview is complete, you cannot take back the document, the admission, the spreadsheet, or the interview responses. Consider turning over during an examination only what is asked, required, and not privileged; your smoking gun today is the IRS’ smoking gun tomorrow. Generally, the IRS cannot require a taxpayer to prepare or create new documents, including tax returns or a spreadsheet summarizing the taxpayer’s records. If the IRS’ requests are unreasonable, consider whether you should require the IRS to issue a summons and enforce that summons in court before turning over privileged, irrelevant, and/or unduly burdensome documentation.
5. New LB&I Directive On IDRs–The Rules Have Changed
The IRS Large Business & International Division (“LB&I”) recently issued a Directive on the IDR enforcement process. The new enforcement process contains three phases for issuing and responding to IDRs. The new process includes: (i) mandatory discussion with the taxpayer (or representative) before issuance of an IDR to determine what information exists and is required; (ii) one IDR per issue rather than “fishing expedition” IDRs containing countless unrelated requests; (iii) customized IDRs for the taxpayer; (iv) the taxpayer (and not the IRS) must [be] provide[d] a reasonable time frame to respond; and (v) if the responses are not timely provided, the examiner must follow the “enforcement process” of a delinquency notice, a pre-summons letter, followed by a summons. Taxpayers should create procedures for dealing with the new Directive, including deciding who speaks to the IRS for the Taxpayer.
6. M&A Activity Leads To Audit Issues
For companies involved in M&A transactions, many issues arise during the transaction that can become the focus of a later IRS audit. A prime example is the treatment of transaction costs. Certain transaction costs incurred before a defined “decision date” are deductible by the taxpayer rather than capitalized. The decision date is the earlier of (i) the date on which a letter of intent, exclusivity agreement, or similar written communication (other than a confidentiality agreement) is executed by representatives of the acquirer and the target; or (ii) the date on which the material terms of the transaction (as tentatively agreed to by representatives of the acquirer and the target) are authorized or approved by the taxpayer’s board of directors (or committee of the board of directors).
Another hot focus area for IRS audit activity is the deductibility of M&A success fees, such as fees typically paid to investment bankers. The issue is what amount of those fees is attributable to services rendered before the decision date, since that portion would be deductible. The IRS recently provided a safe harbor pursuant to which the taxpayer could elect to treat up to 70% of success-based fees as attributable to before the decision date. For taxpayers who do not elect this safe harbor, the IRS will closely scrutinize the supporting documentation for the allocation of the fee.
7. Extension Of The Statute-of-Limitations
By law, the IRS generally has 3 years from the due date of the return or the actual filing date of the return (whichever is later) to audit and make a determination. IRC § 6501(a). Often, the IRS will request that the taxpayer sign a consent to extend the 3 year statute, giving the IRS more time to develop its case. Taxpayers (or their advisors) often feel compelled to extend the statute. Before signing a statute extension, ask these 3 critical questions:
- Are you agreed on every significant issue?
- Has the examiner discovered every troubling issue on your return?
- Has the examiner requested all the right documents and information for the issues he raises?
If you answer “no” to any of the 3 questions, ask what advantage you gain from extending the time that the IRS can assess tax.
8. Prepare For Heightened Transfer Pricing Scrutiny
The IRS issued a “transfer pricing roadmap” for IRS examiners in 2014 that focuses on how to develop transfer pricing cases more efficiently and effectively based on the “too good to be true” standard. Such a vague standard will drastically increase the number of transfer pricing disputes. Any taxpayer engaging in cross-border transactions with related parties should consider transfer pricing studies, and prepare to defend the studies. Further, taxpayers should create their own procedures for effectively dealing with transfer pricing issues raised by the IRS and other government agencies.
9. When Should A Taxpayer Go To The IRS Office Of Appeals?
The mission of the IRS Appeals Division is to resolve tax controversies, without litigation, on a basis that is fair to the taxpayer and the IRS. Unlike the Exam function, Appeals can and will settle issues based on a “hazards of litigation” standard. Outside of alternative dispute resolution, Appeals typically gets involved at one of two phases. Taxpayers may elect to go to Appeals following the issuance of the 30-day letter via Protest, but before the issuance of the 90-day letter (Statutory Notice of Deficiency) provided ample time remains on the statute for Appeals to consider the matter. In such a situation, Appeals can request the IRS examiner to prepare a rebuttal to the taxpayer’s arguments, allowing issues to be further developed by the IRS. To give the IRS examiner ample time to rebut the taxpayer’s arguments, the taxpayer can be asked to sign multiple statute extensions, dragging the matter on for years. Alternatively, Appeals may get involved following the filing of the Tax Court petition. In that case, the Appeals Officer has a limited amount of time to settle the case based on the Court’s timeline and the IRS has the burden of proof on any new issue raised after www.kilpatricktownsend.com the issuance of the Statutory Notice of Deficiency. By limiting the scope of the issues and the time, a taxpayer could reach a better result than if the taxpayer extended the statute and ultimately filed a Protest. In other words, how you chose to go to Appeals can impact the resolution of your case.
10. Dealing With The Difficult Examination
The more difficult the IRS examination, the more the taxpayer and its advisors must focus on strategy and protecting the taxpayer’s rights. For example:
- Does the taxpayer have to appear for an interview and if so, should the taxpayer demand it be recorded?
- What third parties possess relevant documents of the taxpayer and what do those documents say?
- What if the IRS requests attorney-client privileged or work product protected documents?
- When should the taxpayer (including member of the internal tax department) appear before the IRS during the examination, if ever?
Answers to these questions can dictate how deep of a hole the taxpayer may have to dig out of after the close of an unagreed examination.
11. Alternative Dispute Resolution: Other Options
Taxpayers and their advisors should consider all alternative dispute resolution (“ADR”) methods especially when litigation is not an alternative. Taxpayers and their advisors are generally unaware of IRS ADR methods to resolve cases during and after examination because ADR methods are generally handled by litigators just like in other forms of commercial litigation. The primary IRS ADR methods are: fast track, early referral, post appeals mediation, and arbitration. Fast track is similar to a mediation with an IRS Appeals Officer acting as a neutral mediator. Fast track can be extremely helpful for issues pending in an audit where the taxpayer needs “another set of eyes” to show the examiner how the issue should be resolved. Post-appeals mediation allows a taxpayer to engage a neutral IRS mediator and a neutral non-IRS mediator to hopefully help the taxpayer and Appeals resolve an issue more favorably than the initial settlement offered by Appeals.
12. Avoiding Civil Penalties
Generally, to avoid civil penalties, a taxpayer must demonstrate it reasonably relied upon its tax advisor for the positions taken. Do you have that defense to a penalty? Many taxpayers want to avoid the cost of an opinion, but a written opinion can usually
demonstrate reliance. Further, during every field or office examination, IRS auditors must determine, under new examination guidelines, if a tax return preparer penalty should apply. After the audit of the taxpayer is complete, when appropriate, IRS auditors are instructed to open a separate preparer penalty investigation and to contact the preparer.
13. What Is TEFRA?
Many taxpayers are unaware of the fact that partnerships and LLCs taxed as partnerships have their own audit and tax litigation procedures separate from corporations and individuals. The “unified” audit and litigation procedures involving partnerships and
LLCs taxed as partnerships are often referred to by the name of the legislation that enacted them—Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). These rules are very challenging because the IRS audits (and litigates against) the partnership or LLC, yet partners are ultimately liable for any additional tax and/ or penalty determined at the entity-level. Due to the complexity of these rules, the IRS can easily foot fault and misapply TEFRA to the taxpayer’s advantage. A firm understanding of TEFRA is required to recognize the foot fault that creates the procedural advantage.
14. Employment Taxes Are People Too—Just Ask The IRS
In the past two years, the IRS has dramatically increased its enforcement in the employment tax area—especially employer withholding requirements, backup withholding issues, and proper issuance of Form 1099s or W-2s. The IRS also remains focused on the employee versus independent contractor issue as well as the tax implications of the new Affordable Care Act. A company should navigate through the various programs the IRS has for resolving any employee/independent contractor issues to determine the best path for the situation.
15. Which Court?
If you are still not agreed with the IRS after exhausting your administrative remedies, a taxpayer has the option of filing an action in the U.S. Tax Court, U.S. District Court, or the Court of Federal Claims. Most will say the Tax Court’s biggest advantage is that it is a prepayment forum, whereas the District Court and Court of Federal Claims are not. However, a taxpayer should be aware of the differences in how discovery is conducted, who must testify in Court, whether depositions are permitted, how experts areused, who represents the IRS in each forum, and which Court provides the best alternative for settlement before trial. Any of these forum-specific issues could impact the final resolution of your case.
As you can see from the 15 tips, a taxpayer cannot have a “let’s see how it goes” approach to any IRS inquiry; too much is at stake. Instead, the taxpayer must match the IRS strategy with its own strategy, carefully considering each issue that arises during the inquiry with a view towards the impact of the decision on the ultimate favorable resolution of the case.