The IRS Challenge
Touching its customers
As agencies go, the Internal Revenue Service (IRS) is modest in size, representing less than 1% of both federal employees and the 2008 budget expenditures. Yet it collects most of the money that drives the government's important programmes. To carry out this $2.6 trillion annual undertaking, the IRS must touch most of the 215 million adult US citizens and residents, as well as hundreds of thousands of for-profit businesses, charities and other non-profit entities. Success in achieving its ultimate goal - a high level of taxpayer compliance - is directly linked to the quality of its touch.
Successful organizations provide measurable value to their customers. Commercial enterprises do that by making their customers happy so they will return - regularly and often. A 'happy taxpayer' is an oxymoron, so the IRS mission is different: provide taxpayers with quality service by helping them to understand their tax responsibilities, accurately report them and, when there is disagreement, resolve it in a quick and collaborative, rather than prolonged and confrontational, fashion.
By law, IRS customers come back once a year to do business and, when they do, the taxman aims not to minimize or maximize that business, but to have them pay their fair share and feel okay about doing so.
Complexity v simplicity
Because the success of the IRS mission is tied to its customers' understanding of their tax responsibilities, the growing complexity of the country's tax laws is a huge challenge for the institution.
To understand the true impact that decades of legislative complexity has had on tax administration, look at what has happened to the universally recognized symbol and centrepiece of federal taxation - the Form 1040. The basic form now has a growing family, with 24 siblings (excluding the Spanish versions). Its instructions fill 161 pages and readers are told when they arrive at page 89 that, on average, they can expect to spend close to 32.7 hours on gathering the information and completing the form and the basic schedules, and must then pay out-of-pocket costs of $264. Complex returns will bring out the extended 1040 family and add hours, if not days, to the process.
The Bush administration did not deliver on its 2005 promise to simplify the code and tax simplification is not one of the targeted goals of the Obama administration. So tax code complexity will continue and the IRS must accept that. It must also accept that complexity breeds uncertainty, confusion and discontent - which often leads to disagreement.
Dispute Resolution at the IRS
Disputes with the IRS are inevitably prolonged and often contentious. They are prolonged because of tax law complexity, a shortage of IRS resources, uncooperative taxpayers or usually some combination of those factors. They are contentious because they are prolonged, and for other reasons; but they need not be.
The IRS audit selection process is beyond the scope of this update, but it is the bedrock of federal income tax compliance. Sound tax policy requires only that a small representative number of taxpayers be placed under the taxman's microscope. But when the taxpayer pool is enormous, as it is in the United States, every year millions of individuals, businesses and non-profits will be chosen to have their tax affairs looked at. For some, like the Fortune 100 companies, that process is never-ending; large corporate taxpayers are known to spend 60 months plodding through one audit cycle only to start a new one without let-up.
Although largely designed to gather facts, the audit process can become confrontational. Taxpayers are programmed to give less and the government is programmed to ask for more. Also, the IRS has a longstanding rule that does not allow its examiners to exercise judgement or discretion to resolve issues that are not black and white. So inevitably, when the examination process concludes, there are many unresolved cases that must move to the next level for possible resolution, typically the IRS Office of Appeals.
The Office of Appeals has been an IRS institution in one form or another since 1927. The office works tirelessly to convince its taxpayer-stakeholders and their representatives that it is independent from the rest of the organization and can fulfil its mission to "settle tax disputes on a fair and impartial basis without litigation". Perceptions aside, the office has in fact done a pretty good job over the years living up to the independence mantra and fulfilling its mission. The office boasts that it annually resolves about 80% of the cases that come its way. But beneath this number is a foundation that many contend is badly in need of serious renovation.
During the 2008 fiscal year, 116,000 new cases were brought to the Office of Appeals and it disposed of 107,000 old cases. At the end of the year, its backlog of inventory had grown to 60,000 cases. The number of new cases filed has doubled in recent years. With difficult financial times ahead, those numbers can only increase. Taxpayers will choose to contest more proposed assessments or, with existing contested matters, will dig in and look for ways to buy time before paying their tax bills.
There are about 1,800 total staff members in the Office of Appeals (2% of the IRS) and only about half of them actually hear and resolve taxpayer cases. That means each Office of Appeals person has, on average, an inventory of about 70 cases. Moreover, despite the rise in caseload, the headcount has remained flat for a number of years because Congress has not seen fit to provide increased funding to the IRS for its enforcement activities.
The Office of Appeals' arteries are clogged with everything from complex multi-issue cases of global corporations and charity tax exemption disputes to a plethora of individual taxpayer cases involving collection due process, offers in compromise and innocent spouse relief. The simple cases take many months to resolve and the more complex ones take years. For fiscal year 2008, the largest cases (known as coordinated industry cases) took, on average, 654 days to get through the system. Some cases are not resolved and then move to the next dispute resolution stage - litigation in either the Tax Court or the federal court system.
Litigating a tax case in any court is costly, time consuming, unpredictable and very public. While this applies to both sides of the litigation, for most taxpayers it is a last-resort remedial option. And for publicly traded companies with disclosure responsibilities under the Sarbanes-Oxley Act of 2002 and Financial Accounting Standards Board Interpretation 48, litigation often is not viewed as a plausible alternative. For many corporate taxpayers, a five-year audit, three years at the Office of Appeals, and then another five years in court and two more on appeal usually proves to be just a bit too much.
The IRS has 1,500 tax litigators and the Justice Department has 300. That cadre of talent is important in challenging overreaching and unyielding taxpayers and helping the courts to articulate sound policy when the tax rules are ambiguous. But those are a small segment of the disputes that percolate through the system. Most disputes can and should be resolved administratively - something that can and should be accomplished in a much more efficient, cost-effective and collaborative environment. Achieving that is the focus of this update.
The gridlock in the tax dispute resolution process has profound implications. The record budget deficit of $438 billion for 2008 is set to soar to well beyond $1 trillion for 2009 and beyond, as a result of the bail-out and stimulus packages. The IRS is a key player because it is the guardian of the revenue side of the budget. Although the IRS collects most of its tax revenues when returns are filed, each year an additional $50 billion comes in through the collection and enforcement process. There is also the amount that escapes the grasp of the IRS, known as the tax gap - the annual amount of taxes that are owed by all taxpayers but are not paid, either intentionally or inadvertently. That amount is estimated by the IRS to be more than $300 billion each year.
The US tax system has developed a significant 'compliance deficit 'as a result of two factors: a tax code that reads like computer code and an inefficient dispute resolution system that breeds discontent and confrontation. Congress is in charge of the first and contributes significantly to the second by consistently scaling back the administration's budget requests for enforcement resources.(1) It is in that context that this update proposes architectural plans for an extreme makeover.
IRS Dispute Resolution: Post-Makeover
Alternative dispute resolution
For more than 30 years, alternative dispute resolution (ADR) has been the tool of choice for resolving commercial disputes. It usually takes the form of either non-binding mediation or binding arbitration. It is flexible and allows the parties to craft a process and a solution that are tailored to their needs. ADR has proved beyond question to be superior to actual adjudication and conventional two-party negotiation. It is consistently quicker, quieter and more cost effective.
Closer to home, there is extensive experience with ADR (mostly mediation) at other federal agencies, including a large number of monetary claims against the government. A 2007 report to the president from the Federal Interagency Alternative Dispute Resolution Working Group proclaims:
"'Alternative dispute resolution has become well accepted in federal agencies as an effective and efficient method for resolving disputes and has been readily adopted as part of the sound business model.' About one of every three disputes involving the federal government is resolved through an ADR process."
The report highlights the recognizable benefits of using ADR, including managing costs by:
- controlling the costs of conflict such as litigation costs and productive labour that is otherwise dedicated to conflict;
- providing flexibility that produces quicker and more durable results as the parties craft a resolution addressing their interests; and
- preserving resources and redirecting them to support the mission of the agency.
The report also identifies the benefit of strategically managing government resources, both monetary and human, by:
- maximizing resources through focused selection of cases for ADR versus other resolution techniques;
- promoting innovation by giving the parties greater control of the process and the terms of its resolution; and
- fostering continuous improvement and expansion in the ADR programmes based on experiences.
The report concludes that the use of ADR promotes innovation by giving the parties a chance to craft a resolution that captures their needs and interests in a way that may not be possible through other processes. For reasons outlined below, this is a fundamental point not only in the actual resolution of disputes, but also in how it affects taxpayer behaviour and compliance in later years.
Finally, the report points out that even in ADR cases that do not result in a resolution, government representatives consistently report other distinct advantages from the ADR process:
- laying the groundwork for a subsequent settlement;
- increasing clarification of the issues for trial;
- promoting a fair and responsive government; and
- inspiring public confidence and trust in the government through a transparent process.
ADR at the IRS
Congress has been actively promoting ADR within the federal agencies. Starting with the 1990 Administrative Dispute Resolution Act, Congress encouraged federal agencies to use ADR techniques to resolve their disputes. Six years later, it took a more aggressive step by directing that each agency adopt a policy that addresses the use of alternative means of dispute resolution and case management. Then came the Internal Revenue Service Restructuring and Reform Act of 1998, in which Congress mandated the IRS to broaden its pilot mediation programme and develop a pilot binding arbitration programme.
The IRS has responded over the years with two mainstream ADR programmes that are available to all taxpayers, one for non-binding mediation and one for binding arbitration. Four other specialized and limited-use ''fast-track'' ADR programmes have also been adopted. All the programmes are consensual and require the agreement of both the taxpayer and the IRS. Data for the last three fiscal years indicates that these ADR programmes have not caught on.
|ADR Programmes - Closed Cases||
|Four fast-track programmes||129||162||149|
|Total closed ADR cases||165||185||165|
|Total closed appeals cases||102,559||104,429||106,722|
ADR is used in about one of every 500 Office of Appeals cases. Inevitably, not all 100,000-plus cases closed by the Office of Appeals each year are appropriate for ADR because of the nature of the issues (eg, collection cases). Yet there are still thousands of cases that would be appropriate for an ADR programme: those involving valuation or complex factual issues are particularly suitable where a ''Solomon's justice'' result is likely and appropriate. There are many reasons why ADR has not caught on, but one appears to be central. The IRS programmes do not embrace essential ADR principles, those key elements that have worked so well over many years and have led to the unmatched success of mediation and arbitration in a commercial context. There are three main shortcomings.
The two main arbitration and mediation programmes that are available to all taxpayers do not start until the process in the Office of Appeals has concluded and the parties have agreed to disagree. If there is still interest, the parties must negotiate and conclude an agreement either to arbitrate or to mediate. Thus, even at the conclusion of unsuccessful Office of Appeals deliberations, there are no guarantees that the IRS will undertake an ADR process.There are inordinate delays, first to conclude the examination process and then for Office of Appeals deliberations. More often than not, after years of confrontation without a resolution, many taxpayers simply are not interested in starting a new ADR process. They will either throw in the towel or, as a last resort, bring their case to court. Yet it is proved over and over in a commercial and government agency ADR context that the earlier the process occurs, the more likely there will be a successful resolution.(2) The ADR working group report stresses that ''the key to reducing conflict is early intervention and anticipatory dispute resolution which prevent the escalation of disagreement".
Mediation at the IRS is not mandatory. Yet in most federal district courts around the country where mediation has been so successful, the parties are required to undergo mediation before the case can proceed to trial and often before extensive discovery can begin. That process started many years ago in response to the serious case backlog in many district courts and in recognition of the significant time and cost savings of ADR.
Given the dynamics at the IRS of hiring freezes and personnel reductions, coupled with the explosion of new cases arriving at the Office of Appeals' doorstep, a strong case for early mandatory mediation can be made. And it is always instructive to recall that mediation is a non-binding process; if it does not work, the taxpayer and the IRS can always fall back to the comfort zone of the old system.
The IRS mediation programmes require that the mediator be an IRS Office of Appeals employee. The time-honoured practice in a conventional commercial ADR context (and in many government agencies) is that the mediator must be completely neutral, with no direct or indirect links to either party. None of the IRS mediation procedures allows the parties to select an independent, neutral third party to mediate the dispute.
The Office of Appeals proclaims itself to be independent and it has a reasonable track record. However, taxpayers familiar with the process know all too well that Office Appeals ''neutrals'' draw their pay cheque from the Treasury. In the ADR commercial world of successful dispute resolution, perceptions of impartiality speak volumes and independence is an essential behavioural characteristic when the neutral is held to the highest standards.
Recommended dispute resolution changes
The unqualified success of ADR in the commercial and government agency context provides a solid conceptual framework to recommend changes to overcome the shortcomings of the current IRS dispute resolution structure. Here are the four key elements that the IRS should embrace as it looks to revamp its dispute resolution structure:
- Designate ADR as a core strategic dispute resolution tool;
- Accelerate ADR to an early stage in the resolution process;
- Bring genuine independence to the selection of ADR neutrals; and
- Make mediation a mandatory feature at an early stage.
Administrative settlement negotiations between taxpayers and the IRS are conducted in the traditional, timeless two-party adversarial format. The art and science of contemporary conflict resolution and negotiation demonstrate time and again the wisdom of early intervention by a trained and experienced neutral chosen by the protagonists to bring discipline and early closure to the process. The IRS's ADR programmes need to be contemporized.
What to expect
Many studies have been conducted over the years in the commercial world of dispute resolution, testing the efficacy of non-binding mediation in civil money disputes. Those studies tend to focus on the quantitative results coming out of the ADR process, such as improved resolution rates, cost and time savings to the parties and the like. Those studies provide convincing empirical data to support the conclusion that ADR, when undertaken early in the process, is far superior to conventional dispute resolution techniques, either two-party negotiations or litigation.
Those results should serve as a good framework to evaluate similar benefits that would follow if the IRS embraced the recommended programme changes. Also, a revamped programme could be expected to accelerate the inflow of tax revenues to the Treasury. And importantly, it could be accomplished in today's environment of shrinking budgets, hiring freezes and personnel reductions.
The compliance deficit: a finishing touch
As mentioned earlier, tax code complexity and the protracted dispute resolution system are causing a compliance deficit, which can breed taxpayer discontent and confrontation. For those unfortunate taxpayers that have been caught in a prolonged or contentious dispute, the aftertaste can be bitter and lasting. Lurking below all that is a significant potential long-term benefit from introducing the suggested changes, but those benefits are grounded on a much softer data analysis.
Some ADR studies focus on the parties' satisfaction levels from the process and its impact on compliance rates. Here, compliance can have a double meaning. One is the short-term compliance level with the agreed-to result from a particular mediation. The available evidence supports the conclusion that ongoing compliance levels for implementing the result (usually full payment) are much higher when the parties reach a resolution with the intervention of a mediator than when the settlement is conventionally negotiated directly by the parties or mandated by a court.
The second compliance model looks to evaluate the impact of mediation on the longer-term ongoing relationships and perceptions of the parties towards each other. Those results show that favourably resolved mediations can have a measurably positive effect on the future by protagonists' perceptions. The dynamic at work in successful mediations is that the neutral can often facilitate the parties themselves playing a significant role in formulating not only an actual resolution of the dispute, but one that better accords with their needs and interests. In many cases that approach has proved to reduce the level of contentiousness and confrontation in the parties' relationship, and to change that relationship to one based more on collaboration and trust.
Finally, in the analysis of both compliance models, the fairness of the mediation process is itself often cited as instrumental in positively affecting the parties' future behaviour. The data suggest that even unsuccessful mediation can positively affect protagonists' behaviour when compared with compliance patterns in similar situations when no mediation process was undertaken.
This update has examined the conceptual framework for change and the broad outlines for that change - an overhaul that will bring the IRS's dispute resolution system into alignment with well-established and proven ADR principles. ADR has earned its stripes as the optimum dispute resolution tool in the commercial world and at government agencies. The time has come for the IRS to revamp its programmes and practices in recognition of this.
For further information on this topic please contact John C Klotsche at Caplin & Drysdale by telephone (+1 202 862 5000) or by fax (+1 202 429 3301) or by email (firstname.lastname@example.org).
(1) Each additional $1 spent on IRS enforcement activities will bring roughly $5 to the Treasury, a handsome return on investment by most benchmarks. In appropriating IRS resources, Congress must carefully balance those tangible benefits against the social and other costs of a more invasive federal agency. During this decade, Congress has consistently erred on the side of restraint on new resources for the IRS.
(2) In a limited context, it has also proved to be true at the IRS. A 2003 fast-track mediation programme for large companies allows an Office of Appeals officer to 'parachute' into the examination process and mediate a resolution of some disputed issues between the taxpayer and the auditors. More than 80% of cases are resolved and the appeals cycle time (from start to finish) has been reduced from years to less than 100 days.
An earlier version of this update first appeared in Tax Notes on March 9 2009.
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