Newly proposed legislation and regulatory amendments both seek to restrict the participation of private law firms in US taxpayer audits, which would severely limit the Internal Revenue Service’s ability to “outsource” portions of tax audits under Treasury Regulation § 301.7602-1(b)(3).

Just short of four years after the US Treasury Department issued Temp. Treas. Reg. § 301.7602-1T—a regulation that some considered an impermissible attempt by the Internal Revenue Service (IRS) to outsource its audit function—members of the House Ways and Means Oversight Subcommittee and the US Treasury have released separate proposals to nullify or restrict, respectively, that effort. The House Ways and Means Oversight Subcommittee Chairperson Lynn Jenkins (R-Kansas) and ranking member John Lewis (D-Georgia) released a draft of proposed bipartisan legislation (The Taxpayer First Act) that, in part, invalidates final regulation Treas. Reg. § 301.7602-1(b)(3) on a going forward basis, and also invalidates any such outsourcing arrangements previously put in place either under the temporary regulation or the final regulation. Simultaneously, the US Treasury has issued a notice of proposed rulemaking (83 FR 13206 Mar. 28, 2018) to amend the regulations under § 7602(a), that while basically leaving the scope of Treas. Reg. § 301.7602-1(b)(3) unchanged, severely restricts applicability of the regulation to only third parties that have areas of specialties other than US federal tax law or civil litigation.

Present Law

Treas. Reg. § 301.7602-1(b)(3) first gained the attention of the tax press, the courts, and certain congressional members when it was issued as a temporary regulation. On June 9, 2014, the IRS issued without fanfare, and without notice and comment, Temp. Treas. Reg. § 301.7602-1T (Treasury Decision 9669, 79 FR 34626, June 18, 2014) as a “clarification,” which, in relevant part, read:

(b)(3) Participation of a person described in section 6103(n). For the purposes of this paragraph (b), a person authorized to receive returns or return information under section 6103(n) and § 301.6103(n)-1(a) of the regulations may receive and exam books, papers, records, or other data produced in compliance with the summons and, in the presence and under the guidance of an IRS officer or employee, participate fully in the interview of the witnesses summoned by the IRS to provide testimony under oath. Fully participating in an interview includes, but is not limited to, receipt, review, and use of summoned books, papers, records, or other data; being present during summons interviews; questioning the person providing testimony under oath; and asking a summoned person’s representative to clarify an objection or assertion of privilege.

The effective date of the temporary regulation was almost immediate, as it applied to all “summons interviews conducted on or after June 18, 2014.”

What some found to be the most egregious aspect of Temp. Treas. Reg. § 301.7602-1T was the timing of its issuance—about one month after the IRS had awarded a $2,185,000 contract to a private law firm to assist with a US taxpayer’s ongoing tax audit. Those skeptical of the IRS’s intentions inferred that Temp. Treas. Reg. § 301.7602-1T was simply the IRS attempting to retroactively “bless” a prior bad act. Adding to that skepticism was the fact that the private firm was not generally known to have a tax law practice.

On July 14, 2016, the IRS finalized Temp. Treas. Reg. § 301.7602-1T as Treas. Reg. § 301.7602-1(b)(3) (Treasury Decision 9778, 81 FR 45409, July 14, 2016), and the final regulation applied to summons interviews conducted on or after July 14, 2016. The only change between the temporary regulation and its final form was modifying the phrase “may receive and examine books” to “may receive and review” in describing what contractors may do with books, papers, records, and other data received by the IRS pursuant to a summons.

Mounting Criticism

Though the IRS had implemented the proposed regulation without notice and comment, it did not escape the attention of certain members of Congress. On April 22, 2015, Rep. Peter Roskam (R-Illinois), then-chairperson of the Ways and Means Oversight Subcommittee, highlighted the IRS’s engagement of an “expensive, white-shoe law firm to conduct litigation activities, with some lawyers on the account billing the US government over $1,000 an hour” in his opening statement at the subcommittee’s hearing on the 2015 tax return filing season and general operations at the IRS. Mr. Roskam pointed out that this engagement was a substantial allocation of limited IRS budget that diverted funds that could have been allocated to help the IRS’s worsening taxpayer assistance programs.

On May 13, 2015, Senator Orrin Hatch (R-Utah), as chairperson of the Senate Finance Committee, sent a letter to then-IRS Commissioner John Koskinen requesting an explanation of and justification for the IRS’s decision to hire a private law firm to conduct a tax examination of a US taxpayer, and requested an immediate halt to such use of private contractors. In that letter, Mr. Hatch described Temp. Treas. Reg. § 301.7602-1T as “an unprecedented expansion of the role of outside contractors in the examination process, and one that violates” several provisions in the Internal Revenue Code (IRC). Mr. Hatch went on to state that the IRS’s actions in hiring the private law firm for the purpose of audit assistance, including taking testimony (1) appears to violate federal law and the express will of Congress; (2) removes taxpayer protections by allowing a private contractor to perform inherently government functions; and (3) calls into question the IRS’s appropriate use of its limited resources.

On July 12, 2016, the Senate Finance Committee proposed legislation titled the Taxpayer Protection Act of 2016 that limited the participation of third party contractors during sworn testimony taken pursuant to a summons from the IRS. In its proposed legislation, the Senate Finance Committee highlighted that these third parties are not subject to the “criminal and civil conflict of interest statutes, [and] the Standards of Ethical Conduct for Employees of the Executive Branch.” Therefore, to ensure taxpayers’ information is not misused or unlawfully disclosed, the Taxpayer Protection Act of 2016 proposed to bar the IRS “from delegating to third-party contractors the authority under section 7602 to examine books and records, summons persons, or take sworn testimony related to a tax matter.” The proposed legislation’s effective date was as of the date of enactment for any contracts in effect on or after that date.

A Push “from Above”

On April 21, 2017, the Trump administration issued an executive order (Executive Order 13789) that requested the US Treasury review “all significant tax regulations” issued on or after January 1, 2016, and identify all such regulations that (i) impose an undue financial hardship on taxpayers; (ii) add undue complexity to US federal tax laws; or (iii) exceed the statutory authority of the IRS. In Notice 2017-38, 2017-30 I.R.B. 147 (July 24, 2017), the IRS listed the eight regulations the US Treasury identified as meeting at least one of the three criteria specified in Executive Order 13789. One of those eight regulations was Treas. Reg. § 301.7602-1(b)(3).

In Notice 2017-38, the IRS invited comments. In response, the IRS and US Treasury received seven comments from business and professional associations addressing the final regulations under § 7602(a), and all but one recommended complete removal of Treas. Reg. § 301.7602-1(b)(3). The one comment that did not recommend complete removal did recommend the provision permitting a contractor to directly question a witness during a summons interview be removed.

Proposed Legislation

The Taxpayer First Act (Act) contains Section 309, which amends IRC Section 7602 by adding a new subsection (f) that reads:

Limitation on Access of Persons Other Than Internal Revenue Service Officers and Employees. – The Secretary shall not, under the authority of section 6103(n), provide any books, papers, records, or other data obtained pursuant to this section to any person authorized under section 6103(n), except when such person requires such information for the sole purpose of providing expert evaluation and assistance to the Internal Revenue Service. No person other than an officer or employee of the Internal Revenue Service of the Office of Chief Counsel may question a witness under oath whose testimony was obtained pursuant to this section.

The accompanying explanation to Section 309 of the Act explains that § 7602(f):

Prohibits a person, other than an officer or employee of the IRS, from examining books, records, and witness testimony as part of an examination other than for the sole purpose of serving as an expert. This provision also ensures that only IRS employees or the Office of Chief Counsel are able to question a witness under oath.

Effectively, the Act invalidates Treas. Reg. § 301.7602-1(b)(3), but it does not stop there. The proposed § 7602(f) goes on to state:

The amendment made by this section shall apply to any contract in effect under section 6103(n) of the Internal Revenue Code of 1986, pursuant to temporary Treasury Regulation section 301.7602-1T proposed in Internal Revenue Bulletin 2014-28, Treasury Regulation section 301.7602-1(b)(3), or any similar or successor regulation, that is in effect on the date of the enactment of this Act.

It appears that its retroactive applicability seeks to remedy what many consider the “past harm” done by Treas. Reg. § 301.7602-1(b)(3) and its predecessor Temp. Treas. Reg. § 301.7602-1T by voiding any outsourcing arrangements that are currently in force.

Notice of Proposed Rulemaking

The US Treasury has issued a notice of proposed rulemaking to amend the regulations under § 7602(a) regarding the participation of third party contractors in the examination of books and witnesses. The proposed change to Treas. Reg. § 301.7602-1(b)(3) splits the old paragraph into two parts, new subparagraph -1(b)(3)(i) that remains nearly identical to the original language of -1(b)(3), and new subparagraph -1(b)(3)(ii) that adds the new restrictive language. The minor changes to the language of -1(b)(3)(i) is the addition of the opening phrase “Except as provided in paragraph (b)(3)(ii) of this section,” to the first sentence, and the modification to what it means to “participate fully in the interview of a witness summoned by the IRS to provide testimony under oath” so that such no longer includes as an enumerated action “asking a summoned person’s representative to clarify an objection or assertion of privilege.”

The language of -1(b)(3)(ii) is the restrictive language that limits what type of third party may “participate” under -1(b)(3)(i). That proposed language reads:

Exception for certain non-governmental attorneys. An attorney who is not an officer or employee of the United States may not be hired by the IRS to perform the activities described in paragraph (b)(3)(i) of this section unless the attorney is hired by the IRS as a specialist in foreign, state, or local law, including tax law, or in non-tax substantive law that is relevant to an issue in the examination, such as patent law, property law, or environmental law, or is hired for knowledge, skills, or abilities other than providing legal services as an attorney.

Thus, if a third party attorney is retained to assist with a tax audit of a US taxpayer, under Prop. Treas. Reg. § 301.7602-1(b)(3), it should be for the specialty of non-US federal tax expertise, or other non-legal expertise she or he brings to the table. Proposed Treas. Reg. § 301.7602-1(b)(3)(ii) would not permit the IRS to hire an attorney with a specialized knowledge, such as civil litigation skills. These changes are proposed to be effective for examinations begun or administrative summonses served by the IRS on or after March 27, 2018.

Comments on the proposed regulation must be received by April 27, 2018.