Tax executives are familiar with the scenario: Internal Revenue Service examiners are in the building and are beginning to issue information document requests (IDRs) on routine and sensitive issues. One typical taxpayer response is to go on the defensive. This approach includes not voluntarily identifying issues and transactions; responding to IDRs as narrowly as possible; not offering to make factual or legal presentations to Exam; and not responding to notices of proposed adjustment (NOPAs) or responding as narrowly as possible. In other words, the typical taxpayer approach is to conserve resources used at Exam because “Appeals will offer a better deal.”
A Better Approach?
Depending on the circumstances, a better approach might be a more proactive model. This approach involves disclosing certain issues at the beginning of the audit; making factual and legal presentations on those issues; responding to IDRs more fully; and offering interviews with business people (if appropriate). Some advantages of a proactive strategy can include establishing a better rapport with the Exam team; narrowing the number and scope of IDRs; shaping Exam’s view of issues through presentations that explain the issues effectively; and speeding up the audit and resolving more issues.
The proactive model has some compelling analogues. Consider first the Pre-Filing Agreement (PFA) program. The IRS refers to the PFA process as “cooperative issue resolution.” The IRS states that in the PFA process “the taxpayer and the IRS will agree on a proposed timeframe, identification of relevant records, access to records or testimony, and the scope and depth of examination.” The IRS envisions a “one-team concept” that provides for an efficient and timely review of readily available records, reduces post-filing examination cycle time, and reduces costs to and the burden on all parties. Consider also the Compliance Assurance Process (CAP). Under CAP, “the IRS and the taxpayer work together to achieve tax compliance by resolving issues.” Thus, CAP “is based on the transparent and cooperative interaction between the taxpayer and the IRS.” The goal of CAP is to resolve “tax issues through open, cooperative and transparent interactions between the IRS and taxpayers.”
The IRS Approach
In 2016, the IRS’ Large Business & International (LB&I) Division issued IRS Publication 5125 and announced a desire to bring some version of the proactive model into the examination process. For the Exam team, compliance with the publication is largely mandatory. The publication’s introduction, however, acknowledges that it is not universally mandated, stating that “portions of this publication may be more applicable to some cases than others.” Yet, in most cases, Exam is required to act in accordance with the publication. Specifically, Exam is to “work transparently in a collaborative manner with the taxpayer.” Also, Exam is directed to “ensure that each party’s position is fully understood.” Furthermore, Publication 5125 requires that, after examining each issue, Exam must provide the taxpayer with an IDR that sets forth Exam’s understanding of “all relevant facts.”
Publication 5125 requires that in all cases Exam must comply with the IDR procedures that LB&I published in its 2014 Directive on Information Document Requests Enforcement Process (DIDREP). That directive sets forth procedures that seek taxpayer input into the IDR issuance process, as well as procedures to enforce compliance with IDRs if the taxpayer fails to respond or provides an incomplete response.
In contrast, for taxpayers, the paradigm provided in Publication 5125 is aspirational rather than mandatory. It encourages use of the proactive model but does not compel taxpayers to follow it. Although Publication 5125 states that the “examination process can be efficient if the examination team and the taxpayer work together,” the taxpayer’s cooperation is not required.
The Planning Phase
Publication 5125 divides the examination process into three stages: planning, execution, and resolution. In the “planning phase,” taxpayers are encouraged to work with Exam to “establish effective steps to complete the examination in a timely manner.” Taxpayers are urged to participate in a “mutual exchange of information” and to “share their input on how each issue can be effectively examined.” Exam will create “issue teams” to work on identified issues, and taxpayers are encouraged to work with each issue team “in a transparent manner to develop the examination procedures tailored to the issues selected” for examination.
The Execution Phase
In the “execution phase,” the parties are encouraged to develop and document all relevant facts and present their legal positions. Exam and taxpayers are urged to “conduct interactive discussions” and to “actively discuss their factual differences, legal disputes and other areas of disagreement.” To develop facts, Exam will use the IDR process. In this regard, Publication 5125 echoes LB&I’s 2014 DIDREP, which states that Exam and taxpayers should engage in “robust discussions that include the issue that is the subject matter of an IDR” and “what information is necessary to evaluate that issue and why.” In sum, this 2014 directive anticipates that Exam and “taxpayers engage in robust, good faith communication in advance of an IDR being issued.” Furthermore, Publication 5125 requires that, for each unagreed issue, Exam will issue an IDR that states Exam’s understanding of the relevant facts. Exam is “expected to seek the taxpayer’s acknowledgment on the facts, resolve any factual differences and/or document factual disputes.”
The Resolution Phase
In the “resolution phase,” Exam will seek to reach agreement on all issues but will issue a NOPA with respect to each unagreed issue. Publication 5125 “encourages the use of all appropriate issue resolution strategies” and “requires that the issue team consider Fast Track Settlement for all unagreed issues.” It also states that “the taxpayer has the primary responsibility to ensure that all facts and legal arguments are provided during the examination process” so that the issue team can adequately consider them.
Should Taxpayers Adopt a Proactive Approach?
The Planning Phase
In considering whether to embrace the proactive approach that Publication 5125 envisions, what should taxpayers bear in mind with respect to each issue? Starting with the basics, in the planning phase, some issues are likely candidates to discuss with Exam because they already have been disclosed to the IRS. Mandatory disclosures should have been made as prescribed by Form 8886, Schedule M-3, and Schedule UTP and in compliance with Internal Revenue Code Sections 6038, 6038A, 6038B, and 6038C, to name a few. Likewise, Treasury Regulations Section 1.6011-4 (on reportable transaction disclosures) must be made, as well as disclosures for the purposes of IRC Sections 6662, 6662A, 6664, and 6707A.
Moreover, other issues are likely to be raised by Exam and are candidates to discuss with Exam. LB&I has rolled out “issue campaigns” that focus on issues that present a significant risk of noncompliance. LB&I seeks to identify these issues in examinations and will focus IRS resources on them to achieve compliance objectives. As of July 2019, there were fifty-nine of these campaigns. Exam also issues Audit Techniques Guides (ATGs) that explain industry-specific examination techniques. Finally, LB&I issues directives, which, while “not legal guidance,” are intended to “ensure consistent tax administration.” These pronouncements inform taxpayers about the issues Exam is likely to audit. If Exam is likely to raise these issues, it may make sense to get out in front of them.
Apart from those issues, what are the potential advantages of disclosing and explaining issues in the planning phase? First, a cooperative attitude engenders trust with the Exam team. Personal relationships are important. In addition, cooperation in identifying issues may minimize the issuance of IDRs on issues that are not audit worthy. Although accepting the invitation to share “input on how an issue can be effectively examined” could be viewed as helping Exam to do its job to the taxpayer’s detriment, doing so could prevent extraneous and overbroad IDRs that waste time and resources. In addition, cooperation during this phase may generate goodwill that minimizes the risk of penalty assertions. A further benefit is that cooperation may enhance the odds of getting an early entrance to and achieving success in Fast Track Settlement.
The Execution Phase
In the execution phase, there are four considerations regarding the proactive approach. First, as mentioned previously, Publication 5125 states that the issue team and the taxpayer should actively discuss their factual differences, legal disputes, and other areas of disagreement. Often, taxpayers are reluctant to detail their facts and arguments to Exam, preferring to wait until Appeals. It must be borne in mind, however, that if a taxpayer presents facts to Appeals that it did not present to Exam, Appeals will return the case to Exam to examine those facts. If the taxpayer raises a new legal theory at Appeals, Appeals will retain jurisdiction but likely will seek review and comment on the issue by Exam.
Second, LB&I’s 2014 DIDREP provides that Exam should provide draft IDRs to the taxpayer and “discuss [the] contents with the taxpayer.” Often, this will prove useful, because a taxpayer might contend that an IDR is misguided or overbroad. Alternatively, it would be appropriate not to comment if the scope of the IDR is satisfactory.
The third consideration in the execution phase is whether to provide narrow or broad responses to IDRs. Often, an appropriate response is to answer questions as simply as possible, even if the IDR is misdirected. There may be instances, however, where expansive responses can shape the issue and advance the taxpayer’s position. Keep in mind that if the taxpayer responds narrowly and Exam determines that the IDR response is incomplete, the 2014 DIDREP provides for an IDR enforcement process that may lead to a delinquency letter, a pre-summons letter, and, if necessary, a summons.
Fourth and finally, as mentioned above, Exam will provide to the taxpayer IDRs that set forth Exam’s view of the relevant facts for each unagreed issue. Publication 5125 states that issue team members are expected to seek the taxpayer’s acknowledgment of the facts in these IDRs. If relevant facts are absent in an IDR, one has an incentive to point out those facts if one intends to go to Appeals. Responding in detail to the IDR, however, often presents a challenge, especially if Exam has not explained its legal position. Without knowledge of Exam’s legal position, it is difficult or impossible to know what facts are relevant and whether additional facts should be included. Moreover, commenting on the fact statement may imply agreement that, apart from the comments made, the fact statement is complete and accurate. For this reason, it is best practice to preface any comments with a caveat that the comments are provided without knowledge of Exam’s legal position and that the comments do not indicate the taxpayer’s overall approval of the fact statement.
Questions and Cautionary Notes
Admittedly, use of a proactive model in many cases may not be productive. It is possible that disclosure may induce Exam to focus on an issue it might otherwise not have identified. Also, disclosure may be interpreted as evidence of a “guilty conscience” that will lead Exam to distrust the taxpayer’s overall compliance or the taxpayer’s confidence in its position. Finally, if the taxpayer discloses some “mid-level” issues, but not other “high-level” issues, Exam may view that discrepancy as disingenuous and a sign of untrustworthiness.
If you are considering the proactive approach, you should take into account some important touchstones. First, have you adequately developed the facts and legal arguments? Do not start down the disclosure path until you are relatively sure where the path is heading. Indeed, erroneous or incomplete disclosures typically are worse than no disclosures at all. Erroneous or incomplete disclosures can antagonize Exam and negatively affect the entire exam. In addition, if you use statements from business people, be sure to check all documents, records, emails, and other electronically stored information (ESI) to ensure there is nothing inconsistent, incomplete, or incorrect. Any discrepancies can severely undermine credibility, including the credibility of a potential witness at Exam, at Appeals, or in any future litigation. In sum, take the time and effort to be sure of your position and arguments.
As a rule of thumb, what issues might arise with disclosure and a proactive approach? Consider mandatory disclosure items such as Schedule UTP and M-3 issues, issues previously raised on audit, industry issues, recurring issues, issues addressed by LB&I compliance programs, issues coordinated at Appeals, significant transactions, and items disclosed on financial statements, for starters. Obviously, also look at issues that Exam can settle under Delegation Order 2-24 (issues previously settled at Appeals) or 4-25 (issues subject to Appeals settlement guidelines).
How to Disclose
Which leads to the question, how do you make a disclosure most effectively? First, the disclosure should be made early in the examination. Later disclosures seem less voluntary. Also, prepare an effective disclosure that discusses the facts and legal issues. Similarly, when an issue has been raised in an IDR, consider whether to provide information beyond the scope of the IDR.
There are other considerations as well. When making a disclosure, or even before making one, it likely will be appropriate to institute a “litigation hold.” A litigation hold is issued to all persons involved in the disclosed transaction, asking them to retain and secure all paper and electronic documents related to the transaction. A taxpayer typically institutes a litigation hold and then asserts work product protection over material prepared in “anticipation of litigation.” If a taxpayer discloses a transaction and does not institute a litigation hold, it may be difficult to contend later that the taxpayer anticipated litigation. Failing to institute a litigation hold can lead to serious consequences if documents are destroyed or become unavailable after the date the hold should have been implemented.
Before making a disclosure, be sure that the issue has been fully developed both factually and legally. Such preparation should begin when the transaction is closed by obtaining and saving relevant documents and ESI. Those documents should be organized coherently and saved securely. Before memories fade, talk to the relevant business people and be sure their recollections comport with the documents. This is the same preparation you would perform if you were in litigation and preparing to respond to document requests or anticipating depositions.
With respect to legal discussions, be careful to analyze attorney-client privilege issues. Keep in mind that selective disclosures of legal analysis to Exam can result in waiving the privilege concerning that analysis as well as a “subject matter” waiver of the privilege covering undisclosed documents. As to the actual disclosure, provide written explanations that set forth the issues affirmatively and effectively, anticipating likely areas of IRS concern.
Finally, as we will discuss in a future issue of Tax Executive, in a follow-up to this article, if you base your decision not to be proactive on the expectation that “we will get a better deal at Appeals,” you should carefully analyze that expectation. It may not be warranted and, if incorrect, could lead to delays, costs, and litigation. Further, as will be discussed in the follow-up to this article, Exam will continue to be involved if, at Appeals, the taxpayer presents new facts or arguments not presented to Exam.
Eric Solomon and Walker Johnson are partners at Steptoe & Johnson LLP in Washington, D.C.