Tax controversies can result from simple positions taken on a 1040 return to international tax issues facing multinational corporations with millions of dollars at stake. Typical areas generating controversy are independent-contractor-versus-employee issues, worthless debt issues, compensation issues, Section 1031 exchanges, accounting method changes, FBAR, and other issues in the international arena, according to tax controversy practitioners.
A tax controversy is typically initiated when a taxpayer takes a questionable deduction or takes an aggressive position in a grey area, or treats an income item differently than the IRS does, according to Ann Fleming, senior manager at the Atlanta office of Top 100 Firm Warren Averett.
BRING THE KNOWLEDGE
“Tax controversies are my passion,” she said. “As advocates for the taxpayer, we have to have a separate set of skills that’s different from tax compliance and tax planning. We have to not only know the Internal Revenue Code, but we should be familiar with the Internal Revenue Manual. In addition, knowledge of the various statutes of limitation is critical, because the best tax position in the world will not help if we miss a deadline.”
“One of the problems in hand- ling tax controversies is that there are less people working at the IRS today, so the human factor is not there,” she said. “In part to deal with this, the IRS is using automated technology. That’s why we have automated notices being generated even when the IRS offices are not open. It makes it more of a challenge to keep up with a machine, or to argue with an automated system and prevail.”
“We seldom get resolution at the first level unless it’s something that can be handled on the Tax Practitioners Line,” she said. “The taxpayers that I’m helping feel overwhelmed, intimidated and frustrated, so we not only have to negotiate with the IRS but have to calm down our clients as well.”
Fleming, a CPA who is admitted to practice before the Tax Court, noted that it is the only court in which non-attorneys can represent clients. “Approximately 70 percent of cases in Tax Court are handled pro se [on behalf of themselves — without formal legal representation]. It’s really bogging down the system because most taxpayers are unprepared to represent themselves, so the judges are looking to CPAs and EAs who have been admitted to help taxpayers,” she said.
Tax resolution work can be as simple as providing the support for an education credit that’s been disallowed, Fleming observed. “In a recent case, where a return was prepared by a popular storefront company, they missed the deadline to go to Appeals. We took it to Tax Court, which sent it back to Appeals, where it was resolved. It was a very simple case.”
In a more complicated case, Fleming had to prove nine factors of a hobby loss under Code Section 183. “Before we got to court, we resolved the issue as a compromise with IRS Counsel,” she said. “We were strong on some points, not so strong on others, but we were happy with the result.”
Part of controversy practice is communicating and understanding both the taxpayer and the IRS agent handling the case, Fleming noted. “You can’t just bombard the IRS with paper and expect them to figure it out,” she explained. “In a big case, I once flew to New Jersey and sat next to the agent in his office. I went through two files of over 600 pages and walked him through it and explained it to him so he could understand it. In the end we got a good result for the taxpayer.”
Getting a good result often entails “working the system,” according to Fleming. “If you don’t get a good result from a collections officer, you may have to talk with their manager. And sometimes they won’t have the authority to do what you’re asking, so you have to go to their manager, or get the Taxpayer Advocate involved. The Taxpayer Advocate acts within the service, and can call managers to try to get the case moving.”
“Hazards of litigation” is the criteria used by Appeals to evaluate a case, Fleming noted. “It’s an evaluation of the probability of winning in Tax Court. If they think they have a 100 percent chance of winning, they will deny everything, but if it’s 50 percent, they will be more open to negotiate.”
“Appeals is currently seeing quite a few accounting method issues being raised, as well as a lot of international issues,” said Sheldon Kay, former chief of the IRS Appeals Office and a partner at Atlanta-based Sutherland Asbill & Brennan LLP.
A relatively new program, the Appeals Judicial Approach and Culture program, or AJAC, is intended to strengthen Appeals’ policy regarding independence from the compliance functions, according to Kay. “It is intended to have Appeals employees analyze the facts and law presented by taxpayers as well as the compliance functions of the IRS, and act like a quasi-judge,” he said.
“Appeals should not be raising new issues or be finders of fact,” he said. “That way, they can be more independent, which goes to their mission. This helps them appear, and really be, independent.”
“Appeals personnel are supposed to be independent of the Exam function and are authorized to look at case law and see if it can be settled,” according to Stephanie Loughlin and Matt Journy of Venable LLP. “It’s unlike Exam where the examiner takes the IRS position. In Appeals, they consider the IRS position but also look at what courts have decided in determining whether to settle.”
The IRS issued AJAC in September 2014, Loughlin noted. “It’s a year old now, but the impact is still being worked out,” she said. “It’s still a work in progress.”
“AJAC did two main things,” she said. “Generally speaking it prohibits the Appeals officer from raising new issues. This is significant because when Appeals could raise new issues, it could put the taxpayer in a position where they would choose to get a notice of deficiency and go to Tax Court immediately, rather than first go to Appeals, to avoid new issues from being raised.”
“The second thing it did was to prohibit the taxpayer from introducing any new evidence at Appeals. This is the hardest part to deal with,” she said. “The Appeals officer might want to understand different things about the issue than the examiner wanted, so he might want to expand the universe of what they think is relevant. But if you didn’t present the evidence during the exam, this would prohibit you from doing so in Appeals. We still don’t know completely how this plays out.”
“The question is, if new evidence is presented, does the Appeals officer ignore it or send it to Exam to look at the new evidence?” she said. “These rules are still new, and we don’t know how they will work in practice.”
“The IRS agent might ask for documents A, B and C, which the taxpayer provides,” said Journy. “But the Appeals officer also wants to see documents F and G, which are also relevant. Because they were never requested during the exam, the Appeals officer technically can’t consider them even if F and G are relevant and will be considered if the case goes to court.”
“It’s important to be thinking about how this case will work out in the long term,” said Loughlin. “The strategy has shifted between what can be done at Exam versus what can be done at Appeals.”
There has been some confusion over what you have to do under the AJAC rules, agreed Chad Coombs, a CPA and attorney with Greenberg Glusker. “It’s still in the early stages,” he said.
Coombs said that at the state level, Section 1031 exchanges are being openly targeted by the California Franchise Tax Board. “This is especially true of transfers known as ‘swap and drop’ and ‘drop and swap,’” he said.
“On the federal side, I see a lot of worthless debt and worthless stock deductions,” he said. “Also, I see a lot of employment and compensation issues, and employee-versus-independent-contractor cases.”
“When it comes to types of issues that taxing authorities are raising, it could be all over the map. It’s not as targeted as one might think,” he said.
Sheldon Polish, at the Ft. Lauderdale office of Berger Singerman, also noted an increase in examinations over the issue of employee-versus-independent-contractor. “It’s probably one of the bigger areas today that the IRS is interested in,” he said. “We’ve had three examinations in the last six months on this issue.”
“The other area keeping a lot of accountants busy is FBAR [Report of Foreign Bank and Financial Accounts],” he said. For taxpayers who wanted to come clean and avoid going to prison, the voluntary compliance program was a way out, he noted. “It was so successful, they kept extending it, although they raised the penalties for taxpayers who didn’t come forward immediately,” he said. “It’s still a popular program for people who haven’t complied.”
“The program has been going on for a while,” said Miguel Farra, chairman of the Tax and Accounting Department at Top 100 Firm MBAF.
“U.S. taxpayers that have money in an overseas bank are coming under more pressure. The DOJ is still entering into non-prosecution agreements with banks in Switzerland, with the bank agreeing to cooperate in criminal or civil proceedings in the U.S. They’re basically telling their clients to come clean and report their unreported income. If the U.S. taxpayer enters the voluntary disclosure program, they pay a penalty of 27.5 percent on the highest value of the foreign assets, but they escape criminal prosecution. If the Swiss bank does not enter a non-prosecution agreement the DOJ will go after them and impose huge penalties. So far, over 30 banks have entered into a non-prosecution agreement.”
VAGARIES OF THE IRS
There is a mix of skill levels on the IRS Exam team, according to Todd Simmens, national managing partner of tax risk management at Top 100 Firm BDO. “There are some agents that are really good, and others that need some assistance,” he said. “We have to sometimes engage their supervisors a little more, and go up the chain to team managers and area directors. We have to go up the channel when Exam disappears for months, then comes back and expects to close out the case immediately so they can get it out of inventory.”
“They tend to feel that going to Appeals is just part of the process,” he said. “But that should be only if they can’t agree during the exam.”
Simmens cited Fast Track Settlement as a way to help avoid going to Appeals. “It’s a way to keep the case in Exam, and bring in a mediator and negotiate an end game. Both parties have to agree to it. Not every issue is appropriate for Fast Track, but for the ones that are, it can be very useful.”
“Examiners seem to give taxpayers less and less time to answer questions or provide documents,” Simmens said. “That can be a challenge. Their ability to be flexible is slowly being eroded through guidance, not budget cuts.”
There are several “ones to watch” in the tax controversy world, according to Peter Stathopoulos, a partner at Bennett Thrasher. “The Ohio Supreme Court has a case where several Internet retailers are challenging the Ohio commercial activity tax, which is imposed on an economic nexus basis. If your sole connection is a sale over the Internet to an Ohio resident, Ohio wants you to file a commercial activity or gross receipts. You have to pay whether you’re profitable or not profitable.”
“Other ones to follow include the alternative apportionment method by states,” he said. “The states have basically been challenging taxpayers in order to get around P.L. 86-272, the federal law that provides immunity from state income taxes for firms whose business activities within the state consist merely of the solicitation of orders within the state.”
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