Do you suffer from IRS Audit Complacency Disease? Typically, taxpayers contract this affliction after the IRS has finished their continuous audit, packed up their belongings, and left the building.
That false sense of relief is buttressed by the recognition that in the past few years, the IRS’s resources have been dramatically undermined because Congress has slashed the agency’s budget. The result of an underfunded IRS has meant that the IRS’s Large Business and International division has had fewer and lighter examinations, making fewer and smaller audit adjustments.
That was then, but this is now! The comprehensive tax reform we are experiencing will likely change that. By all accounts, the new tax law asks more questions than they answer. Tax professionals are scratching their heads over what the law means and how to implement it. As the Treasury and the IRS scramble to release much needed guidance, the environment is ripe for creative interpretations and inventive strategies. Although tax reform brought lowered tax rates, accelerated expenses and forced repatriation of foreign earnings, it also increased the risk of an IRS audit.
The first wave of examinations will focus on what taxpayers did in 2017 in expectation of tax reform. Given the 14 percentage point corporate rate differential between 2017 and 2018, there was an incentive to accelerate deductions and defer income last year. Atypical activity may serve as a red flag and trigger IRS scrutiny. For example, numerous taxpayers accelerated their deductions for bonus compensation to ensure that the liability to pay bonuses in 2018 was fixed and determinable by the end of 2017. Taxpayers may have implemented strategies in 2017 to manage their foreign earnings and profits, and cash levels, in anticipation of deemed repatriation. Similarly, many taxpayers may have engaged in accounting method changes and taxable year changes.
An ounce of prevention is worth a pound of cure! Be proactive. Anticipate an IRS audit, and the additional scrutiny. Protect your confidential communications. Separate the business advice from the legal tax advice. Here are some tips to help inoculate your return positions:
• Understand the factual and legal tax bases for your positions. Develop the facts and legal analysis that you will need to justify and support your return position. Have an “audit ready file” for all positions subject to scrutiny. If you booked a reserve for an issue, you have a file ready to go!
• Analyze and document your “story.” You should have the full picture of the issue (the good, the bad and the ugly) before the IRS opens the audit. Be familiar with what your documents say to see if they support your story. For document intensive issues, consider creating an electronic database or “data room.” Your story should be consistent, reasonable and plausible.
• If you expect controversy with the IRS on an issue, obtain legal advice as to whether you have a duty to preserve documents and information and should issue a litigation hold notice.
• Identify personnel, including consultants, who may have knowledge. Determine what they will say if interviewed by the IRS. Your counsel should interview potential fact witnesses and prepare privileged summaries for future reference. Memories fade with time and former employees may be reluctant to provide assistance.
• Expect the IRS to reach out to third parties, including former employees and consultants. Send the IRS a “third-party contact” letter to determine who they are contacting, and ask third-parties to advise of any communication with the IRS.
• Expect significant involvement of LB&I Counsel. LB&I Counsel will advise the IRS examination team on both issue and factual matters. If they are preparing for litigation, you should too!
• Determine your facts before you provide information to the IRS. The IRS typically seeks information from a taxpayer by issuing an Information Document Request. Realize that whatever you say in response to an IDR can and will be used against you in court because your responses are considered admissions.
• Protect privileged communications. The IRS frequently challenges the confidential nature of putatively privileged communications. So don’t be surprised by requests for your privileged communications. The administrative summons is a favorite weapon the IRS uses to force taxpayers to disclose the legal tax advice received from outside legal and tax advisors. So don’t make things easy for the IRS and mistakenly waive privilege by sharing confidential communications with people outside of the sphere of confidentiality.
• Know when to hold them, and know when to fold them! Think strategically about whether and when to waive privilege. Be mindful that work product and attorney-client privilege protection from disclosure are waived if the taxpayer relies on counsel’s advice as a reasonable cause defense for a IRC section 6662 penalty. Moreover, waiving privilege extends to all communications on the same subject matter. So waiving privilege can open up your files and those of your outside advisors.
• “Informal interviews” are not so informal. If the IRS seeks to take an “informal interview,” prepare like it is a deposition. A recorded and transcribed interview is just a deposition by another name. Indeed, the transcript can be used to impeach the witness in court. Your counsel should be experienced in preparing employees (current and former) for IRS tax depositions.
• Expect the best, but plan for the worst. We hate to throw cold water on your rate-reduction parade, but skipping that third glass of your own Kool-Aid will go a long way to prepare you for the IRS examination to come. If the issue is important to your company, it’s worth the time and resource investment before Uncle Sam comes knocking. When in doubt, prepare like you will be litigating the issue in four years.
Carefully consider your response to IRS requests to extend the statute of limitations for assessment. Without an extension, the IRS has three years from the date of filing to audit your tax return. If you want to be the lead case on an issue consider options to accelerate the audit.
If settlement is even a possibility, consider using the IRS’s highly successful Alternative Dispute Resolution techniques: Fast Track Mediation, Appeals or Post-Appeals Mediation.
Carefully consider where you want to litigate. You have three options: the U.S. Tax Court, the federal district court where your business is located, and the U.S. Court of Federal Claims. The top factors are case precedent and the ability to pre-pay.