On March 23, 2017, the IRS Large Business and International (LB&I) division announced the initial identification and selection of 13 “campaigns” to combat perceived tax compliance issues, with more campaigns to be identified and launched in coming months.
Several of these campaigns either explicitly or implicitly will target mid-market businesses. These include a campaign to examine transactions with non-U.S. related parties, a separate campaign to specifically examine the transfer pricing used by inbound distributors, whether S corporation are claiming losses in excess of basis, the repatriation structure being used for tax-free repatriation of funds into the U.S., and whether foreign companies doing business in the U.S. are filing a Form 1120-F with the IRS.
In its announcement the IRS has indicated that depending on the particular issue, the “treatment stream” (a great example of IRS-speak) may include starting an issue-focused examination or issuing a “soft letter” (where the IRS invites the taxpayer to either amend its tax return or respond to the IRS explaining why the taxpayer’s treatment of a particular issue was appropriate).
All of this begs the question — and this applies to a dispute with the IRS as well as any other taxing authority– of how should a taxpayer manage a dispute with the taxing authority. Based on my 25+ years of practice as a tax attorney (and with the standard tax attorney caveat that of course these rules could change depending on the circumstances), here are my four rules for how to manage a dispute with a tax authority:
“The best defense is a good offense.” Here’s how I apply this adage to tax matters. Don’t wait until you are audited to consider how a tax position will be perceived if audited. Also, recognize that sometimes tax positions are “invisible” and stem from items that are not reflected on the books of the business. For example, in an international perspective, a U.S. parent company may not be charging a foreign subsidiary for home office services when it should.
When you are planning for how to book a transaction or whether or not to take a particular tax position, take the time to consider (or ask your tax advisors) how consequential tax positions will be perceived by the IRS (or other tax authorities). This means thinking through whether your facts are sufficient to support your tax position and whether your documentation is sufficient to support your facts. Gather the appropriate documentation and keep it for later scrutiny in case a challenge arises.
Also, consider how strong your legal or technical basis is for the intended position. Don’t be afraid to ask questions to your tax advisors and exercise healthy skepticism towards the strength of their advice. I’ve been involved with various tax-savings strategies where the “solution” saves tax dollars in the short term, but later on, the solution creates limited (or no) savings when with hindsight, it is determined that the position is weak and it is necessary to take penalties and interest into account. Recognize that the best way to manage a tax dispute is to avoid a needless one.
Be proactive in dealing with the tax audit. No (sane) business or individual likes the scrutiny of a tax audit (or dealing with inquiries from the IRS), but good, bad or indifferent, audits are a fact of life. An essential first step is to understand the scope of the audit and then develop an appropriate strategy reflecting the potential risk. Particularly, in audits of businesses, sometimes the auditors get focused on low-hanging fruit, succulent for the auditor to sink his or her teeth into, but with relatively low exposure for the taxpayer. Don’t prevent the auditor from chasing these tasty issues.
Once you know the scope of the audit, try to stay a step ahead of the auditor by trying to anticipate how the auditor will perceive your responses to their questions and information-requests. Be mindful that you don’t want to inadvertently create more confusion by incomplete or superficial responses. Dangerous to over-generalize, but sometimes it will be to your advantage to volunteer negative information that will inevitably arise so you can give it to the auditor in a manner and context that mitigates the potential exposure. I’ve been involved with cases where on close (internal) review of a topic, the client determined that it had taken an incorrect position on a tax return. Giving the auditors the adjustment not only resulted in a lower potential audit change (lower adjustment and no penalties), but it established credibility that was helpful on other issues.
Help the auditor be your advocate. There are lots of different theories (and war stories) on this but I believe that most auditors want to arrive at the right answer. Sometimes tax adjustments are the result of the taxpayer not presenting information clearly to the auditor. In a “toss-up” issue where you have decent facts and/or law supporting your position, make it clear to the auditor why your position should prevail. Sometimes, this means synthesizing the critical facts into a compelling story or giving the auditor a position paper explaining in appropriate detail why your technical basis (i.e., legal interpretation) is superior to theirs. In the end, everyone has to justify their conclusions to their manager, so try to make it as easy as possible for the auditor to have the ammunition to convince their boss to accept your position.
Know when to fight; Know when to fold. Some issues will be worth fighting for. Develop the facts at the Exam level as best you can and go to Appeals. In some (hopefully rare) high-exposure cases, the taxpayer needs to be prepared to litigate. On the other hand, in some instances, the taxpayer needs to accept the inevitable– that a tax position was incorrect. In these cases, ending a dispute and accepting the tax liability on a particular tax position allows the taxpayer to move on to more productive (and profitable) endeavors. Be mindful that conceding a small issue today can set a precedent with the tax authority that results in larger exposure in later years.
The bottom line is that every situation is going to be different and the taxpayer (and their advisors) need to be flexible and not be wedded to “one-size-fits-all” responses. Recognize that the most effective management of tax disputes starts well before a tax audit or even before a tax return is prepared and filed. Rather, the tax consequences of a transaction should be evaluated when a business initiative is being evaluated. By so doing, taxes can be appropriately contemplated in the economic analysis, the tax reporting and potential audit issues can be considered in advance, and an informed decision about whether to take a particular tax position may be made by the taxpayer.