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Tax audits at the federal level can have significant state tax implications. In this article, Timothy J. McCormally and Lawrence E. Mack of KPMG LLP discuss the IRS's new risk assessment and issue selection criteria for examinations of large businesses.
By Timothy J. McCormally and Lawrence E. Mack
Timothy J. McCormally, J.D., and Lawrence E. Mack, J.D., are Directors in the Washington National Tax practice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP
The expression “needs must” roughly means that sometimes necessity compels you to do something that you might not rather do. For more than a decade, the phrase — which dates to a century before Shakespeare popularized it in All's Well that Ends Well — has been applicable to the Internal Revenue Service which has found itself severely resource constrained because of budget cuts and hiring freezes. Specifically, the IRS has been forced to implement fundamental changes in how the agency's Large Business & International (LB&I) Division is organized and identifies issues and taxpayers for its enforcement efforts. Only time will tell whether the changes, complemented by global trends in tax transparency and developments in the field of data analytics, will end well.
LB&I's new structure is part of an IRS-wide “Future State” initiative that, beginning in 2014, charged each operating division with reconciling its “concept of operation” with both budget reality and the IRS's vision of what it should look like in five years and beyond. In late 2015, LB&I became the first division to announce its new design, and the organizational structure became preliminarily effective in early February 2016. Although LB&I explained that its new structure was intended to reflect a new approach to enforcement — an “issues based” approach —a major element of this reformation remained in development until earlier this year when LB&I released the first tranche of issues to be addressed using a new method of auditing the country's large and middle-market companies.
In late January 2017, LB&I released information on an initial 13 different “campaigns” and identified a variety of “tailored treatments” designed to improve tax compliance from an identified (but not necessarily disclosed) group of business taxpayers. The information released by LB&I included a short description of each campaign and briefly described the agency's designated tailored treatment or treatments for each campaign.
This article reviews the thinking behind LB&I's new risk assessment and issue selection methodology and discusses several open questions about LB&I's new process, critical transition issues, and what lies ahead for LB&I and the affected business taxpayers.
Risk assessment has long been a part of the IRS's examination process, but for half a century the IRS essentially assumed that the largest business enterprises deserved scrutiny without regard to their particular tax profile. In 1966, the IRS established the Coordinated Examination Program — now called the Coordinated Industry Case (CIC) Program — under which LB&I audits the nation's largest and most complex corporations, each with assets generally exceeding $250 million. (LB&I's overall taxpayer portfolio includes business taxpayers with assets greater than $10 million.)
Thus, pursuant to standards contained in the Internal Revenue Manual (IRM), LB&I divided its part of the tax world into two components — large CIC taxpayers and smaller Industry Case (IC) taxpayers. Whereas IC taxpayers were generally audited for a single cycle by one or two revenue agents (with the audit usually taking less than 12 months), CIC taxpayers were examined by a team of agents on pretty much a continuous basis.
In assigning companies to one or the other program, LB&I historically used a points system based on factors such as gross assets of the entity (including controlled domestic and foreign affiliates), gross receipts of the combined entity, the number of operating entities and separate industries involved, the number of IRS team members and specialists required, and estimated support work required of other agents. The points system was not absolute: The IRS always had the option of placing a taxpayer in the CIC program even if it did not meet the points criteria of the IRM, when the return was sufficiently complex to warrant inclusion.
After five decades, LB&I's large-case program has undergone a significant makeover. Driven in large measure by revenue constraints and personnel reductions, the objectives of LB&I's new process are spending less time with compliant taxpayers, reducing the time spent looking for issues, and increasing the time devoted to resolving issues that present a risk to tax administration. The idea is not necessarily to audit more returns, though the shift in focus should allow resources to be directed at other compliance priorities, including scrutinizing smaller, mid-market enterprises, but to improve IRS case development and resolutions through a variety of treatments across the LB&I filing population.
LB&I's new approach is undergirded by four guiding principles:
To advance these principles, LB&I not only revamped its core structure, but also retooled its overall approach to determining who and what to examine and how to ensure compliance. On the structural front, effective February 2016, LB&I transformed from an organization primarily based on industries (or types of taxpayers) to one constituted along geographic and subject matter lines. Thus, LB&I created four geographically based Practice Areas (Western, Central, Eastern, and Northeastern), and five Practice Areas differentiated by their subject-matter focus: Pass Through Entities, Enterprise Activities, Cross-Border Activities, Withholding & International Individual Compliance, and Treaty & Transfer Pricing Operations.
The structural changes in LB&I are highly significant because they are designed to provide LB&I management with a direct “line of sight” into specific compliance challenges and, optimally, enable LB&I to agilely adapt its initiatives based on “real time” feedback. That said, the new structure has inevitability prompted questions about how the different Practice Areas will interact with one another and with taxpayers whose activities could involve multiple Practice Areas, and how real-time feedback will be incorporated into the process.
Structure aside, more visible day-to-day changes will flow from LB&I's new approach to determining who, what, and how the IRS operates in scrutinizing the activities of particular business taxpayers. At a high level, LB&I's overall approach will shift from comprehensive, enterprise-wide audits to examinations of centrally identified tax compliance issues. Traditional audits will not disappear, especially for the largest companies in the country. These companies will invariably remain subject to continual audits by teams of revenue agents (which, once assigned to a case, have historically had responsibility for determining which issues should be scrutinized) at least in the near term. The roles and responsibilities of both IRS personnel and taxpayers these traditional examinations — including the expectation that these audits will be more focused — will be guided by the processes and procedures set forth in IRS Publication 5125, LB&I Examination Process, accessible at https://www.irs.gov/pub/irs-utl/p5125.pdfandhttps://www.irs.gov/irm/part4/irm_04-046-001.html.
This does not mean, however, that it is “business as usual” within LB&I. The division's new strategy envisions that the enterprise-wide audits that historically marked the CIC program will inevitably constitute a smaller percentage of LB&I's overall workload. In the place of traditional team audits will be an ever-evolving group of “campaigns” and “treatments” aimed at addressing centrally identified compliance risks. LB&I's new methodology is aimed at focusing resources on taxpayers that have particular issues in their returns rather than just on the largest taxpayers across the issue.
Using feedback and suggestions from its employees and other sources and data analytics, LB&I has released its first tranche of campaigns and associated tailored treatments. The announced campaigns, however, do not reflect a determination by LB&I that the campaigns involve the issues of greatest concern or highest compliance priority to the IRS. Rather, they represent significant issues that were ready to be “rolled out” and, as important, illustrate the full range of available treatments, types of taxpayers, and the breadth of issues addressed by the campaigns strategy.
Thus, the treatments range from (1) clarifying the governing rules by developing new guidance ( e.g., as part of an Industry Issue Resolution (IIR) project), to (2) issuing so-called soft letters to affected taxpayers ( e.g., identifying potential areas of noncompliance and inviting the taxpayer to file amended returns or otherwise clarify, support, or rectify the position taken on their returns) to (3) conducting full-fledged examinations of the specified issue. LB&I's initial release also includes a description of each campaign and in some cases references to associated “practice units” (described below) that provide additional information about the issue, including the applicable processes, authorities, and analyses, as well as the associated tailored treatments.
In addition, to ensure greater transparency into LB&I's activities, the release identifies the LB&I executive with responsibility for the campaign and, significantly, invites feedback from taxpayers, practitioners, and other stakeholders about the campaigns and treatments, although the details of how feedback from outside LB&I will be received and acted upon is still a work in process.
The baker's dozen of LB&I's initial campaigns are an eclectic group. LB&I executives have explained that the 13 announced campaigns do not represent the most significant issues that the IRS is facing. They do, however, encompass a diverse array of domestic and international issues that were fairly far along in terms of the IRS's evaluation and analysis. Five different LB&I Practice Areas are involved, with seven campaigns falling under the responsibility of the Enterprise Activities practice area. Two campaigns are aimed specifically at mid-market companies, potentially a sign of things to come. And the campaigns as a whole illustrate the variety of treatments LB&I intends to employ.
The 13 campaigns are:
The tailored treatments for the announced campaign are expansive — from traditional examinations, to industry issue resolution initiatives, to the issuance of soft letters. The first set of campaigns seem focused more on traditional examinations than on alternative treatment streams. LB&I executives have offered assurances, however, that the broad spectrum of various resolution alternatives will be featured in future campaigns.
More campaigns will be identified, vetted, approved, and launched in the coming months. LB&I executives have stated that there is no fixed timetable for the release of new campaigns. Details on the campaigns can be accessed on LB&I's website (search for “Large Business and International Launches Compliance Campaigns”). Consistent with LB&I's commitment to bring substantial transparency to the campaigns initiative, LB&I is expected to post the practice units associated with many, if not most, campaigns on the IRS website. (Part of LB&I's knowledge management efforts, practice units are developed through internal collaboration and serve as both job aids and training materials on tax issues; e.g., practice units provide IRS staff with explanations of general tax concepts as well as information about a specific type of transaction. Some of the practice units were available on LB&I's website even before the campaigns were announced. To date, 122 practice units are currently listed on the IRS website. More information about practice units can be accessed at this link:
The full contours of LB&I's compliance campaigns will likely not be known for some time, but many aspects of the new initiative have been addressed by LB&I executives in presentations at conferences or on webcasts, as well as in materials published on the IRS's website. For example, LB&I has acknowledged that groups of taxpayers falling within the ambit of the announced campaigns have already been identified. In addition, although there is currently no requirement that taxpayers be informed when an inquiry is campaign-related, LB&I executives have confirmed that, if asked, the IRS will answer the question “ Is this related to a campaign?”
That a taxpayer has an issue addressed in one of the campaigns, however, does not mean that the taxpayer will definitely be ensnared by the campaign. LB&I's risk assessment protocols may dictate otherwise, especially if the taxpayer is already under examination. When the issue is not included in the examination plan, a decision to expand the audit to include the campaign issue will not rest with the case manager and traditional audit team. This is because the essence of the campaign/treatment methodology is centralized risk assessment. (Also, taxpayers included within a campaign will not automatically face an adjustment.)
Thus, an examination team that is interested in including a campaign issue within an ongoing audit will be required to revert to the lead executive about whether the campaign issue is of sufficient importance to merit consideration during the current examination. It may be that the issue will not be examined until the next cycle (if then). This might also be the case if the campaign issue only comes to the fore near the scheduled end of the examination. Again, if the issue is truly material or there is some other compelling reason to include it, that may happen (and a prudent taxpayer should likely anticipate it), but the ultimate decision will not lie with the examination team.
It is too early to predict where the overall campaign initiative will take LB&I, but it is reasonable to assume that, over time, the percentage of campaign-connected work will increase. Based on statements by LB&I executives, it may never be 100 percent, but it is likely to be more than 50 percent. LB&I has repeatedly stressed that resource constraints make it impossible for the IRS to continue to operate as it has it in the past, using the CIC/IC distinction to identify and conduct traditional examinations of business taxpayers. Those same constraints have necessitated LB&I's reevaluation of the Compliance Assurance Process (CAP) program, under which a select number of taxpayers are audited on a real-time basis, but LB&I executives have said that no decision has yet been made on the future of the CAP program. (At the same time, LB&I's announcement in August 2016 that no new companies will be admitted into the CAP program pending the end of its current reevaluation does not bode particularly well for the future of the program.) Similarly, LB&I executives have suggested that the IRS's other “early certainty” programs — including Fast Track Settlement and Pre-Filing Agreements — could face changes in the future.
Moreover, as the number of campaigns grow, it will become more and more likely that a taxpayer will be subject to multiple campaigns simultaneously (the same taxpayer may also be subject to a traditional examination). The coordination of the campaigns, and the work associated with the traditional examination, will proceed in accordance with the procedures set forth in Publication 5125.
In other words, dramatic as LB&I's strategic shift is, the new compliance campaign initiative has not changed the rules of engagement and collaboration, including LB&I's policy that no person hold “51 percent of the vote” in resolving disputes. This basic fact, combined with LB&I's commitment to seeking and acting on feedback on a real-time basis, means taxpayers should feel empowered to raise concerns. Ordinarily, concerns should be raised, first, with the first line manager, then the senior manager, then the executive. (The IRM 18.104.22.168.3.2 sets forth the process for engaging the “compliance chain of command” and the “subject matter chain of command.”)
Thus, if a taxpayer is concerned about lack of coordination ( e.g., between the traditional CIC examination and the compliance campaigns), the taxpayer should discuss those concerns in the first instance with the case manager. It is the case manager, by the way, who will ordinarily be the person primarily responsible for controlling the statute of limitations. In addition, taxpayers seeking to meet with the issue specialist (or executive lead) to discuss matters relating to a campaign should make that request through the case manager. And, if discussions with the case manager do not prove satisfactory, the taxpayer should not hesitate, if necessary, to elevate the issue to the senior manager and, eventually, all the way up to the executive lead.
LB&I has also emphasized that the shift to campaigns does not represent a return to LB&I's “tiered issue process,” which began in 2006 to help LB&I set examination priorities and address certain corporate tax issues that the IRS believed posed challenges to compliance. The tiered issue process was developed, in part, to combat abusive tax shelters, and several of the initial tiered issues dealt with listed transactions. Although intended to ensure consistency of treatment and uniform disposition of these and other types of cases, the tiered issue program was criticized as “prejudging” taxpayers and leading to automatic adjustments. The program was ended in 2012. A distinguishing characteristic of the compliance campaigns initiative is the developing robust feedback loop embedded in the program that, combined with LB&I's commitment to transparency, aims to avoid the shortcomings (or misperceptions) of the tiered issue program by allowing LB&I to nimbly address concerns raised by both taxpayers and examination teams.
In addition, compliance campaigns by their nature are fundamentally different from tiered issues because the campaign initiative envisions the development of alternative treatment streams. Finally, each executive lead for a campaign is supposed to have a clear “line of sight” into all the issues and cases (and possible problems) involved with campaigns, whereas the issue champion under the tiered issue program was sometimes not as fully or visibly engaged.
Another aspect of LB&I's new approach that bears noting is that the advent of the compliance campaigns does not portend any change in the role of the Office of Chief Counsel in audits or the involvement of Appeals. As has historically been the case with traditional examinations, personnel from Chief Counsel will continue to serve as a resource to exam, and play a role in developing and assisting in the rollout of campaigns. For example, Counsel will likely be involved in reviewing practice units that are developed in connection with campaigns.
Similarly, LB&I has confirmed that Appeals has not been involved in the development of the campaigns process or in particular campaigns. Hence, Appeals remains independent.
While LB&I has issued so-called soft letters in the past ( e.g., where a taxpayer's “concise description” of an uncertain tax position on Schedule UTP was considered inadequate), the use of such letters as tailored treatments in campaigns will likely greatly increase the number of taxpayers receiving them. For example, if LB&I identifies a position on a return at odds with the established position of the government, a letter might be sent to the taxpayer noting the discrepancy and essentially asking —
In short, a soft letter can be viewed as a “conversation starter” about a position taken on a return. Some taxpayers may explain their position, and the IRS will accede; other taxpayers may choose to file an amended return; and in still other cases, the IRS and taxpayers will know that a dispute lies ahead. LB&I executives have stated that, when the tailored treatment includes soft letters, LB&I will follow-up on both the responses received and any failure of a taxpayer to respond. Depending on how the taxpayer responds, LB&I may conduct a traditional examination of the issue. One open question is whether an IRS inquiry about a taxpayer's response to a soft letter represents the opening an examination, which can trigger various procedural rules.
One final point: Although the soft letters will be subject to internal vetting before they are issued, there are no current plan to externally vet them before their issuance to affected taxpayers, or there have been no assurances that soft letters will be publicly released, say, by posting on the IRS website. That said, as part of the integrated feedback loop, comments received from taxpayers or taxpayer representatives about soft letters (or other aspects of particular campaigns) could prompt adjustments going forward. Also, soft letters will (often, though perhaps not always) be linked to practice units.
One big unknown is how the effectiveness of LB&I's compliance campaigns will be measured. LB&I executives have explained that the measures employed in this new program will be different from those that the IRS currently uses to evaluate its traditional examination program, and they will likely differ from campaign to campaign. The historical importance of currency and cycle time to LB&I examinations is not expected to dissipate under the IRS's new approach, particularly when examinations are the tailored treatment associated with a specific campaign. Nevertheless, the possibility of “serial” campaigns involving the same taxpayer may test how currency is measured.
As for the effectiveness of particular campaigns or treatment streams, it is not currently anticipated that LB&I's metrics will be publicly released, but the following types of items could be taken into account in measuring success:
Since the cornerstone of the campaigns initiative is feedback, the evaluation process will focus, among other things, on how well the feedback loop works.
LB&I has repeatedly stressed that the effective operation of its “integrated feedback loop” is absolutely essential to the agile operation of the compliance campaign initiative. Thus, LB&I has invited feedback on the campaign process and on the 13 announced campaigns from its employees, taxpayers, and the tax community at large. The feedback will optimally focus not only on the analysis of the relevant technical issues contained in the practice units related to particular campaigns, but also on the efficacy of the designated treatment streams (and possible alternative ones) and suggestions for new, and the possible termination of existing, campaigns. In addition, feedback on the core campaign process and the day-to-day interaction of the campaign teams, traditional examination teams, and taxpayers will be welcome. LB&I intends for feedback to be constant and for campaigns to be modified on an ongoing basis.
Although the “integrated feedback loop” is still a work in process — i.e., no formal mechanism has yet been announced — feedback can be currently provided in a number of ways, from reaching out directly to the executive lead of a campaign, to providing comments to senior LB&I executives (such as the Deputy Assistant Commissioner, Compliance Integration), to communication with the campaign or traditional audit team, to asking question or raising concerns at conferences, meetings, and other public events.
In addition, since late 2014 when it published the first of its practice units, LB&I has provided an email address to allow the public to comment on the published practice units. Submissions through this process have prompted adjustments to a number of the published practice units.
While the genesis of the new compliance campaigns lay in the phrase “needs must,” resource-constrained LB&I is committed to ensuring the success of its new strategy. As part of its communications outreach, the IRS decided to move beyond traditional steps such as the issuance of formal announcements and press releases, the giving of interviews, and the participation of LB&I representatives in conferences and other meetings. Specifically, LB&I has announced an initial series of eight no-charge webcasts to explain how and why the new campaign strategy was developed and how it may affect taxpayers, as well as to respond to questions related to the announced campaigns.
The first webcast, held on March 7, was hosted by KPMG, and featured two senior LB&B executives—Tina Meaux, Assistant Deputy Commissioner, Compliance Integration, LB&I; and Kathy Robbins, Director, Enterprise Activities Practice Area, LB&I. They were joined by Sharon Katz-Pearlman, KPMG National Principal in Charge of Tax Controversy Services and Tax Dispute Resolution, and Michael Dolan, KPMG National Director of IRS Policies and Dispute Resolution and a former IRS Deputy Commissioner. (A replay of the webcast can be accessed on the “KPMG TaxWatch” website.) This webcast, which attracted more than 3,000 registrants, covered a substantial number of questions about the campaign process, and LB&I's responses are incorporated into this article.
The second webcast, held on March 28, was hosted by Ernst & Young and covered general questions about the campaigns program ; subsequent programs, which will be hosted by other accounting firms or professional associations, will address not only open process questions but also the particular 13 campaigns. (The third webcast will be held on April 20 and the fourth on April 26; the dates of other programs have not yet been fixed.) Details will be announced on LB&I's website (search for “Compliance Campaign Webinars”).
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