The issue focus approach after one year: can LMSB steer clear of the shelter paradigm?

• Author: Blair, David B.
• Position: Large and mid-sized business

Introduction

In the spring of 2007, the IRS's Large and Mid-Sized Business Division (LMSB) announced its "Industry Issue Focus" approach to the selection of issues for examinations. (1) Now that LMSB and taxpayers have had the benefit of a full year of experience with the new approach, it is appropriate to evaluate the approach, which has become the cornerstone of the LMSB enforcement strategy. LMSB has modified the program slightly and has sought to modify the messaging about what the program means. This article discusses the changes to the IIF program, reviews comments and criticisms of the approach, and presents LMSB management's response to those comments. It then discusses options and strategies for resolving controversies involving these issues.

To start, LMSB has changed the name of the program. Rather than Industry Issue Focus, LMSB now refers to the program as just "Issue Focus." This change was made in part to avoid confusion with LMSB's Industry Issue Resolution (IIR) program, but also reflects the reality that some of the issues covered in the program cross industry groups.

Discussion

1. Overview of the Issue Focus Approach

   Under the Issue Focus approach, LMSB identifies key compliance issues and clusters those issues into three tiers with varying degrees of coordination from tier to tier. For each issue, LMSB forms an Issue Management Team (IMT) which is led by an Issue Owner Executive (IOE) to coordinate the development and resolution of the tiered issue. Tier I and Tier II issues require oversight and control of the taxpayer's issue by the IOE, who is responsible for ensuring that the issue is identified, developed and resolved in a consistent manner across all LMSB cases involving similarly situated taxpayers. The disposition of any Tier I or Tier II issue must be in accordance with the guidance from the IOE and his or her IMT. Tier III issues do not require oversight and control by the IOE.

   The principal purpose of the Issue Focus approach is to set priorities in respect of LMSB's limited audit resources. The Pre-Filing and Technical Guidance (PFTG) office, which is responsible for the coordination under the Issue Focus approach, has more than 100 Technical Advisers (TAs), each with his or her own list of issues that the TA considers worthy of audit attention. PFTG recognizes that LMSB cannot audit all these issues with the same level of intensity. Accordingly, a Compliance Strategy Council designates certain issues as Tier I or Tier II. Currently, there is no opportunity for direct taxpayer input into the designation of an issue as a Tier I or Tier II issue. By designating an issue, LMSB sends a signal to its audit teams as well as to taxpayers that the issue is a priority for the IRS. Even after the selection of an issue has become public, there is still no formal mechanism for taxpayer input, although the IOE is also publicly identified and taxpayers can contact that person or file submissions.

   PFTG also hopes to use the Issue Focus approach to preserve resources by staying ahead of the curve. Through programs like Compliance Assurance Process (CAP) and Pre-Filing Agreement (PFA) programs, LMSB hopes to identify emerging issues earlier in the audit cycle. The clearest examples of this approach are that the designation of both the domestic production deduction under section 199 and foreign earnings repatriation under section 965 as Tier I issues even though taxpayers have only recently filed returns affected by these relatively new code provisions. (2) Thus, LMSB recognized that the coupling of potentially large dollars at issue with relatively new code provisions would require significant resources. Identifying each as a Tier I issue signaled to taxpayers that LMSB will look closely at these issues. In the long-run, the IRS believes that devoting the resources at the front-end will save resources compared with the normal audit timeline.

   When the tiering approach was first announced, there were 15 Tier I issues (counting all listed transactions as one Tiered Issue). No new issue has been designated as a Tier I issue, but Nonqualified Deferred Executive Compensation (section 409A) was removed from the Tier I list in the summer of 2007 and backdated stock options dropped from the list in April 2008. There were initially 12 issues identified as Tier II issues. Since then, no new issue has been designated as a Tier II issue and one issue (Deferred Home Construction Costs) is no longer considered a Tier II issue. As of June 1, 2008, no issues had been formally designated as Tier III issues. PFTG management has indicated that each Industry Director within LMSB has been asked to identify two Tier III issues. PTFG hopes to make those designations public shortly.

   What causes an issue to be a Tier I issue versus a Tier II issue is somewhat mysterious. Tier I issues are those that the IRS concludes have high strategic importance. They tend to be more established issues in the sense that they have a longer history of development with taxpayers and the IRS. (3) Tier I issues often build on a technical advice memorandum (TAM) or generic legal advice memorandum (GLAM) that provides technical backup to the IRS position. For these tiered issues, the IOE has jurisdiction over all settlements, and any settlement with LMSB must follow the IOE's guidance.

   Tier II includes emerging issues where the IRS believes that there is a need for further development in the law or guidance. Among the IRS's objectives with Tier II issues is to identify good candidates for litigation or the issuance of guidance. The examination function must coordinate with the IOE, so that the disposition of a Tier II case does not undermine LMSB's overall strategy for developing the law in the area. The IOE, however, does not have exclusive jurisdiction over the settlement terms. In our experience, there appears to be more flexibility to negotiate a settlement of a Tier II issue, which may reflect the distinct characteristics of this portion of the Issue Focus approach.

   An interesting example of a Tier II issue is the Gift Card issue. In the directive, the Technical Advisers identified three issues involving the recognition of income from gift cards that "must be raised" by examining agents. (4) The directive also contains a detailed elaboration of the IRS position on these three issues. In addition, the directive identifies 14 other issues that the Technical Advisers are "aware of," but does not provide any description of the issues or the IRS's proposed position. Presumably, the IRS position on these related issues remains in the development stage. This type of early warning provides taxpayers an opportunity for substantive input as the IMT is still developing its strategy on the issue.

   Review of the issues reveals that both Tier I and Tier II contain a wide variety of issues in terms of substantive areas (with a heavy dose of international), industry scope, history, and level of development of the IRS position. As a practical matter Tier I issues generally involve more tax dollars than Tier II issues. Tier I issues affect more industries or taxpayers, and therefore are assigned a higher priority by LMSB. Tier II issues appear more likely to be contained within one industry or affect a more limited number of taxpayers. Thus, although an enhanced enforcement priority, Tier II issues are a step behind the Tier I issues.

   Each IMT, under the direction of the IOE, is responsible for developing the strategy for the IRS approach to the tiered issue. IMTs include personnel from multiple IRS functions, including Technical Advisers, Appeals, LMSB Counsel, and National Office Counsel? They publish directives outlining the designated IRS approach to the issue. All Tier I issues have at least one published directive, and some Tier I issues have had multiple published directives and may have other backup materials, such as a coordinated issue paper (CIP). (6)

2. Effect of Coordination

   The coordination that is the hallmark of the Issue Focus...