Compliance assurance process.

• Author: Opper, Loren M.

History

In 2003, Mark Everson, then Commissioner of Internal Revenue, commented ruefully that it took the IRS five years to complete an audit of a corporate tax return. (1) To address the delay, the Internal Revenue Service expanded the pre-filing agreement (PFA) process (2) to accelerate corporate income tax audits. The PFA agreement process was designed to resolve the tax treatment of a specific item before the filing of the tax return in which the tax treatment of the item appeared. If the IRS agreed with a taxpayer's PFA request, the IRS engaged in fact-finding for the item. The taxpayer and the IRS then sought to agree on the return position for the item. If the IRS and taxpayer agreed, and if the taxpayer reported the position in accordance with the agreement, the issue was spared any post-filing review. The taxpayer thus was certain about the tax treatment of the item.

Donald Korb, then IRS Chief Counsel, said that if the pre-filing concept could be applied to all material tax items occurring during a taxable year, the application would be the "ultimate pre-filing agreement." (3) The IRS decided to test the concept in 2005 by establishing the compliance assurance process (CAP) pilot program. (4) The pilot program initially had 17 participants. To evaluate the effectiveness of CAP for participants in the pilot program, the IRS had to develop measures that were different from those typically used by the IRS to evaluate the effectiveness of post-filing audits. The effectiveness of post-filing audits may be measured by the magnitude of audit adjustments, but the CAP program produced no audit adjustments. Instead, the effectiveness of CAP depends on a taxpayer's disclosure and resolution of issues in a pre-filing environment, which saves the IRS resources when compared with the resources that it uses for post-filing audits.

Having decided that the CAP program is effective, the IRS moved CAP in 2011 from a pilot program to a permanent program. (5) The permanent program applies for taxable years beginning after December 31, 2011. At the time of the IRS decision to make CAP a permanent program, the program had 140 participants. A taxpayer participated in the pilot program by invitation from the IRS. In contrast, a taxpayer participates in the permanent program by filing Form 14234 with the IRS and being accepted into the program.

Purpose of CAP

The purpose of CAP is to have the IRS and taxpayer collaboratively identify and resolve material issues during the taxable year in which the issues arise so that a post-filing examination, if any, of the tax return for that taxable year may be unnecessary, or if necessary, may be completed promptly. The unique feature of CAP, as contrasted with post-filing audits, is the upfront disclosure by the taxpayer of material issues. A taxpayer does not typically disclose material issues to the IRS in a post-filing audit, subject, of course, to the mandated disclosures that the taxpayer is required to make with the filing of its tax return.

This article discusses the advantages and disadvantages of CAP. An appendix sets for the procedures for CAP. The weight that a taxpayer gives to a specific advantage or disadvantage obviously will depend on the taxpayer's own circumstances.

Advantages of CAP for a Taxpayer FIN 48 (ASC 740)

CAP increases a taxpayer's certainty of its financial position by eliminating or diminishing a need for financial statement tax reserves. FASB Interpretation No. 48, adopted in 2006, (6) specifies standards for recognition and measurement in a taxpayer's financial statement of tax benefits claimed in its tax return. By resolving issues during the taxable year, CAP decreases, even if it not does eliminate, uncertainty about the recognition and measurement of tax benefits, and it decreases the number of tax benefits for which reserves are required.

In some circumstances, a taxpayer may not be able to demonstrate affirmatively to its public accounting firm that it is more likely than not that the taxpayer will recognize a tax benefit. Absent that showing, the taxpayer will reserve for the unrecognized tax benefit and thereby reduce financial earnings. CAP may be an effective means by which to produce the affirmative evidence that supports recognition of the tax benefit.

Avoidance of Financial Statement Restatement

A taxpayer may reflect a tax benefit from a transaction in its tax return but not appreciate that the IRS has grounds to disallow the benefit. As a consequence, the taxpayer's financial statement will not reserve for any risk that the transaction presents. If, in a post-filing audit conducted some years after the taxpayer engaged in the transaction, the IRS successfully asserts a significant tax deficiency for the transaction, the taxpayer's financial statements for past periods will have overstated earnings because of the absence of the reserve. The overstatement may require the taxpayer to restate its financial earnings for past periods to record the reserve for the tax risk. (7) A restatement of financial statements also may expose the taxpayer to class action litigation for having published incorrect financial statements. The prospect of having to restate financial statements obviously is a burden to be avoided. CAP, of course, avoids this restatement risk.

Tax Planning

A taxpayer having half a dozen years in examination and almost as many in Appeals often has an impossible task of predicting with accuracy the effect of tax planning for the current year. If CAP is working effectively, a taxpayer will not have many, if any, years open in audit and Appeals and thus will be able to estimate the effect of tax planning with significant precision. (8)

Participation of IRS in Planning

The IRS's CAP team obviously does not participate in the taxpayer's tax planning. Nonetheless, instances have been reported in which the taxpayer has explained why it was planning to structure a transaction in a particular manner. By providing the CAP team with advance information about the intended structure of the transaction and the reasons for it, the CAP team could understood the intended tax treatment and readily accept the taxpayer's return position without replowing through the entire transaction after it was consummated.

Negotiations in Merger and Acquisition Activity

CAP may benefit a taxpayer involved in negotiating the structure of a merger or acquisition. The structure proposed by the taxpayer's counter-party to the merger or acquisition may pose tax risk, and the counter-party may attempt to shift that tax risk to the taxpayer. A CAP taxpayer's negotiating hand is strengthened in deflecting this attempt by pointing to the certainty that the IRS will examine the merger or acquisition as part of CAP.

Acceleration of Audits of Pre-CAP Years

To be eligible to apply for CAP, a taxpayer is required to have no more than one filed return that has not been closed in examination and one unfiled return for the year most recently ended and for which the return is not yet due. If the taxpayer has several years of filed returns that are currently under examination and wants to accelerate the completion of the examination, the taxpayer might consider applying for Pre-CAP. The Pre-CAP process is designed to facilitate the audit of the filed returns so that the taxpayer will meet the eligibility requirements for CAP. Pre-CAP facilitates the audit process by focusing on material items as spelled out in the Pre-CAP Memorandum of Understanding. An integral feature of Pre-CAP is that the taxpayer discloses to the audit team the material transactions in which the taxpayer engaged during the Pre-CAP years.

Resolution of Legal Issues

The CAP team does not supplant the IRS Office of Chief Counsel, which provides advice on legal issues. Nonetheless, instances have been reported in which participation in CAP facilitated resolution of legal issues. Because of CAP, a taxpayer was able to present its legal position promptly and have it considered directly by representatives of Chief Counsel.

Alternatively, if different constituencies in the Office of Chief Counsel are not in agreement about guidance that should be provided for an issue raised in CAP, the CAP taxpayer nonetheless may find that resolution of the issue with the IRS is attainable. Because of CAP, the IRS may desire resolution of the issue, and the CAP taxpayer may find that this resolution is within reach either at the examination level or with fast-track settlement in Appeals. (9)

State Income Tax Returns

State tax law typically requires a taxpayer to file an amended state income tax return that incorporates changes in federal taxable income resulting from an IRS audit of the taxpayer's federal return for the same taxable year. In ideal circumstances, a CAP taxpayer will not have any federal changes to report to state tax authorities because CAP will have definitively determined federal taxable income for the taxable year. CAP thus may increase a taxpayer's efficiency in preparing and filing state income tax returns because of the absence of federal changes.

Federal changes also may whip-saw a taxpayer on state income tax statute of limitations issues. A federal change may result in a state income tax deficiency. This deficiency is not time-barred by the state statute of limitations because the state statute typically is extended for state income tax assessments caused by federal changes. At the same time, the taxpayer may then identify a...