LMSB's industry issue focus approach: applying lessons learned from battling tax shelters to mainstream tax issues.

• Author: Blair, David B.
• Position: Large and Mid-Size Business Division

Introduction

The IRS's Large and Mid-Size Business Division has announced a new Industry Issue Focus (IIF) program, which promises to be a significant development in the evolution of IRS's tactics for issue identification, development, and litigation. Under the new program, LMSB management designates selected substantive issues for mandatory audit, and field examiners are required to coordinate the development of these issues with an issue management team (IMT) that is responsible for the issue. In addition, the leaders of the IMTs, or Issue Owner Executives, must approve the field examiners' proposed resolution of these issues. Where a taxpayer has an IIF issue, therefore, the field examiners will have far less discretion over the conduct of the audit and the ultimate disposition of the issue.

LMSB has published a list of IIF issues, which are organized into "tiers." The list is striking in its diversity. Some of the issues have a long history with well-developed positions by both the IRS and taxpayers; other issues involve the application of new legislation where there has been little audit activity, identification of contested issues, or legal development. Indeed, the common characteristic of these issues is seemingly the large potential tax dollars at stake. In addition, certain IIF issues purport to cover broad areas where material facts will vary from taxpayer to taxpayer. One would expect the courts to pay particular attention to the underlying facts, rather than accepting a one-size-fits-all position. This raises another aspect of the IIF list: the negative connotations in a number of the issue descriptions. (For example, "[section] 118 abuse.") If field examiners treat designation as an IIF issue as an indication of an "abusive" transaction, as they typically did with listed transactions, it may blind them to potentially decisive factual differences among the affected taxpayers.

LMSB management has explained the new program as a means to advance its strategic objective of more efficiently allocating the IRS's limited audit resources. That may be true, but the IIF program also represents the IRS's taking lessons learned from battling corporate tax shelters and applying them to the next generation of tax controversies. With tax shelters, the IRS used teams to select and analyze paradigm cases, develop the IRS's technical position for the generic transaction, and in some cases announce a standard settlement. Whether these tactics can succeed in the context of the more mainstream issues in the IIF program (e.g., the domestic manufacturing allowance under section 199 of the Internal Revenue Code) where material facts vary from taxpayer to taxpayer, is an open question. For now, taxpayers should monitor the list of issues that LMSB has designated under the IIF program because the new program will affect the dynamics of their audits and their options for achieving a favorable resolution.

The IIF Program and its Heritage

1. Overview

   Under the IIF program, LMSB plans to focus its resources on the issues having (in its view) the greatest compliance risk. LMSB established three "tiers" of IIF issues. Tier I issues are of "high strategic importance" to LMSB and have a significant effect on one or more industries. Tier II issues are those where LMSB believes there is a significant risk of noncompliance. Tier III issues, none of which have been publicly identified to date, are industry issues that LMSB teams consider when conducting their risk analysis. LMSB has placed issues in the three tiers based on several criteria, including the number of taxpayers and industries affected and LMSB's strategy to identify vehicles to further develop the law in a particular area. LMSB has been public about this new audit program, outlining the approach at meetings of Tax Executives Institute and other organizations, and even devoting a section of its website (www.irs.gov) to the IIF program and targeted IIF issues.

   The lists of Tier I and Tier II issues do not conform to any particular pattern, other than their potential to generate significant tax. (1) Several issues have been around for some time, and both the IRS and taxpayer positions are fairly well established. For example, the lists include R&E credits, migration of intangibles under costs-sharing arrangements, casualty losses, and non-shareholder contributions to capital under section 118, which have long been focal points for IRS audit enforcement. Not surprisingly, then, they are on LMSB's list of coordinated issues, and thus it will be fairly easy to predict the direction of the IRS's examination team, Appeals treatment, and litigation.

   In other instances, the IRS has not yet developed an approach and is simply flagging an issue for later development. For example, the IIF lists recent legislation enactments as "issues," including the domestic production deduction (section 199), foreign earnings repatriation (section 965), and nonqualified deferred executive compensation (section 409A). Given the newness of this legislation (and associated IRS guidance), there has been little audit activity, identification of live disputes, or opportunity for the IRS to develop positions covering real facts. Moreover, a number of the not-so-new issues are awaiting further development by the IRS. For example, LMSB recently released the Issue Directive on Casualty Loss Deductions noting that audit guidelines would be forthcoming "as the issue is being developed" and, in the interim, audit teams should contact the Utilities Technical Advisors for guidance and approval of Forms 5701. (2) On the one hand, IIF is likely to delay the IRS's examination of issues-in-progress and to enhance the unpredictability of the eventual IRS position. On the other hand, there may be opportunities to influence the IRS's understanding of the typical facts, the underlying business concerns, and the policy considerations.

   Many IIF issues are highly fact dependent. For example, the research and experimentation credit typically involves a fact-intensive inquiry into the level of substantiation that the taxpayer can muster in support of its claim. In these instances, the field examiners should play a critical role in evaluating the evidence and making the factual determinations that ultimately result in a finding regarding the validity of the credit. Including the R&E credit on the IIF list will require coordination with other IRS constituencies, which has the potential to undercut the fact-finding role of the field examiners (or, worse, serve as a signal to the field that all R&E credit claims should be challenged). In the tax shelter wars, listing a transaction was a red flag for auditors in the field and typically resulted in an adverse revenue agent's report (RAR). Optimally, LMSB management will communicate to the field that the same reflexive disallowance is improper for fact-dependent IIF issues.

   The largest single group of IIF issues involves international tax: "section 936 exit strategies," "foreign tax credit generators," repatriation, hybrid instruments, cost sharing, stock options in cost sharing, and the former extraterritorial income exclusion transition rules. This is consistent with LMSB's strategic objective of focusing audit resources on international tax issues, including transfer pricing. Like the other IIF issues, the international issues are diverse in the level of prior IRS issue development and the potential variation in material facts.

   Finally, the list of IIF issues reflects some issues that can only be described as opportunistic. For example, "backdated stock options" is included as a Tier I issue. The inclusion of this issue reflects, at least in part, the flurry of press coverage and SEC investigations of the backdating issue. As the IRS and taxpayers learned of the issue, it led the IRS and tax departments to flag the issue for field examiners. This kind of monitoring of press reports for corporate issues that have a tax angle seems well suited to the IIF program, if LMSB can respond quickly with a substantive position and audit guidelines for the field.

2. Tiering of IIF Issues

   The IIF issues are assigned to Tiers I or II. (There also is a Tier III, but no issue has been assigned to this tier.) Among the criteria that LMSB has identified for Tier I designation are issues involving a large number of taxpayers, significant dollar risk substantial compliance risk, and high visibility. Tier I encompasses issues on which LMSB believes the law (or at least the IRS position) is well established. (3) Typically, LMSB's position on these issues is built around National Office or LMSB Field Counsel guidance, such as a Technical Advice Memorandum (TAM) or a Generic Legal Advice Memorandum (GLAM). (4)

   Tier II encompasses emerging issues on which LMSB concludes there is a need for further development in the law or guidance with respect to the IRS's position. (5) Accordingly, the required coordination on Tier II issues includes as an objective promoting the IRS's development of the law (e.g., through selection of cases...