Sauce for the goose: standards applicable to taxpayers, practitioners - and the IRS; the contention among the parties results not from a lack of reasonable standards, but rather from an apparent failure by some IRS personnel to follow those standards in practice and the relative lack of accountability.

• Author: Lerner, Matthew
• Position: PROFESSIONAL STANDARDS - Cover story

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The relationship between the Internal Revenue Services Large Business & International (LB&I) Division and its constituent taxpayers is complex, marked by alternating episodes of cooperation and contention. LB&I often invites taxpayers and their representative groups to participate in the agency's critical self-evaluation and listens closely to suggestions and complaints. At the same time, there are frequent areas of open hostility and feverish dispute with, for example, the agency's ill-considered decision to hire an outside law firm to assist in the inherently governmental function of auditing a taxpayer's transfer pricing. (1)

Increasingly, large corporate taxpayers express frustration with the arc of their audits. Their perception is that IRS exam teams do not listen to their input and arguments, fail to advance audits in a timely manner, or raise issues that taxpayers feel should not even be on the table, and then become relentless in pursuing those same questionable items. IRS agents express similar frustrations, often believing that taxpayers take unduly long to respond to requests, treat them with disrespect, hide issues, pursue unreasonable positions, and use their perceived greater resources to "lawyer the IRS into submission." (2)

Two crucial aspects of this relationship should be compared: the standards to which IRS personnel are held and should be held in managing audits and a comparison of such standards to those that govern the conduct of taxpayers and their representatives. The problem is not an absence of reasonable standards but rather a failure by some IRS personnel to follow the existing standards and the relative lack of accountability when agents fail to meet IRS managements expectations and guidelines.

The Three Legs of the Standards Stool

Taxpayers complain that there is an asymmetry of standards, in that they are held to rigorous requirements for reporting positions on tax returns, whereas agents can raise nearly any issue they choose. Although agents are probably not quite so cavalier, an asymmetry may exist between return filing and IRS examination standards. At first blush, this difference appears unfair. However, this is not the right basis of comparison. Instead, what should be compared are the rules governing how taxpayers may defend their returns on audit and the rules governing the agents engaged in the campaign against them. In other words, do similar standards apply to both parties during the audit? In principle, the answer is mostly "yes," but in practice the answer is different. There are also a few meaningful distinctions in the standards worth noting.

The First Leg: Return Preparation

The United States has a self-reporting system of federal income tax. "There is legal compulsion, to be sure, but basically the government depends upon the good faith and integrity of each potential taxpayer to disclose honestly all information relevant to tax liability." (3) As a carrot, taxpayers are free to arrange their affairs to minimize their taxes, but an accuracy-related penalty for underpayment of tax that is attributable to negligence or disregard of rules or regulations is a stick the IRS uses to facilitate compliance.

This penalty, however, does not apply if the taxpayer has a "reasonable basis" (with or without disclosure, depending on the circumstances) for the tax position, thereby protecting from sanction a taxpayer acting in good faith. (4) The reasonable basis standard is generally satisfied if the position is reasonably based on one or more of the authorities set forth in Treas. Reg. Sections 1.6662-4(d) (3)(iii), taking into account the relevance and persuasiveness of the authorities and subsequent developments. (5) The reasonable basis standard is a "relatively high" standard, and a position that is "merely arguable" or is a "colorable claim" will not satisfy the requirement. (6) In effect, that reasonable basis standard serves as the statutory floor for taxpayer good faith and integrity. (7) Moreover, many corporate taxpayers hold themselves to an even higher standard and will not take a position on their tax returns unless they are more likely than not to prevail on the merits if challenged. (8)

In addition to the accuracy-related penalty regime, in-house and outside tax practitioners are subject to a variety of ethics rules and other professional responsibilities. For example, accountants are subject to the standards provided by the American Institute of Certified Public Accountants (AICPA), which require they act with integrity and objectivity. (9) Similarly, tax lawyers must comply with state bar association rules, which require candor toward the tribunal and fairness to the opposing party. (10) A tax practitioner whose actions fall short of these standards may be sanctioned.

In addition to those general professional standards, Treasury Department Circular 230 imposes additional rules on practitioners (attorneys, CPAs, etc.) who prepare and submit returns. Karen Hawkins, while director of the IRS Office of Professional Responsibility, stressed that in-house counsel are subject to Circular 230. (11) (For more on Hawkins' views on this matter, see Tax Executive, September/October 2015, page 43.) In short, any specified professional whose responsibilities relate to reporting an item on a tax return must comply with Circular 230.

In 2003, the IRS significantly strengthened Circular 230 in response to the perceived abuses of corporate tax shelter transactions. Then-IRS Commissioner Mark W. Everson stated that the revisions "changed ... the playing field for tax advisors" and sent "a strong message to tax professionals considering selling a questionable product to clients." (12) Hawkins emphasized that Circular 230 extends far beyond tax shelters. Circular 230 "scoops in first-time home buyer stuff ... it scoops in the new [foreign bank account reporting] stuff" over which the IRS has oversight. (13) Circular 230 now requires practitioners to adhere to best practices in return filing, including "relating the applicable law (including applicable judicial doctrines) to the relevant facts and arriving at conclusions supported by the law," "advising the client regarding the import of the conclusions reached," and "acting fairly and with integrity in practice before the Internal Revenue Service." (14) In addition, Circular 230 prohibits practitioners from advising a taxpayer to take a position on a return that lacks a reasonable basis. (15) The penalties for violating Circular 230 are severe: a practitioner can be fined, censured, suspended, or disbarred from practice before the IRS. (16)

The result of all these standards is well defined, and there are strict rules for what can be reported on a tax return in the first place. They are the sticks designed to ensure that the self-reporting regime works.

The Second Leg: Defending an Audit

The rules for taxpayers and their advisors in defending audits are less well developed, rigorous, and restrictive than the reasonable basis standard for reporting positions on tax returns. These rules allow taxpayers much greater freedom to defend positions. This greater freedom is evident within the structure of Circular 230 itself. Section 10.34(a) states that the reasonable basis standard is limited to positions taken in preparing tax returns and claims for refund. Under Section 10.34(b), when dealing with documents, affidavits, and other papers submitted to the IRS, the standard shifts to a significantly lower threshold of (1) not for the purpose of delay, (2) not frivolous, and (3) not an omission of information in a manner that evidences an intentional disregard for the rules.

The lower audit standards are not the only standards in play. Neither taxpayers nor their advisors may make any sort of false statement to the IRS in connection with an examination, at the risk of both civil and criminal sanctions. (17) When responding to information document requests (IDRs) and discovery requests, taxpayers must be certain their answers are honest, complete, and do not misrepresent in any way what is being provided. (18) Circular 230 similarly provides that any practitioner (which includes inside and outside tax representatives of the company) who is addressing the IRS has an obligation to ensure the accuracy of statements made. (19) Likewise, anyone providing information to the IRS must exercise due diligence in preparing or assisting in the preparation, approval, and filing of documents, affidavits, and other papers relating to IRS matters and in determining the accuracy of oral or written statements made by the practitioner to the IRS. (20)

Moreover, Circular 230 defines practice before the IRS broadly so as to include many audit-related activities--all matters connected with a presentation to the IRS relating to a taxpayer's rights, privileges, or liabilities under laws or regulations administered by the IRS. (21) Such presentations include but are not limited to: preparing documents; filing documents; corresponding and communicating with the IRS; and representing a client at conferences, hearings, and meetings. These general rules, and the requirements of Circular 230 that practitioners adhere to best practices, apply in the audit context as well. While acting fairly and with integrity is not precisely defined in the audit context, it does not seem to prohibit advancing any and all arguments to support a position previously taken on a tax return, even if such arguments are relatively weak and contrary to the weight of authority, so long as the arguments are not frivolous. (22)

Similarly, the penalties for negligence or intentional disregard of rules and regulations do not apply to taxpayers or their representatives in defending an audit. So long as the taxpayer is honest and acts fairly and with integrity, they may advocate a position that is not frivolous to defend their return. Presumably, because the...