Matthew D. Lerner is a Partner at Steptoe & Johnson LLP in Washington, D.C.
Amanda Pedvin Varma is a Tax Associate at Steptoe
Handling Tiered Issues Under the
IRS’s Industry Issue Focus Program
By Matthew D. Lerner and Amanda Pedvin Varma
Matthew Lerner and Amanda Pedvin Varma summarize the
key aspects of the IRS’s Large and Mid-Size Business Division’s
Industry Issue Focus Program, describe taxpayer and practitioner
criticisms of the program and suggest approaches to resolve
tiered issues successfully.
T
he Industry Issue Focus (IIF) Program was implemented in March 2007 by the Large and Mid-Size Business Division (LMSB) of the IRS. Under the IIF Program (also referred to as “Issuing Tiering”1) the IRS identifi es certain compliance issuesand then prioritizes (“tiers”) each issue based on stated factors, including the prevalence of the issue and the compliance risk raised by the issue. Although some taxpayers and practitioners have expressed concerns that the program has negatively affected the audit process, taxpayers and practitioners can help mitigate these perceived negative effects and improve their chances of achieving a successful resolution of a tiered issue by understanding the program and taking a proactive approach to planning and controversy.
This article (1) summarizes the key aspects of the IIF Program; (2) describes taxpayer and practitioner frustration with the program; (3) suggests approaches that taxpayers and practitioners can take to resolve tiered issues successfully; and (4) provides a case study of how taxpayers and practitioners can use materials compiled by the IRS to improve their han-dling of tiered issues.
Overview of Industry
Issue Focus Program
LMSB offi cially implemented the IIF Program in March 2007. According to the IRS, the IIF Program partially is a response to two of its major chal-lenges. First, the IRS asserts that it must be able to respond to the continually changing business environment. Business is increasingly globalized. In-ternational transactions, from cross-border payments to structured fi nance transactions, raise complex and unsettled issues. In addition, many businesses have sophisticated tax teams that the IRS views as being one step ahead. The IRS asserts that its second major challenge is that it is constrained by limited resources. For example, individual agents may be responsible for scores of corporate tax returns, which are often long and complex.
The IRS believes that the IIF Program will help it achieve several objectives. First, the IIF Program may allow LMSB to concentrate on higher-risk is-sues across industry lines. By concentrating limited resources on certain higher-risk issues, LMSB may increase coverage of noncompliant taxpayers, at least on the most important issues. Second, the IRS be-lieves that the IIF Program is designed to give LMSB fl exibility to respond to changes in business practice. A prevalent and complex issue may be designated ve ex ve oners resse ffe can he i d conc the a lp miti e p reso gramm an o d on taakinng sop one h step ahead. eam e IRRS asse t ts that its s k ra ed baise ativ d nnega er ra neg ay d d p gra prac am yers d ctiti ha and ion s n d p ct
initially as a higher-tiered issue, but may be put in a monitoring stage as the IRS is able to develop guid-ance and strategies for resolving the issue. The IRS also may deploy resources where needed. Third, the program is designed to promote consistency. Under the IIF Program, LMSB may resolve issues that are common to several different industries in a consistent fashion.
The Three Tiers
An issue may be designated as a Tier I, Tier II or Tier III issue. Tier I issues are considered to be of high strategic importance to the IRS and generally have a signifi cant impact on one or more industries. In addi-tion, a Tier I issue typically involves a large number of taxpayers, has a signifi cant monetary value to the IRS, has high visibility and/or represents a substantial compliance risk. Tier I issues are divided into two categories: “compliance” issues and “shelter” is-sues. According to the IRS, Tier I compliance issues do not necessarily relate to abusive transactions or practices—rather, they have been designated as Tier I because the issue is of high importance to the IRS. The current Tier I compliance issues (that have not yet been placed into “monitoring status,” as described below) are
Code Sec. 118 abuse;2
research credit claims;
domestic production deductions; mixed service costs;
cost sharing/offshore transfer of intangibles; foreign earnings repatriation;
foreign tax credit generators; and
U.S. withholding agents reporting and withhold-ing on U.S. source FDAP income.3
The Tier I shelter issues include all transactions listed by the IRS as abusive tax shelters and transac-tions, as well as “redemption bogus optional basis” and distressed asset/debt transactions.
When LMSB believes that a resolution strategy for that issue has been fully developed, it may move the issue from “active” status to “monitoring status” in the same tier.4 LMSB states that “[w]hile issues in
monitor-ing status may no longer require the focused attention of an Issue Management Team, they still need to be managed in accordance with established guidance whenever they appear on a tax return.”5 According
to the IRS, an issue will be considered eligible for monitoring status when the relevant Issue Manage-ment Team (described below) has (1) identifi ed the returns likely to contain the issue; (2) provided
nec-essary direction to the fi eld; (3) issued appropriate procedural guidance and a legal position; (4) devel-oped a resolution strategy; and (5) determined that there is no need to continue the heightened level of oversight.6 As of April 21, 2009, the following Tier I
issues have been placed in monitoring status: Code Sec. 118 universal service fund;7
Code Sec. 118 bioenergy payments; Code Sec. 118 environmental remediation; Code Sec. 936 exit strategies;
backdated stock options; government settlements;
international hybrid instruments; and mixed service costs (Phase I).
Tier II issues typically represent issues that the IRS views as having potentially high compliance risk. Ac-cording to the IRS, “Tier II includes emerging issues where the law is fairly well established but a need exists for further development, clarifi cation, direction and guidance on LMSB’s position.”8 The following
issues are classifi ed as Tier II issues:
casualty loss: single identifi able property/capital vs. repairs;
cost sharing stock-based compensation; enhanced oil recovery credit;
extraterritorial income exclusion effective date and transition rules;
gift card deferral of income;
healthcare accounting issues: contractual al-lowance;
interchange and merchant discount fees; nonperforming loans;
specifi ed liability losses;
super completed contract method; and
upfront fees, milestone payments and royalties in biotech and pharmaceutical industries.
Tier III issues represent issues that the IRS views as high compliance risks in particular industries and require unique treatment in that industry. The follow-ing are classifi ed as Tier III issues:
Communications, Technology and Media
carriage/launch fees paid to cable/satellite/ television operators by programmers/content providers; and
amortization of intangibles for licensed program contract rights.
Financial Services
real estate mortgage investment conduits; and premium defi ciency reserves.
on; or eporti nd ng and withh sh all t ers and s tr ac annsac Ti b er II issues p ar present is ut ues thhat th g/o horeffsh ce F . soourc pat en ene ho g ar ax g nin cre old gs edit ing rep t ge ag nts DAA
Heavy Manufacturing and Transportation
uniform capitalization for automobile dealer-ships; and
loyalty programs in service industries.
Natural Resources and Construction
delay rentals; and
Code Sec. 198 expensing of environmental re-mediation costs.
Retailers, Food, Pharmaceuticals
and Healthcare
cost segregation studies; and vendor allowances.
LMSB gathers potential tiered issues from several sources, such as fi eld agents and discussions of cur-rent developments. Potential Tier I or Tier II issues are presented to LMSB’s Compliance Strategy Council for review and approval. In deciding how to classify the issue, LMSB considers several factors, including whether the issue spans multiple industries, the scope of the issue, how resource-intensive it is and how many taxpayers are affected by the issue. If an issue is approved as a tiered issue, the issue is assigned to an Issue Owner Executive (defi ned below) to develop a compliance strategy.
IIF Personnel
To fully understand how the IIF Program functions, it is important to understand the roles of the specifi c IRS personnel who administer
the program. Key positions in the IIF Program include Issue Owner Executives (IOEs), Issue Management Teams (IMTs), Issue Spe-cialization Teams (ISTs) and the exam teams.
An IOE is chosen when an issue is designated as tiered by the LMSB
Com-pliance Strategy Council. The IOE is responsible for creating an action plan for a particular tiered issue. He or she also facilitates requests for legal advice and guidance and selects the members of the IMT.
An IMT usually includes an LMSB technical advisor and/or specialist, an Appeals technical guidance coordinator, LMSB industry counsel, a National Offi ce Chief Counsel representative and other members as necessary. The IMT is responsible for developing LMSB’s strategy on a tiered issue,
providing direction and guidance to the fi eld, fa-cilitating development and resolution of signifi cant issues and developing the audit techniques to be used for a particular issue. The IMT also evaluates whether the issue needs to be addressed through litigation and identifi es the best case or cases for factual and legal development. When appropriate, the IMT coordinates with Appeals. According to LMSB, the IMT does not necessarily get involved in specifi c cases except to discuss how they affect LMSB’s overall strategy on that issue.
An IST typically is formed for complex, time-consuming or widespread tiered issues. The IST contains senior agents, revenue agents and special-ists. It assists the examination team as necessary, which may include drafting information docu-ment requests (IDRs), examining taxpayer records, drafting Forms 5701 and 886, and participating in meetings with taxpayers.
The exam team typically issues to the taxpayer IDRs, summonses, proposed adjustments and other specifi c documents that have been developed by the IST or IMT. The exam team also handles the nontiered issues of the taxpayer.
IIF Program Materials
As discussed below, a taxpayer or practitioner dealing with a tiered issue should be familiar with materials that the IRS has compiled in connection with the IIF Program. These materials, which may be found on the IRS website, include (1) general information about the IIF Program and the examination process and (2) guidance on specifi c tiered issues.9
Several sections of the Internal Revenue Manual (“IRM”) describe the IIF Program. IRM 4.51.5 pro-vides a general overview of the program and the process by which the IRS designates issues as tiered.10 IRM 4.51.1 describes
the LMSB “Rules of Engagement,” which explain the roles and responsibilities of various IRS personnel involved in the IIF Program and clarifi es lines of authority.11 IRM 4.51.6 describes procedures that
should be followed by IRS personnel in implement-ing the IIF Program.12
The IRS also has compiled guidance for each Tier I and Tier II issue on individual Web pages.13 For
[T]he program is designed to
promote consistency. Under
the IIF Program, LMSB may
resolve issues that are common
to several different industries in
a consistent fashion.
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ieSeveraal sec adminnist me anaage ns es de r Ke gra ey p am Exe posi inc ecu ition clud tiveexample, the webpage for the Tier I research credit claim issue includes links to two Industry Direc-tor Directives, one Notice, a MandaDirec-tory Research Credit Claims IDR, and the Research Credit Claims Audit Technique Guide. Each Tier I and Tier II issue also has a “Quick Reference Guide.” The Quick Reference Guide typically contains a summary of the current status of the issue; lists the IOE, the members of the IMT and other relevant contacts; describes how the audit team should execute the IMT strategy; and provides links to and descriptions of guidance.14
Evaluating the IIF Program
Practitioner and Taxpayer Concerns
Practitioners and taxpayers have expressed several concerns about the IIF Program. First, some have complained that adding another administrative layer has complicated and slowed audits. Second, prac-titioners and taxpayers have argued that, in LMSB’s attempt to achieve consistency, the exam team’s fl ex-ibility has been undercut.
Third, some have com-plained that the actual decisionmakers have little or no direct contact with the taxpayer. Fourth, some have reported that certain transactions are being in-correctly labeled as tiered by an agent, and once so labeled, are subjected to
IDRs and legal positions inappropriate to the facts. Fifth, some practitioners and taxpayers have said that the IIF Program contributes to Appeals losing its abil-ity to function as an independent decisionmaker.
Concern 1: Audits Have Slowed
Taxpayers and practitioners have complained that the IIF Program has caused audits of tiered issues to slow because there are more levels of review, agents cannot or will not make necessary judgments, and bona fi de explanations of distinguishing facts that warrant different treatment are not receiving full consideration. Moreover, arguments regarding the issue frequently must be made to an agent, who must then act as a conduit to present the taxpayer’s argu-ments to the IMT or IST, which delays resolution and leaves the taxpayer having to rely on the agent to be its advocate (see Concern 3, infra.).
Concern 2: Exam Flexibility
Has Been Undercut
Some practitioners and taxpayers believe that the IIF Program creates a “one size fi ts all” approach to tiered issues, despite IRS assertions to the contrary. Practitioners and taxpayers have complained that the exam team often is unwilling or unable to deal with a tiered issue and acts only as an information gatherer for the IMT. As such, some taxpayers and practitioners say that they have been unable to obtain information or clarifi cation on why the exam team has taken a certain action. Some individuals who have been through the audit of a tiered issue also complain that IMTs and/or ISTs seem unwilling to listen to counterarguments from taxpayers because they assume that the IRS’s position must be correct because it was developed through the IIF process.
Concern 3: Decisionmakers are Unreachable
Taxpayers and practitioners also have been frus-trated with their inability to communicate with the relevant decisionmakers on a particular issue. For example, some taxpayers have reported that exam teams are not willing to engage in a discussion about distinguishing facts, and that they are similarly unable to have substan-tive discussions with the IMT or other decision-makers. LMSB, however, has stated that the exam team has more discretion than is being reported in these taxpayer anecdotes.
Concern 4: Issues Are Labeled Incorrectly
Some practitioners and taxpayers believe some of their audit issues have been labeled incorrectly as tiered issues because the issue has some similarity to a tiered issue. Once an issue is incorrectly labeled, these practitioners and taxpayers report, it is diffi cult to get the issue re-labeled correctly. Rather, the issue must be dealt with through the slower tiered issues process.
Concern 5: Appeals Is Losing Independence
Some practitioners and taxpayers have complained that the IIF Program has contributed to Appeals losing its ability to make independent decisions. Appeals generally is supposed to take a “fresh look” at an issue after the issue has gone through the examination stage.
Through the very practice of
tiering issues in the IIF Program,
the IRS is providing taxpayers and
practitioners with a valuable list of
issues seen as signifi cant to the IRS.
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ed a iereas ti ers ctition so ns to al an su nd o ubje po i onc ecte osit i ce s ed t ion in dSome fear, however, that Appeals may not take a fresh look at tiered issues because the IMT, which decides strategy with respect to an issue, includes an Appeals representative. As such, it is argued that Appeals has been compromised. The IRS, however, has countered that Appeals does take a fresh look at the issue after exam and that Appeals withdraws from IMT discus-sions if the IMT discusses specifi c cases. This response has been met with skepticism however, because with respect to an issue where the IRS’s position is that it is common across industries, discussion of facts in the abstract is simply a surrogate for evaluating a series of supposedly identical cases. In addition, it is important that taxpayers continue to perceive Appeals as untainted by involvement with examinations. Even if Appeals suc-cessfully maintains its independence, the appearance of bias will shake taxpayers’ faith in the process.
Dealing With Tiered
Issues in Practice
Although taxpayers and practitioners may have valid concerns about the IIF Program, understanding how the IIF Program works and taking a proactive ap-proach in planning and controversy may improve one’s chances of dealing successfully with a tiered issue and may help mitigate the perceived negative effects of the program.
Planning
Use the Tiered Issue List in Planning
Through the very practice of tiering issues in the IIF Program, the IRS is providing taxpayers and practitio-ners with a valuable list of issues seen as signifi cant to the IRS. As a result, taxpayers should evaluate their current practices in light of whether an issue has been placed on the tiered issues list. If a taxpayer engages in a transaction or practice on the tiered issue list, the taxpayer should understand that the issue will be scrutinized by the IRS. Furthermore, although examiners will focus in the current audit cycle on transactions and practices that have already occurred, taxpayers should recognize that some tiered issues are not specifi c to discrete transactions and will continue to be evaluated by agents in future years. For example, a taxpayer making payments to foreign persons should examine its Code Sec. 1441 withhold-ing practices in light of the IRS’s increased focus—if the IRS will scrutinize the taxpayer’s practices later, the taxpayer should scrutinize them now.
Use Materials Compiled by the IRS
As described above, the IRS has developed and/or compiled materials on tiered issues and how audits will proceed under the IIF Program. Taxpayers and practitioners should review these materials to (1) understand how their audit will proceed; (2) un-derstand the IRS’s view of the law on each relevant tiered issue; (3) consider their planning in light of the IRS’s position; (4) develop and maintain adequate contemporaneous documentation.
Although IRS guidance on tiered issues does not necessarily refl ect the “correct” interpretation of the law and the materials do not have the force of law, taxpayers and practitioners should recognize that these publications refl ect the IRS’s current view. Tax-payers and practitioners should understand the risks of engaging in transactions or practices that confl ict with the IRS’s view of the law as stated in these ma-terials. If taxpayers and practitioners disagree with the IRS’s current view of the law as stated in these materials and, after weighing the risks, engage in a transaction or practice that confl icts with the IRS’s view of the law, they should refi ne the arguments supporting their position in advance of a later ex-amination of the issue.
Many materials developed or compiled in connec-tion with the IIF Program describe the documentaconnec-tion that an examiner will ask for in an audit, as well as the IDRs that the agent will issue to the taxpayer. Taxpayers should review these materials to ensure that they are developing, retaining and organizing the documentation that the IRS will expect. First, at the time of the transaction, the taxpayer should be sure to create and preserve the type of information the IRS will request. Second, by preparing, even well in advance of the audit, to provide documentation to an agent, the taxpayer can help encourage the audit to proceed at a reasonable pace. With all of the pres-sure agents face to remain current, having responses carefully prepared in advance for the IDRs one knows will be forthcoming will improve the atmosphere surrounding an audit, if not the substantive result. Taxpayers should thus review any pattern IDRs and ensure that they will be able to respond promptly and accurately.
During the Audit
Be Proactive
Taxpayers should approach an audit of a tiered issue differently than an audit of a nontiered issue. Rather tie taxpay g i ers an s in th d pract fi the uld ev n issue a ha te s beeen n a an a d
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actic rovi l in ffthan simply waiting for and then responding to an agent’s requests, the taxpayer should be proactive and present its case to the exam team as if it were presenting a case to Appeals. The taxpayer should be ready with documentation, responses to mandatory or optional IDRs, and well-developed factual and legal arguments.15 The taxpayer may also wish to ask outside
persons involved in the issue, such as consultants or technical specialists, to be available to speak to the exam team. Taxpayers also should be proactive about directing examiners to substantiation and should explain its relevance, rather than just providing the examiners with documents and leaving the examiners to discern the relevance of the material.
Taxpayers should work to defi ne the direction of the audit. If a taxpayer has an issue that is similar to a tiered issue, but not identical, the taxpayer should explain why its facts are distinguishable from the actual tiered issue to help the agent avoid mistakenly labeling the issue as tiered. A taxpayer has a much better chance of preventing a mislabeling of an issue from the outset than succeeding in having an issue recharacterized once the audit is underway.
Even if the taxpayer agrees that its issue is a tiered issue, it still must be proactive to defi ne its case from the beginning of the audit. For example, the taxpayer can review sample facts in IRS guidance and explain why its facts are distinguishable from the facts in the guidance. The taxpayer also should draft its IDR responses carefully to defi ne the issue, as the initial IDR responses are critical in infl uencing the direction that the examiners will take.
Do Not Argue the Law
A taxpayer or practitioner generally will not benefi t from arguing the law with an agent. The IRS’s legal position on a tiered issue is developed with input from many different parties, including the IOE and IMT, and an agent does not have the authority to change the IRS’s position on that issue. If the taxpayer or practitioner has a novel argument or seriously be-lieves that an aspect of the IRS position is extremely misguided, there may be some benefi t to discussing the law with the IRS. This discussion, however, should take place with the IMT, not an agent.
Even if a taxpayer or practitioner is able to elevate the discussion to the IMT, the taxpayer or practitioner should recognize that the IRS already has deliberated on the law and may not be open to reconsidering its view. The IRS generally prefers to resolve cases at the lowest possible level. Although LMSB has stated
that it encourages the IOE and IMT to be engaged in a dialogue with external stakeholders, it admits that its success on this point has varied. In general, if an issue is case-specifi c, the IRS encourages taxpayers to proceed according to the rules of engagement and the appropriate lines of authority. The IRS “Issue Tiering Fact Sheet” states that “[t]axpayers should address questions pertaining to their specifi c cases through their examination team and management chain under LMSB’s normal Rules of Engagement,” but recognizes that “[i]n some instances, it may be appropriate for taxpayers to discuss general—but not case-specifi c— questions regarding an issue with the Issue Owner Executive. Such communications should be fully transparent and with the goal of ensuring that any direction or guidance issued on the issue considers all relevant facts.” If a taxpayer has general questions about an issue that are not case-specifi c, the IOE or IMT may be more willing to engage in discussion.
Work With Others
Taxpayers and practitioners should recognize that tiered issues tend to be common to many taxpayers across several industries. As a result, other taxpayers and practitioners may be helpful resources in dealing with a tiered issue. Taxpayers and practitioners with the same tiered issue can work together to learn about each other’s facts, understand the IRS’s approach, form coalitions and work to get the most favorable case before a court. If a particular tiered issue is new and the IMT is still formulating its strategy with respect to that issue, taxpayers with a common issue may benefi t from accelerating the cases with the most favorable facts—this may help infl uence pattern IDRs, augment any impetus to give exam teams fl exibility on the issue and improve the taxpayers’ overall legal position.
Consider the IRS’s Docket
Taxpayers and practitioners should consider the IRS’s docket on their issues and form their strategy accordingly. They should look at cases that the IRS is litigating, evaluate the facts in those cases, and distin-guish their own facts from those cases. Taxpayers and practitioners should also consider the strength of their case in relation to cases that may be further along in audit and/or controversy. For example, a taxpayer with very favorable facts should try to accelerate the pace of their audit. Because the IOE and IMT do not want to make the law with cases that have good facts, a taxpayer may achieve a favorable settlement if it can push its case to the front of the IRS docket.
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The exam team is required to present proposed settle-ments of a tiered and listed issue to the Technical Advisor, Issue Specialist and/or Counsel before agree-ing to any resolution with the taxpayer other than the taxpayer’s full concession. The IOE also must agree to any settlement of a tiered and listed issue. If an issue is tiered but not listed, whether the settlement must be presented to the IMT may depend on several factors, including: (1) issue maturity (i.e., how well developed is the IRS position, whether other cases have been settled, etc.); (2) whether the settlement is consistent with any published guidance; and (3) whether the issue has been designated or is being considered for litigation.
Taxpayers and practitioners should also consider alternatives to litigation. Fast Track may be available to resolve tiered issues. Although the taxpayer, exam team, IMT coordinator and
the Fast Track coordina-tor must agree to use Fast Track, there may be several benefi ts to choosing to me-diate rather than litigate. First, parties in Fast Track agree to seek a resolution within 120 days, which may conserve the tax-payer’s resources. Second, the taxpayer may be able
to achieve agreement with the relevant IRS decision-makers and thus have a higher degree of certainty in the outcome. Taxpayers, however, should remember that Fast Track is a mediation process, and thus must be approached with an expectation of compromise.
If a taxpayer thinks Fast Track is a viable option, the taxpayer generally should try to get support from the exam team fi rst. If the exam team agrees, it may be willing to contact the other constituencies, including the IMT coordinator and explain why your issue should be resolved in Fast Track. Once a taxpayer proceeds to Fast Track, the taxpayer should be prepared to address the views and concerns of all constituencies involved in the process. For example, the IRS may be more receptive to settlements that can be used in other cases.
Case Study
As discussed above, taxpayers and practitioners dealing with tiered issues should be familiar with
both (1) IRS materials describing procedural aspects of the IIF Program and (2) relevant substantive IRS guidance on tiered issues. This section provides a case study of how taxpayers and practitioners with the Tier I issue of research credit claims can use these materials. Although these materials do not necessarily describe the correct interpretation of the law,16 they
do describe the IRS’s current approach and should be evaluated by taxpayers and practitioners as such as an aid in case preparation.
The Research Credit Claims Quick Reference Guide summarizes the issue as follows:
Formal and informal Research Claims are fi led using high-level estimates, invalid assumptions, lack of nexus between qualifi ed research expens-es (QREs) and the businexpens-ess component without contemporaneous documentation to support the claim. Major accounting fi rms and professional boutique fi rms market research credit studies as a tax product, and in many instances are preparing these claims on a contingency fee basis. Thus, a taxpayer faces limited risk when claims are prepared under a contingency fee agreement. Audit teams expend enormous resources perfecting these claims and generally disallowing a large portion of the claim.17
This description provides taxpayers and practitio-ners with insight as to how the IRS views the issue, and how individual agents are likely to approach the issue. Agents are likely to be generally suspicious of research credit claims, especially if they appear to result from prepackaged products. They are likely to focus on whether the taxpayer can provide contem-porary documentation and are likely to evaluate the taxpayer’s estimates, assumptions and nexus.
Taxpayers and practitioners can gain a better under-standing of the audit process and lines of authority with respect to a particular tiered issue by reviewing internal (but public) IRS memoranda regarding that issue. For example, Industry Director Directive #2 on the research credit claims issue describes certain IRS procedures in examining a research credit claim.18
According to the directive, a research credit claim not
The IRS could improve the
program by clarifying the authority
and role of examiners; facilitating
dialogue between the IOE, IMT
and external stakeholders; and
generally responding to taxpayer
and practitioner concerns.
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currently under examination is not subject to manda-tory examination, but exam teams will perform a risk assessment to determine whether the claim should be examined, considering “adjustment potential, future year impact, resources, and the abusiveness of the research credit claim.”19 If research credit claims are
currently under examination, exam teams must issue the mandatory IDR unless the examination has not progressed beyond the mid-point of the examination, in which case the IMT recommends that the IDR be issued if “substantial examination activity” has not been performed on the claim.20
The IRS has published a “Research Credit Claims Audit Technique Guide” (RCCATG),21 which may
assist taxpayers in understanding what examiners will focus on in an audit. For example, the RCCATG frequently states that examiners should be wary of estimates provided by the taxpayer. As a result, tax-payers and practitioners should begin organizing all relevant documentation to ensure they are able to respond promptly to documentation requests. The RCCATG also indicates that examiners will focus on the nexus between expenditures and qualifi ed research activities, especially the accounting method or approach used by the taxpayer to demonstrate this nexus. A taxpayer should be prepared to respond to questions on nexus.
As the Quick Reference Guide and Industry Director Directive #2 describe, a taxpayer under examination for a research credit claim generally will be issued a mandatory IDR. Because these IDRs are likely to be the fi rst request made of the taxpayer at the beginning of an examination, a taxpayer can begin formulating responses in advance of an examination or even when a return with a research credit claim is fi led.
The initial IDRs are important because they may set the focus of the examination. The RCCATG instructs examiners that “the responses to the mandatory IDR will identify the issues that you will need to focus on and will assist you in developing an audit plan.” For example, the fi rst question in the mandatory IDR concerns whether the taxpayer retained a third party
to assist it in preparing the claim and, if so, whether the taxpayer paid a fee contingent on the amount of the research credit ultimately allowed under the claim. Examiners are likely to be skeptical of the tax-payer’s claim if the answer to both of these question components is yes. Other questions highlight areas that examiners will focus on, including contempora-neous documentation, whether the taxpayer made a Code Sec. 280C(c)(3) election, whether the taxpayer aggregates its research expenditures with other mem-bers of a controlled group, and the methods used to calculate the claim. By knowing these areas of focus in advance, taxpayers and practitioners can plan to address these issues.
A taxpayer should not rely on an examiner to substantiate its claims. In fact, the Quick Reference Guide states that a goal in auditing research credit claims is “not to expend audit resources reconstruct-ing taxpayer claims, but to audit only claims that can be properly substantiated. This IDR will enable the determination. If the claim is not adequately supported, a Notice of Claim Disallowance may be warranted.” Taxpayers and practitioners should be ready to present documentation and substanti-ate its claim at the beginning of an audit to avoid quick disallowance.
Conclusion
Taxpayers and practitioners may be justifi ed in their criticisms of the Industry Issue Focus Program. The IRS could improve the program by clarifying the authority and role of examiners; facilitating dialogue between the IOE, IMT and external stakeholders; and generally responding to taxpayer and practitioner concerns. Taxpayers and practitioners, however, also can assist in improving the functioning of the IIF Program by understanding the process. Furthermore, taxpayers and practitioners should recognize that they can improve the likelihood of successfully resolving a tiered issue by taking a proactive approach to plan-ning and controversy.
1 Although the program was introduced as
the “Industry Issue Focus Program,” the IRS currently refers to the program as “Issuing Tiering.” See, e.g., IRS, Issuing Tiering—
LMSB, available at www.irs.gov/businesses/ corporations/article/0,,id=200567,00.html.
2 Use of a name that includes “abuse” does
suggest that the issue has been pre-judged.
3 For more information on Fixed,
Determin-able, Annual, Periodical (FDAP) income, see
www.irs.gov/businesses/small/international/ article/0,,id=96404,00.html.
4 The IRS currently states that “LMSB
will not ‘demote’ issues from higher-priority to lower-higher-priority tiers.” IRS, Issue
Tiering Fact Sheet—LMSB, available at
www.irs.gov/businesses/corporations/ article/0,,id=200574,00.html. This appears
to be a recent change in policy, as the IRS previously had demoted “Backdated Stock Options” from Tier I to Tier II in April 2008. Backdated Stock Options is now listed as a Tier I issue in the monitoring stage.
5 Id.
E
NDNOTES xpaye r c aminat l at the beg ion or i fi begin ormula even w d he ause t CCATTG y in ma st y ruct Tax n i p m y prooving th p he tit uncctiooni , n , g of thhe IIF R. B ausBeca rch ressea th an xpa adv est at ma ion van ade n, a nce e of tax of a h n e6 Id.
7 Other types of “Code Sec. 118 Abuse” (not
involving universal service fund, bioenergy payments, and environmental remediation) are not yet in the monitoring phase.
8 IRS, Issue Tiering Process Frequently
Asked Questions, available at www. i r s . g o v / b u s i n e s s e s / c o r p o r a t i o n s / article/0,,id=204371,00.html.
9 A helpful starting point for information on
the IIF Program is the main “Issue Tiering” page at the IRS website. IRS, Issuing Tiering—
LMSB, available at www.irs.gov/businesses/ corporations/article/0,,id=200567,00.html.
10 IRS, Internal Revenue Manual—4.51.5
Industry Focus and Control of LMSB Compli-ance Issues, available at www.irs.gov/irm/ part4/ch43s05.html.
11 IRS, Internal Revenue Manual—4.51.1 Rules
of Engagement, available at www.irs.gov/ irm/part4/ch43s01.html.
12 IRS, “Internal Revenue Manual—4.51.6 Issue
Management Process Guide,” available at http://www.irs.gov/irm/part4/ch43s06.html.
13 See, e.g., IRS, LMSB Tier I
Issue—Re-search Credit Claims, available at www.irs.gov/businesses/corporations/ article/0,,id=200599,00.html. Links to
guidance for each tiered issue may be found on the main “Issue Tiering” page. IRS, Issuing Tiering—LMSB, available at
www.irs.gov/businesses/corporations/ article/0,,id=200567,00.html.
14 See, e.g., IRS, Tier I—Research Credit
Claims, available at http://www.irs.gov/pub/
irs-utl/quickrefre.pdf.
15 Although, as further described in the text,
a taxpayer generally will not benefi t from arguing the law with an agent, a taxpayer should be prepared in advance with its legal arguments so that the taxpayer may present (a) facts in support of its legal position to the agent, and (b) its legal position to the IMT when appropriate.
16 See David L. Click, Zeal and Activity in
the Arena of the Research Tax Credit, 121
TAX NOTES 1305 (Dec. 15, 2008), 2008
TNT 242-48 (Dec. 16, 2008). Mr. Click
argues that the IRS uses the IIF program to undermine taxpayer’s ability to claim the Code Sec. 41 research credit by adopting an overall “skeptical attitude” to the research credit in its IIF materials, creating a higher standard of documentation through its IIF audit guidelines, and using IIF audit guide-lines to “avoid Administrative Procedures Act requirements, including the notice and comment period associated with the promulgation of regulations.”
17 See, e.g., IRS, Tier I—Research Credit
Claims, available at www.irs.gov/pub/irs-utl/ quickrefre.pdf.
18 IRS, Industry Director Directive #2 on
Research Credit Claims (Jan. 15, 2009), available at www.irs.gov/businesses/corpo-rations/article/0,,id=202712,00.html.
19 Id. 20 Id.
21 IRS, Research Credit Claims Audit
Tech-niques Guide, available at www.irs. gov/businesses/article/0,,id=183208,00. html.