IRS Launches New Industry Issue Focus Strategy

By Scott E. Powers, J.D., LL.M.; James E. Brennan, CPA

Editor: John L. Miller, CPA

To keep pace with changing business environments and cope with limited government resources, the IRS has implemented a new Industry Issue Focus (IIF) strategy to concentrate on high-risk tax issues. In recent years, the Service has begun to address issues associated with the dynamic nature of the global business environment in which some of its taxpayers operate. These taxpayers often retain sophisticated tax advisers who arrange very complex transactions in an effort to reduce their clients’ overall U.S. tax. With this challenge comes the realization that the IRS must make certain that specific industry issues are properly addressed.

The IRS Large and Midsize Business Division (LMSB) has jurisdiction to examine business taxpayers with $10 million or more in assets. Fiscal-year 2006 statistics indicate that LMSB taxpayers paid approximately $206 billion in taxes and filed 175,862 returns, many of them thousands of pages long (see, e.g., “Industry Issue Focus (IIF) Fact Sheet—March 2007,” available at,,id=168490,00.html (IIF Fact Sheet)). For example, the IRS announced that, on paper, General Electric’s e-filed return would have been approximately 24,000 pages long, the nation’s longest tax return; see IR-2006-84, available at,,id=157845,00.html.

To examine these taxpayers and returns, the Service employs 5,132 revenue agents and LMSB specialists (this number does not include support personnel involved in these compliance efforts). The IRS believes that LMSB taxpayers deserve more attention, because government estimates for 2006 indicate that they account for $25 billion (7%) of the tax gap (the difference between estimates of taxes that should be paid and taxes actually collected).

LMSB Tax Compliance

As part of the new IIF strategy, the LMSB has implemented a system for prioritizing tax compliance issues. This system is designed to provide nationwide oversight on important designated issues to ensure consistency in issue resolution across industry lines; see “Industry Issue Focus,” available at,,id=167377,00.html. The LMSB’s implementation of this strategy, which identifies and manages specific issues, should materially alter the Service’s approach to these issues during taxpayer examinations. In addition, the IRS recently published Internal Revenue Manual Section 4.51.5, Industry Focus and Control of LMSB Compliance Issues, which further describes the new strategy; see

Under the updated procedures, Service field functions identify potential compliance issues from various sources, both internal (examinations) and external (outside stakeholders, new legislation, etc.). Issues are received from the Pre-Filing and Technical Guidance technical advisers, Industry Counsel, Schedule M-3 reviews and other specialist programs (international and field specialists). Known cross-industry issues are submitted for consideration to all affected industries by technical advisers or other submitters. In addition, industry directors, director field specialists and directors of field operations identify issues for each sub-industry through attendance at sub-industry meetings and field visits.

The identified issues are then ranked and tiered based on their prevalence in the respective industry and relevance to compliance risk. Other factors include:

1. Visibility and uncertainty surrounding the issue’s tax treatment due to new legislation or litigation;

2. Materiality, in terms of affecting a large number of taxpayers, resulting in large audit adjustments or requiring significant time spent by agents examining the issue; and

3. Potential for abusive tax avoidance or promotion.

A Compliance Strategy Council (CSC) reviews all proposed Tier I and Tier II issues. After the CSC approves an issue for a tier designation, it assigns ownership to an industry or specialty area. IRS management’s attention and resource deployment focus on those areas with the greatest risk. Other benefits engineered into the design of the tiered classification system include increased operational efficiency, ability to leverage technology, experience to identify and prioritize tiered issues, increased examination coverage and flexibility in resource deployment; see IIF Fact Sheet.

Although designated issues can be classified into one of three tiers, at press time, the IRS has not designated any Tier III issues. According to Barry B. Shott, LMSB industry director for financial services, the Service is currently developing industry-related Tier III issues, which typically are those that should be considered by LMSB teams when conducting their risk analyses; see Tandon, “LMSB Releases Details on New Tiered System for Compliance Issues,” Tax Notes Today, 2007 TNT 49-2 (3/13/07). Tier III issues will be listed by industry on a centralized website along with Tier I and II issues; links will be provided to available guidance (e.g., audit technique guidelines) on industry or technical adviser websites to promote consistent development and resolution throughout the LMSB.

For issues classified as Tier I or II, an issue owner executive with nationwide jurisdiction is assigned to coordinate the IRS’s examination efforts on the individual issue. Once these issues are identified, issue management teams, composed of personnel from many different Service areas (e.g., counsel, technical advisers, appeals staff and field representatives) develop guidance for examination teams nationwide and provide instruction on the examination processing of each issue. IRS Commissioner Mark Everson, in July 2006 testimony to the Senate Finance Committee, noted the formation of issue management teams to provide executive oversight and focus on high-risk areas (similar to the approach used by the Service in formulating tax-shelter settlement initiatives over the past several years); see “Written Testimony of Commissioner of Internal Revenue Mark Everson before Senate Committee on Finance on Compliance Concerns Relative to Large and Mid-size Businesses, June 13, 2006,” available at

Tier I

Tier I addresses issues that the IRS has classified as having the utmost strategic importance and the most significant effect on one or multiple industries. After the Service categorizes an issue as Tier I, LMSB-wide coordination and executive oversight are required to ensure examination coverage, consistent development and issue resolution. At press time, the IRS had designated the following as Tier I issues (see “Industry Issue Focus—Tier I Issues,” available at,,id=167379,00.html):

  • Domestic production activities deduction (Sec. 199);

  • Research and experimentation credit claims (Sec. 41);

  • Transfer of intangibles offshore/cost sharing;

  • Foreign tax credit generators;

  • Foreign earnings repatriation (Sec. 965);

  • International hybrid instrument transactions;

  • Mixed service costs;

  • Nonshareholder contributions to capital (Sec. 118);

  • Exit strategies (Sec. 936);

  • Department of Justice settlements (Sec. 162(f));

  • Backdated stock options; and

  • Nonqualified deferred executive compensation (Sec. 409A).

In addition, Tier I includes two tax-shelter transactions: distressed asset/debt and redemption bogus optional basis, and all currently listed transactions; see Notice 2004-67 and “Listed Abusive Tax Shelters and Transactions,” available at,,id=120633,00.html.

Tier II

Tier II issues represent areas of potential high noncompliance and/or significant compliance risk to the LMSB or an industry. At press time, the following were designated as Tier II issues; see “Industry Issue Focus—Tier II Issues,” available at,,id=167381,00.html:

  • Casualty loss: single identifiable property/capital vs. repairs;

  • Cost-sharing, stock-based compensation;

  • Enhanced oil recovery credit (Sec. 43);

  • Extraterritorial income exclusion effective date and transition rules;

  • Gift cards: deferral of income;

  • Healthcare accounting issues: contractual allowance;

  • Interchange merchant discount fees;

  • Nonperforming loans;

  • Specified liability losses (Sec. 172(f));

  • Deferred home construction contracts;

  • Super completed-contract method; and

  • Upfront fees, milestone payments and royalties in the biotech and pharmaceutical industries.


The tiered system allows the LMSB to resolve certain issues across industry lines. In particular, the Service desires consistency in issue resolution and enhanced oversight and accountability.

Although the entire new IIF strategy has yet to be fully made public, it is apparent that the plan removes discretion from examination teams and places it under the centralized control of issue owner executives and issue management teams with nationwide influence for identification, development and resolution of designated issues that pose significant compliance risks. The discretion afforded examination teams in applying the guidance depends on the issue’s tier designation. Guidance developed for Tier I issues will be nondiscretionary: field personnel must implement the guidance determinations in all cases and may not use discretion when applying them. They will, however, be able to use discretion when applying guidance developed for Tier II (and most likely Tier III) issues, based on the facts and circumstances of each case.

In response to these new initiatives, taxpayers need to be especially attentive in establishing their positions on tiered issues. If the IRS requests information about a designated issue, the taxpayer should be prepared to respond quickly with the relevant information. A prompt, effective and comprehensive response to the examination team may provide opportunities (such as alternative dispute resolution) for early and more taxpayer-favorable resolution of these issues than would have otherwise been available.

Finally, given the IIF strategy’s clear purpose of promoting consistency and centralizing management control over the resolution of tiered issues, the migration of case control may further stretch Service resources. Many of the facts relevant to the designated issues are frequently developed during the examination stage. With nondiscretionary procedures for tiered issues that remove control from examination teams, one significant question is how the IRS will be able to continually exercise centralized management of these issues.

Mr. Miller is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. Mr. Brennan is the chair, and Messrs. Snow and Tierney and Ms. Hodes are members, of that committee. For further information about this column, contact Mr. Miller at

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