Details of IRS Expanded Policy of Restraint Not Yet in IRM; Range of Applicability Unclear

Editor: Mindy Tyson Weber, CPA, M.Tax.

Procedure & Administration

Though the IRS in 2010 expanded its policy of restraint in requesting audit and tax accrual workpapers, it has not yet updated the Internal Revenue Manual (IRM) to reflect those changes. Furthermore, the range of applicability of the policy expansion remains unclear. The IRS expanded the policy of restraint to cover once-privileged documents where a waiver of the privilege occurred as a result of inspection of the documents by independent auditors and to allow for redaction of tax reconciliation workpapers that contain information from Schedule UTP, Uncertain Tax Position Statement.

IRM Section 4.10.20 contains the rules for IRS revenue agents with respect to obtaining audit workpapers, tax accrual workpapers, and tax reconciliation workpapers from taxpayers during an audit. While IRS auditors should request tax reconciliation workpapers as a routine matter in IRS audits, under the policy of restraint, unless unusual circumstances or listed transactions are involved, audit workpapers and tax accrual workpapers should not be requested (IRM §4.10.20.3, Service Policy for Requesting Workpapers).

The basic elements of this policy of restraint have been in effect for more than 30 years, although important changes related to listed transactions (permitting the request of tax accrual workpapers) were implemented in 2002. In Announcement 2010-76, the IRS expanded the policy “in connection with its decision to require certain corporations to file Schedule UTP.” Because this expansion of the policy has not yet been written into the IRM, the announcement is the primary source for learning what new protections have been afforded taxpayers in light of the requirement to file Schedule UTP, on which uncertain positions taken on some tax returns must be described to the IRS.

The announcement states that:

If a document is otherwise privileged under the attorney-client privilege, the tax advice privilege in section 7525 of the Code, or the work product doctrine and the document was provided to an independent auditor as part of an audit of the taxpayer’s financial statements, the Service will not assert during an examination that privilege has been waived by such disclosure. [Emphasis added.]

However, if the taxpayer has taken any other actions that waive the privilege, or if unusual circumstances or listed transactions exist, the IRS may request the document and use enforcement efforts to obtain it. The announcement, however, also allows redaction of tax reconciliation workpapers related to Schedule UTP:

Under current procedures, examiners request tax reconciliation workpapers as a matter of course. IRM 4.10.20.3. The taxpayer may redact the following information from any copies of tax reconciliation workpapers relating to the preparation of Schedule UTP it is asked to produce during an examination:

(a) working drafts, revisions, or comments concerning the concise description of tax positions reported on Schedule UTP;

(b) the amount of any reserve related to a tax position reported on Schedule UTP; and

(c) computations determining the ranking of tax positions to be reported on Schedule UTP or the designation of a tax position as a Major Tax Position.

The announcement also states:

This announcement describes the policy of the Service for seeking the documents…from taxpayers and third parties during an examination. It does not create or imply the application of the attorney-client privilege, the tax advice privilege under section 7525 of the Code, or the work product doctrine to any document of any taxpayer or third party. [Emphasis added.]

It is unclear exactly how far throughout the IRS organizational structure the tenets of the announcement apply. Note the emphasis above on “Service” and “during an examination.”

The Appeals function is part of the IRS, as can be concluded from the following in Rev. Proc. 2012-18 (note the added emphasis):

[The Internal Revenue Service Restructuring and Reform Act of 1998] specifically directed the Commissioner to “ensure an independent appeals function within the Internal Revenue Service, including the prohibition * * * of ex parte communications between appeals officers and other Internal Revenue Service employees to the extent that such communications appear to compromise the independence of the appeals officers.”

Since the foregoing language clearly indicates the Appeals function is part of the IRS, it would seem that the expanded policy of restraint would apply when a taxpayer takes unresolved issues to Appeals. However, the passages quoted above from the announcement may mean that the expansion of the policy of restraint applies only during the examination process and not when Appeals has the matter.

This raises the issue of whether Appeals can request the taxpayer to produce the examination-privileged documents during an Appeals proceeding. As a practical matter, Appeals generally does not investigate “new” factual matters that have not been previously reviewed by the IRS’s examination function. However, based on a literal interpretation of the language in the announcement, the policy of restraint would appear to be inapplicable to Appeals. As a consequence, Appeals might be unrestrained in its information gathering.

On the other hand, the IRS has indicated in frequently asked questions (FAQs) about Schedule UTP that “the changes to the policy of restraint apply to any request for documents during the administrative process of determining the correct tax liability, which includes Appeals’ consideration of proposed audit adjustments.” However, FAQs posted on the IRS website are for informational purposes only and can be changed by the IRS at any time. Moreover, they are not official IRS guidance nor do they constitute “substantial authority,” so practitioners should be cautious about relying on them.

Another open issue is whether the expansion of the policy of restraint made by the announcement applies when taxpayers litigate unresolved tax issues and, more pointedly, whether the rules of discovery are beyond the scope of the voluntary policy of restraint. That, too, is unclear. If the litigation is handled for the government by IRS Chief Counsel attorneys, perhaps the policy of restraint could apply, and the IRS’s Schedule UTP FAQs indicate that “Counsel attorneys will not issue discovery requests for documents or information that the IRS would not seek under its policy of restraint.” But the FAQs also indicate that the application of the policy of restraint to Chief Counsel attorneys in Tax Court litigation will be addressed in a future revision of the Chief Counsel Directives Manual (parts 30 through 39 of the IRM). Also, if the Department of Justice is handling litigation for the government, for example, in a summons enforcement action, it is unlikely to adhere to the expanded policy of restraint.

Because IRM Section 4.10.20 has not been updated to reflect the changes made by the announcement, the two need to be read together. Because that is not universally known, the failure to refer to both sources could result in taxpayers’ unwittingly waiving privilege for issues they intend to litigate in instances where they provide privileged documents to their financial auditor. It would be helpful to taxpayers, their representatives, and IRS personnel if the IRM update occurred soon. Furthermore, it would be equally helpful if the IRS would clarify where within its organizational realm the expanded policy of restraint applies. While the IRS has given some additional protections over privilege and confidentiality to offset the intrusiveness of Schedule UTP disclosures, the boundaries of those additional protections should be made absolutely clear.

EditorNotes

Mindy Tyson Weber is a director, Washington National Tax in Atlanta for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.