Practice & Procedures
The IRS recently issued new directives to its Large Business and International (LB&I) division that effectively change the process by which LB&I personnel handle information document requests (IDRs). While the goal of these changes is to increase efficiency, they also present a more subtle nuance that practitioners should recognize. Rather than the previous method of issuing formal IDRs at the outset of an examination, the new directives instruct examiners to issue draft IDRs, designed to act as starting points for discussion and subsequent agreements between the IRS and taxpayers. This process culminates into formal IDRs that are specific and issue-focused.
These changes lead to uncertainty regarding the effect of the draft IDR on the 15-day disclosure window provided by Rev. Proc. 94-69. Specifically, it is unclear whether the initial draft IDR is sufficient as a written information request to begin the 15-day period for the avoidance of accuracy-related penalties under Rev. Proc. 94-69. Without further IRS guidance, practitioners would be prudent to treat the draft IDR as a written information request for the purposes of avoiding accuracy-related penalties through adequate disclosure under Rev. Proc. 94-69.
Rev. Proc. 94-69
One of the more frequently imposed penalties is the Sec. 6662(a) accuracy-related penalty, which is imposed if a taxpayer's underpayment of tax is substantial or is due to negligence or disregard of the rules or regulations (Sec. 6662(b)). However, adequate and timely disclosure of any contrary position provides safe haven from an accuracy-related penalty being imposed on that item, so long as the position is supported by at least a reasonable basis (Sec. 6662(d)(2)(B)(ii)). This disclosure must be made on a Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement (if the position being disclosed is contrary to a regulation), attached to the taxpayer's original return or a qualified amended return (Regs. Sec. 1.6662-4(f)(1)). A qualified amended return is an amended return or a timely request for administrative adjustment filed after the return's due date (determined with regard to extensions of time to file) but before the taxpayer is contacted by the IRS concerning an examination of the return (Regs. Sec. 1.6664-2(c)(3)(i)).
Notwithstanding the timing requirements outlined in the regulations, Rev. Proc. 94-69 provides certain taxpayers the ability to satisfy the adequate disclosure requirement after being contacted about an examination. Specifically, Rev. Proc. 94-69 allows taxpayers to avoid the accuracy-related penalty if they disclose any contrary positions in a written statement within the 15-day window beginning with the IRS's first written information request. Similar to the regulations, Rev. Proc. 94-69 still requires the taxpayer to have a reasonable basis for the position.
A written statement made under the rules of Rev. Proc. 94-69 is treated as a qualified amended return for purposes of the disclosure exception to the accuracy-related penalty. Under Rev. Proc. 94-69, the description of the item in the statement is considered adequate if it contains information that reasonably may be expected to apprise the IRS of the identity of the item, its amount, and the nature of the controversy. If the taxpayer takes a position that is contrary to a rule or regulation, the statement must adequately identify the statutory or regulatory provision or the ruling in question.
The plain language of Rev. Proc. 94-69 suggests that these special disclosure provisions apply only to taxpayers designated as Coordinated Industry case taxpayers (CI), which were known as Coordinated Examination Program (CEP) taxpayers when Rev. Proc. 94-69 was issued. Taxpayers designated as CI are the largest taxpayers and are usually under regular annual IRS audit. Despite the apparent limitations of this plain language, Rev. Proc. 94-69 applies to all taxpayers, not just those designated as CI, as the IRS cannot discriminate between or treat similarly situated taxpayers differently (see Computer Sciences Corp., 50 Fed. Cl. 388 (2001) (holding that the IRS cannot discriminate between similarly situated taxpayers absent a rational basis for the discrimination); see also Oshkosh Truck Corp., 123 F.3d 1477 (Fed. Cir. 1997); and International Business Machines Corp., 343 F.2d 914 (Ct. Cl. 1965)). In practice, an IRS examiner will likely initially cite to the language of Rev. Proc. 94-69 and deny extending it to smaller taxpayers, but producing the case law providing otherwise has been sufficient to convince examiners of its universal applicability.
LB&I IDR Directives
Recently, the IRS recognized that, because of the broad scope of the formal IDR process, response times for information requests were excessively long. Because formal IDRs were issued before significant discussions between the IRS and taxpayers occurred, examiners were armed with less information, which forced examiners to issue more-extensive IDRs than they would have otherwise. The resulting inefficiencies led to the new LB&I directives on the IDR process.
Now, instead of the formal IDRs, LB&I examiners are to issue draft IDRs to taxpayers at the beginning of the examination. The draft IDRs should give taxpayers a general idea about the subject matter and scope of the forthcoming examination. They are not specific requests for information, but rather starting points to begin determining what information and documents are actually needed to complete a thorough examination.
Following discussions between the IRS and the taxpayer, the parties are to reach an agreement that dictates the content of the formal IDRs. Because the initial discussions are, in part, investigatory, the formal IDRs resulting from this process are considerably more specific and should lead to a smoother examination.
Before the new LB&I IDR directives were issued, the timing of the beginning of the 15-day disclosure window was undisputed. Because all IDRs constituted formal information requests, taxpayers generally had 15 days following the issuance of the first IDR to avoid penalties through disclosure. Now, this simplicity has vanished. Without any formal or informal guidance from the IRS following the issuance of the directives, it isn't clear which IDR begins the 15-day disclosure period provided under Rev. Proc. 94-69. Absent clear direction, practitioners must take positions on the issue blindly.
One argument is that the draft IDR does not actually request anything from the taxpayer and, as such, is not sufficient to constitute a written information request. And because the taxpayer is not actually required to produce information or documents until a formal IDR is issued, the disclosure period should not begin until then. Nonetheless, waiting until the formal IDR is issued before disclosing is risky.
Like most things, the IRS's position on this issue will more likely than not be the opposite of the taxpayer-friendly position. That is, the IRS will likely consider the 15-day disclosure period to have begun upon the issuance of the draft IDR at the outset of the examination. Part of the rationale behind the short disclosure window in Rev. Proc. 94-69 is to provide grace to taxpayers willing to make admissions regarding their returns before they know whether the disclosed information will be obtained by the IRS regardless of their cooperation. Allowing taxpayers to wait to disclose until after the initial discussions with the IRS at the beginning of the examination encourages taxpayers to "feel out" the IRS and determine what the Service knows or what it will find out during the examination. This selective disclosure is contrary to the purpose of a voluntary disclosure process, including the one in Rev. Proc. 94-69.
In addition to these reasons, the IRS still retains the ability to control the conduct of examinations. That is, if taxpayers are successfully using the new IDR process to selectively disclose, the IRS could simply alter the process to prevent this, such as issuing, along with the initial draft IDR, a formal written information request for a comparably de minimis item. That small request would be sufficient to begin the Rev. Proc. 94-69 disclosure window at the same time the IRS issued the draft IDR.
Most of the time the safer option on an unsupported or weakly supported item in a tax return is recommended, but even more so on this issue. Simply put, accuracy-related penalties can be significant, and the benefit of waiting to disclose under the new LB&I directives does not outweigh the value of avoiding accuracy-related penalties under Rev. Proc. 94-69.
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP