Trends in Federal Tax Planning and Compliance for 2004

Tax Controversy Alert
01.14.04

The coming year in the Federal tax area here in Washington, D.C. is more difficult than most to predict. Major, un-passed tax legislation from last year remains pending, but because it is a Presidential election year (and one that promises to be highly partisan), popular sentiment is that it may be hard for the politicians to agree to pass anything. There will be new players with potential new agendas at key positions within the tax system, including at the IRS and Treasury. Tax administration is clearly moving in a new direction, away from an emphasis on taxpayer education/service and towards tax compliance, but constraints on IRS resources make it unclear how much change we will see in the compliance area. For all of these and other reasons, it is hard to know what the specifics of 2004 are likely to be. For the reasons explained below, however, we believe certain important trends in the Federal tax area are clear.

Tax Legislation

There are an unusually large number of tax bills that were considered but not passed last year, including bills dealing with expiring tax provisions, technical corrections, individual taxes (charitable deductions, child credit refunds, estate tax repeal, expatriate limitations, simplification, and taxpayer protections), the pension funding rate fix, energy tax incentives, international taxes (ETI replacement, earnings stripping, and simplification), the internet tax moratorium, and comprehensive tax compliance (tax shelters, corporate sanction deductions repeal, and corporate inversions). Several of these bills were considered extensively last year, and Treasury and Congressional staff indicate that prospects are good for passage this year of at least some of them. See Treasury’s FY ‘05 Budget Proposals (announced January 13, 2003). However, election year vagaries make predictions hazardous on specific provisions of the pending legislation. Possible but unlikely is a major tax bill. More likely is a limited tax bill, perhaps with some of the tax compliance provisions to pay the cost. Because the legislative window is expected to be short in this election year, what happens before the Memorial Day recess is likely to be key.

As an example of how unpredictable tax legislation this year may be, consider that President Bush last year proposed a budget that included an estimated present value of the future costs of Federal retirement and healthcare programs (Social Security, Medicare, and Medicaid). That is, the President’s budget discounted to present value the estimated future budget deficits attributable to the retirement and healthcare costs of the baby boomers. The result is an eye-popping $42 trillion present value, which the President says we need today if we are to pay for such benefits in the future. Earlier this month, the Brookings Institute presented a report and announced a panel presentation by prominent Democrats generally agreeing with the estimate and taking the President to task for his tax and fiscal policies in light of the estimate. Regardless of your political persuasion, if this type of issue were to arise during the Presidential campaign, both parties likely would agree on at least one thing, the need to ensure that our tax system operates as effectively as possible to collect the proper amount of taxes, so that the prospect of raising future taxes to pay the boomers’ benefits is minimized. The ramifications of such a bipartisan agreement, if it were to occur, are difficult to predict, but it could have a major impact on the tax matters discussed above and below. The essential point is that the need for our tax system to operate, and be perceived as operating, fairly and effectively to ensure that everyone pays his, her, or its “fair share” is again in vogue, and that has ramifications for purposes of the present tax discussion.

Tax Policy and Administration

Assistant Secretary for Tax Policy Pam Olson has announced she will be leaving at the end of February. Her replacement is uncertain, particularly since the Senate confirmation window is expected to close earlier than usual in a partisan Presidential election year. The Senate is expected to confirm President Bush’s nomination of Don Korb to become the Chief Counsel after Senate Finance hearings in the early part of the coming year. Additional staff changes at Treasury are always possible, as many staffers have been in their positions for at least three years. Bob Green, previously with Proctor & Gamble, recently was appointed as the U.S. Competent Authority.

Commissioner Everson has been putting his new team in place, and with Don Korb’s anticipated confirmation, his team should be on board. The new Commissioner is taking a very tough stance on tax noncompliance. During his confirmation hearings last year, he stated:

The IRS must deter those who might be inclined to evade their tax obligations, and appropriately pursue those who actually do. A substantial element of a proper enforcement posture will be closer work with practitioners. There are clear signals that professional standards have eroded in some corners of the practitioner community. Attorneys and accountants should be the pillars of our tax system, not the architects of its circumvention.

As the new Commissioner, Everson last year sent continued signals that he intends to get tough on the promoters, users, and facilitators of overly aggressive tax reduction transactions (“TRTs”). The reason became apparent last year, as it became increasingly clear that the IRS is facing a widespread tax noncompliance problem that includes not just large corporations, but taxpayers of all sizes and kinds. Each of the IRS operating divisions last year announced major, new initiatives to deal with indications of substantial and growing tax noncompliance, including not only LMSB for large and mid-sized businesses and SBSE for smaller businesses, individuals, and trusts, but also TEGE for charities and other tax-exempt organizations, retirement plans, and tax-exempt bonds.

Commissioner Everson appointed as his Deputy Commissioner for Services and Enforcement Mark Matthews, formerly Chief of the IRS Criminal Investigation Division. Everson also recently created the Office of Professional Responsibility (previously called the Office of the Director of Practice), announced that the size of that office would be doubled, and appointed as that Office’s initial Director Cono Namarato, a tough, no-nonsense, well-respected criminal tax attorney who previously served as an Assistant Attorney General (Criminal Tax) in the Tax Division of the Department of Justice. Although it remains to be seen what these appointments will mean, it is expected, under Everson’s leadership, that Matthews will reallocate resources within the IRS to deal with promoters (including large accounting firms, law firms, and investment banks that aggressively market TRTs) and with taxpayers that purchase or use such TRTs. It is anticipated Namarato will begin to deal with tax professionals who are involved with promoters, advise users, or provide opinions to facilitate promotion and use of TRTs. Recently proposed changes to Circular 230 and changes in the regulations dealing with the extent to which taxpayers can rely on opinions to protect them from penalties also signal a get-tough attitude toward non-compliance. See Legal Times article entitled, “Treasury Takes Aim At Tax Lawyers,” January 5, 2004, which describes some of these changes

Congressional hearings by the Senate Finance Committee last fall focused on promoters, users, and facilitators of TRTs. If necessary to the passage of pending tax compliance legislation, some Senate staffers have indicated that similar hearings can be held in the coming year. The thrust of last fall’s Senate Finance Committee hearings was to dramatize how widespread and egregious the promotion and use of TRTs had become. However, the most effective hearings to dramatize the corrosive effects of TRTs on tax compliance and tax practitioner professional standards were two days of hearings last November by Senate Governmental Affairs Permanent Investigations Subcommittee, the staff of which had been investigating TRTs for over a year. Credible evidence and testimony at the Subcommittee hearings indicated that the development and marketing of TRTs by large accounting and law firms was substantial, deliberate, and ongoing. One memorandum by a Final Four accounting firm stated clearly that the firm’s decision not to register a popular TRT (that the IRS treated as a listed transaction) was based on the determination that the firm’s anticipated profits from the sale of the TRT would be more than enough to accommodate the cost of any formal penalties the IRS might impose. The highlight (lowlight) of the hearings occurred when a well-known member of a prominent national law firm stunned the audience by taking the Fifth Amendment when asked about the hundreds of opinions he and his firm had provided to serve as penalty protection for marketed TRTs.

The cumulative effect of the revelations during these Senate hearings, the Congressional report on Enron’s tax affairs released last year, the guilty plea of HealthSouth’s Vice President of Taxes last summer, and the results of numerous TRT audits, summonses, and John Doe summons enforcement actions involving promoters and users of TRTs clearly impacted those involved in tax regulation at all levels of the Federal government. The impact was heightened further by ongoing, increasing media coverage of these TRT events. The result appears to be at all levels of government a determination for the IRS to do whatever it takes to deal effectively with past tax noncompliance and thereby to deter future noncompliance. The result is a much tougher attitude on the part of the IRS personnel in their dealings with taxpayers that are perceived as having been involved in overly aggressive TRTs.

The change in IRS attitude became apparent last year in our client dealings with IRS personnel in Examination, Appeals, Criminal Investigation, and Counsel. Generally, if a TRT became involved, the IRS became more contentious and the resolution or settlement of clients’ controversies became more difficult. Despite the scarcity of resources, IRS personnel indicated increased willingness to push cases toward litigation by refusing to budge from tough settlements and by threatening penalties if statutory notices had to be issued. For the future, we are anticipating the likelihood that the IRS will be unwilling to offer pattern settlements of TRTs under guidelines that our clients are likely to find acceptable. We also are anticipating the likely imposition of penalties in more of our clients’ cases that involve TRTs.

Because most of our clients are penalty-averse, we therefore are anticipating that more of our clients’ cases are likely to proceed to litigation. In such event, forum selection may become difficult. Based on past experience, the Tax Court has not been a friendly forum for TRTs. Although the refund forums generally have been friendlier, we are unsure what the future will hold in light of the media coverage that is beginning to link TRTs in the tax area to the prior, highly visible corporate financial transaction scandals, many of which will be litigated in the coming year. These cases, plus professional liability actions against accounting and law firms involved with TRTs, could sensitize the Federal judiciary to the tax noncompliance issues of TRTs. Our prior concern was that courts like the Tax Court and the Court of Federal Claims whose judges were located in Washington, D.C. and were exposed to the ongoing efforts of Federal regulators to dramatize the extent of taxpayer noncompliance might be less favorable forums to try TRT cases than Federal District Courts whose judges were further from the potential impact of such activity. Time will tell whether or not our prior attitude will continue in the future. Our best guess at this point is that future forum selections likely will be made on a case-by-case basis, after weighing what may be competing considerations.

Commissioner Everson, who was the Deputy Director of OMB before he became Commissioner, is attempting to obtain more resources for the IRS. There have begun to be Congressional rumblings about giving the IRS more resources. But based on past experience, only time will tell whether or not that will happen. Without additional resources, it will not be easy for the IRS to reallocate sufficient additional resources to deal with the volume of TRT cases, particularly if the IRS becomes increasingly willing to push cases to litigation. Nevertheless, we understand that within the IRS the developing attitude is to get tough with TRT taxpayers and let the IRS top-level executives worry about finding the resources to deal with the increased volume of litigation. If the IRS begins to move in this direction, Don Korb, the new Chief Counsel, and Lee O’Connor, the Assistant Attorney General for the Tax Division of the Department of Justice, could be challenged to use existing resources to handle the likely volume of resource intensive TRT cases of well-represented taxpayers. In that event, the “when,” “where,” and “how” a company’s case is litigated are likely to become even more important considerations, particularly if penalties are involved.

Interestingly, the IRS and particularly LMSB appear to be inclined to divide taxpayers with whom they deal into two different groups compliant taxpayers and noncompliant or potentially noncompliant taxpayers. The former are treated much more favorably than the latter. Compliant taxpayers are offered opportunities to participate in expedited (LIFE) audits, to accelerate entire audit cycles, to help plan their audits, to use the new LMSB programs to resolve or settle any issues that may arise during an audit, and ultimately to skip future audit cycles so the IRS can devote more resources to noncompliant taxpayers. On the other hand, taxpayers considered to be noncompliant or potentially non-compliant are unlikely to enjoy any of these benefits and instead face a harsher, more unrelenting IRS.

As is often the case, it also is our experience that IRS personnel, particularly in the Field, are not always able to tell the difference between aggressive but legitimate tax planning and overly aggressive tax planning transactions. As a result, it is not always possible to tell whether the IRS Field personnel will be able to distinguish compliant from noncompliant taxpayers. Finding ways to persuade the IRS that a company is indeed a compliant taxpayer, despite what the IRS may think of one or more TRTs in which the company has been engaged, is likely to be one of our major, difficult challenges.

For this reason, a company should focus on the importance of its classification by the IRS and on the need to avoid or extricate itself from being considered a noncompliant or potentially noncompliant taxpayer. A company undertaking a transaction that may be viewed by IRS compliance personnel as an overly aggressive TRT, may wish to consider ways to avoid or minimize such characterization or even to permit the IRS to review the transaction before it comes up in a routine audit cycle. Furthermore, if the pending tax shelter legislation, discussed above, were to be passed later this year, the stakes for a company’s tax planning with TRTs will become even higher because the scope and impact of the “economic substance” test in the legislation is even more uncertain and the penalties and other sanctions under the legislation are even more punitive and difficult to avoid.

Conclusion

As we enter 2004, we appear to be moving into a phase in which the IRS will become more focused on taxpayer compliance. The IRS will reallocate its existing resources (and ask Congress for more resources) to deal with perceived tax noncompliance. If the pending tax shelter legislation were passed, the IRS would be given substantial new techniques and sanctions to deal with perceived noncompliance. Because the IRS personnel are not always adept at distinguishing proper from improper TRTs, companies should take care in their tax planning and in their IRS compliance activities to maximize their ability to be properly characterized by the IRS as compliant taxpayers because the competitive benefits of doing so, and the corollary detriments of failing to do so, are likely to be significant.

For further information, please contact:

Larry Gibbs, lgibbs@milchev.com, 202-626-6005

David Blair

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