The Internal Revenue Service has issued a third Industry Director Directive (IDD) potentially affecting any taxpayer that has relied on section 118 to exclude from income payments received from a governmental entity. More significant than the technical position asserted in the IDD, however, is the "generic" Information Document Request (IDR) issued with it. This IDR indicates a disturbing expansion of the IRS's policy regarding demands for information regarding the advice of outside professionals and internal deliberations ?? even in otherwise routine audits.

Under the new IDD, all taxpayers relying on section 118 to exclude receipts from income -- regardless of circumstances -- may be asked to provide the IRS not only with the related tax accrual work papers, but also with copies of any communications with internal or outside tax advisors on the issue. Even more troubling, where the taxpayer's internal and outside tax advisors provided different advice, the taxpayer may be asked to describe the basis for the differing views and the taxpayer's thought processes in resolving or reconciling the differences.

Specifically, the IDR asks the following with respect to each payment excluded from gross income:

• Whether the taxpayer received advice from outside professionals, including counsel, accountants, auditors, investment bankers, or consultants (referred to as Outside Professionals in the IDR).
• If so, the taxpayer is asked to describe the fee arrangement, and to provide the engagement letter and copies of all communications discussing the tax treatment of the excluded items, including legal opinions, comfort letters, analyses, memoranda, recommendations, and emails.
• Whether the taxpayer received advice from its internal legal or tax departments.
• If so, the taxpayer is asked to state from whom, and to provide copies of all communications with respect to such advice, including any meeting minutes or notes, analyses, memoranda, recommendations, and emails.
• If the a advice from the taxpayer's Outside Professionals and internal departments differed, the IDR asks the taxpayer to state the basis of the difference and the steps taken to reconcile the difference in forming its tax position.
• Whether the taxpayer relied upon the internal and/or the outside advice provided.
• If the taxpayer does not provide all information responsive to the request, the taxpayer is requested to provide a comprehensive explanation of the reasons for withholding the information.

The breadth of this request is extraordinary, and in our opinion, wholly inappropriate as a "one size fits all" policy where there is otherwise no indication of an abusive tax position. Although the application of section 118 has been designated a Tier 1 issue, there is no inherent abuse present in the application of section 118. In the vast majority of situations, taxpayers' application of the provision falls squarely within the scope of the relief intended to be provided by Congress.

Equally alarming is the prospect that this may signal the IRS's inclination to begin demanding all such information ?? including a description of the taxpayer's thought processes in determining how to employ tax advice ?? with respect to any Tier 1 issue.

Section 118 has been designated a Tier 1 issue under the IRS's Industry Issue Focus initiative. LMSB has issued two prior IDDs with respect to issues arising under section 118. The new IDD rejects the continued existence of a common law doctrine similar to section 118. LMSB-04-1007-069 (October 5, 2007). The IDD directs examination teams to challenge all arguments raised by taxpayers operating in a non-corporate form that amounts are excludible from income as a contribution to capital under section 118 "or any other theory." Examination teams are further directed to issue the generic IDR asking the taxpayer for a list of all section 118 exclusions from income.

On its face, the compliance concern identified in the new IDD is limited to taxpayers operating in non-corporate form, and presumably its direction to issue the generic IDR should be limited to such taxpayers. However, the "audit techniques" section of the IDD is stated more broadly and could be interpreted to require the issuance of the generic IDR to any taxpayer that has or may have excluded governmental payments under section 118. As a result, any taxpayer that has excluded a governmental payment, subsidy, or incentive from income in reliance on section 118 should be on the alert for this IDR.

In responding to this IDR, taxpayers should carefully consider the availability of a privilege to disclosure, including the attorney-client privilege and the work-product doctrine. The recent decision in United States v. Textron, Inc., 100 AFTR 2d 2007-5848 (D. R.I. 2007) is instructive.

Miller & Chevalier is available to assist taxpayers in determining the most appropriate response to this IDR and to defend against LMSB challenges to the application of section 118.

For further information, please contact any of the following lawyers:

Patricia Sweeney, psweeney@milchev.com, 202-626-5926

James Atkinson

Dwight Mersereau

The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

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