Internal Revenue Service and Tax Executives Institute large case audit program best practices.

Executive Summary

The Illinois District of the Internal Revenue Service and the Chicago Chapter of Tax Executives Institute have taken an in-depth look at the Coordinated Examination Program as it exists in the Illinois District. The goal was to identify the Best Practices that both the IRS and the Taxpayer community were utilizing in conducting successful large case examinations in the District.

The IRS Team, under the direction of District Director Robert Brock, was composed of Larry Barzyk, CEP Branch Chief; Frank Rodjius, CEP Case Manager; Howard Martin, International Manager; Mark Janus, Engineering Manager; and, Jack Aurora, Industry Economist. The TEI Team under the direction of Chicago Chapter President Reginald G. Young, Jr. of The Quaker Oats Company was composed of Kurt Meier of Morton International, Inc.; Theodore D. Novak of Tribune Company; Jack L. Simmons of R.R. Donnelly & Sons Company; and Paul J. Schaffhausen of McDonald's Corporation. The combined large case audit experience of both teams is more than anyone cared to compile.

The resulting work is divided into six sections, covering the phases of most large case audits. The common thread that runs throughout each of these sections is the commitment by both sides to develop and to work in an environment of professional respect and ongoing communication. There is no "silver bullet" or "magic pill" contained in these pages. What is here is a compilation of some of the best ideas that have been utilized by Tax Directors and Case Managers on the audits of some of the largest corporations in America. Some readers on both sides of the audit process may view these suggestions as fantasy world instead of real world. Trust us! These are proven techniques that work and will result in a more efficient and less time consuming audit -- an important consideration for both sides in an era of constrained resources.

Each taxpayer is unique and both sides must use maximum flexibility to select the best approach to solve audit problems. These techniques were developed to solve real problems on real audits and resulted from the willingness of both sides to take a risk and try something new. The next step is yours. Try implementing some or all of these approaches on your next audit. Better yet, try something that we haven't thought of!

Robert W. Brock District Director-Illinois District

Reginald G. Young, Jr. President-TEI Chicago Chapter

I. Cooperative Effort & Professional Conduct

Introduction: The audit process is inherently adversarial. This can often create barriers to open communication, resulting in delays and wasted effort unless both sides work at building a strong, professional working relationship. Both the taxpayer and the IRS have a common goal of completing the audit in a fair, timely, and efficient manner. Accomplishment of this common goal requires open communication, trust, and professional conduct between the audit teams on both sides.

Here are some suggested action items that can help to build the relationship to achieve the common goals:

Orientation Meeting: At some point early in the audit, ideally during "Step 1" of the Planning Process, it can be helpful to hold an orientation meeting. This is especially appropriate when a new examination team is assigned to a taxpayer's audit. This is an informal meeting, separate and apart from the Opening Conference, and may actually take place prior to the formal Opening Conference. At the orientation meeting, both sides should introduce the members of their audit teams and clearly define the responsibilities of each team member.

The taxpayer should provide a brief overview of the industry, the company's structure, financial performance, accounting records and other information that would facilitate the audit process. The IRS should have analyzed the historical and planning files prior to the orientation meeting and should be prepared to discuss the examination's intended areas of emphasis identified to date.

Planning Process: Open communication and a joint planning effort by the parties are essential elements of the professional conduct of the audit. This helps in building cooperation between two organizations with adversarial, but often overlapping, roles.

The taxpayer should be invited to attend one or more of the examination planning meetings. The agenda should include an open discussion of potential issues and compliance checks that can be expected to arise during the audit. This will enable both parties to plan the necessary resources that will be required to conduct the audit efficiently. The examination team and the taxpayer should discuss the type and scope of issues requiring specialists. Taxpayer input can be very useful in the identification of specialists' areas and also in building the cooperative effort needed to conduct a good audit. The specialists and their managers should be involved in the planning of the audit and should be present at the Opening Conference where schedules permit.

If the taxpayer is expected to have any potential Coordinated Issues, the Industry Specialist should be invited by the Case Manager to discuss them with the taxpayer.

The taxpayer should alert the examination team to all post-return adjustments that will effect the years under audit. Claims for refund or carrybacks to the audit years should also be discussed.

The examination team should complete the Audit Plan in a timely manner and a full copy of the plan must be given to the taxpayer when requested. Any changes to the audit plan should be discussed with the taxpayer.

Best Practice: Schedule a follow-up meeting to go over the Audit Plan once the taxpayer has had a chance to review it.

Work Papers: Complete workpapers can help in the decision-making process of the examination team and avoid unnecessary IDRs. The taxpayer should provide the Schedule M workpapers and other basic tax return information to the examination team at the beginning of the audit. The examination team should completely review the workpapers before issuing any IDRs to determine whether the information being requested is already contained in the workpapers.

New Issues: Significant new issues that arise during the audit should be discussed with the taxpayer as soon as they are identified and prior to any extensive audit work.

Issue Resolution: Issues that can be resolved should be resolved as quickly as possible. When an issue cannot be resolved, the parties should agree to disagree and move on with the audit.

Personality Conflicts: Personality conflicts should be identified and addressed as soon as possible in a professional manner. If the conflict is beyond resolution, alternative methods of conducting the examination should be devised by both teams. In extreme situations, both teams should consider assigning other personnel to the audit.

Conclusion: Both sides have the mutual objective of completing the audit process in an efficient and professional manner, with an agreed case. The suggested action items by the TEI/IRS Working Group can provide some of the positive steps to improve the working environment and efficiency of the audit process.

II. Orientation Process

Introduction: Inefficiencies in the audit process can be reduced when the taxpayer is familiar with IRS practices and when the examination team is adequately acquainted with the taxpayer's company and industry. A lack of familiarity with the taxpayer's business can cause an increase in the examination time. In the same way, a lack of familiarity with CEP examination procedures and practices can result in less meaningful responses from the taxpayer. A solid orientation for both the taxpayer and the examination team can streamline the entire audit process and significantly reduce examination time.

Best Practice: In some cases, an informal orientation meeting can be scheduled prior to the formal Opening Conference. This can be especially valuable when a new examination team is assigned to a taxpayer's audit.

Opening Conference

The Opening Conference is the official start of the audit, and it presents an important opportunity for the examination team and the taxpayer to set some basic ground rules that will govern the conduct of the examination. One of the primary objectives of this conference is to mutually plan how best to use both parties limited resources. In addition to the items mandated by the Internal Revenue Manual, the following areas should be covered at the Opening Conference:

   A review of the mutual benefits of involving the taxpayer in the audit
   planning process. Start with the last audit -- review the critique. If it
   worked last time, do it again. If it did not work, agree to fix it for this
   audit or eliminate it.

   The timing of the examination including an estimated completion date and
   benchmarks by which to measure the progress of the examination.

   Introduction of personnel, on the taxpayer's team and the examination team,
   who will be involved in the examination and their roles and
   responsibilities. Establish who is in charge on both sides.

   Establish the ground rules on Information Document Requests (IDRs). Agree
   to talk first and write the IDR second; to write an IDR, not a summons; to
   establish reasonable response times; and to meet periodically to review
   open IDRs.

   Establish ground rules for proposed adjustments. Agree to work to resolve,
   as far as possible, factual differences on unagreed issues. Consider early
   referral to Appeals if the issue is appropriate.

Best Practice: No Form 5701 (except for rollovers or recurring items) should be issued until the issue has been fully discussed with the taxpayer by the examination team.

Housekeeping Issues should be discussed:

* Examination team office and equipment needs;

* Security issues such as hours of access to the building, ID badges, and "roaming rights";

* Dress code, if any including, "business casual" attire; and

* Formal notification of the audit start for purposes of the current Revenue Procedure.

One final suggestion:

Best Practice: Make use of the TEI-IRS Video. It gets all of these points across with key players from both sides!

Corporation and Industry Orientation

An orientation meeting should be held to acquaint the examination team with the taxpayer's industry and company. This can be as formal or informal as the situation dictates, but it should be designed to give background information on the company's general business operations and not focus on detailed financial data. In many cases, several shorter meetings work better than one long meeting. There is no one way to do this, but here are a few suggestions:

   Use pre-existing orientation materials for new employees such as videos and
   hand-outs;

   When appropriate, conduct a tour of some or all of the company's
   facilities.

   Give a short presentation by one or more of the company's knowledgeable
   operations people.

   Provide a broad overview of the company's accounting and recordkeeping
   systems. It may be helpful to have the Computer Audit Specialist present
   for this.

Workpapers Orientation

The taxpayer should familiarize the examination team with the tax return workpapers early in the examination process. The workpapers should be available to the examination team at that time. The examination team should review the workpapers before issuing any IDRs for specific information.

Best Practice: Most CEP taxpayers are asked for basic financial information such as Annual Reports, 10-K, organization charts, etc. at the beginning of every audit. Have the information ready at the Orientation Meeting.

III. Audit Plan

Introduction: The Internal Revenue Manual requires the preparation of an audit plan for each CEP taxpayer. This document reflects the expected nature and duration of the examination. Each audit plan is designed to fit the unique facts of the taxpayer for the tax years involved. Because of that, audit plans are normally finalized several months into the audit process after the examination team has reviewed annual reports, tax returns, and other relevant data and has received responses to the preliminary IDRs. Once this work is completed, the specific items to be examined, the procedures to be followed, and the expected time commitments involved can be detailed in the audit plan.

Both the IRS and TEI have advocated involving the taxpayer in the process of developing an audit plan, and then providing the taxpayer with a complete (all three parts) copy of the plan. This action is designed to improve the cooperative effort and communication between the examination team and the taxpayer. The ultimate result should be a more efficient audit for both the examination team and the taxpayer.

Taxpayer involvement must be accomplished without compromising the examination team's ownership of the plan. The plan should be viewed by both parties as a commitment to jointly pursue a course of action within a defined time-frame. Significant deviations from the plan should be promptly discussed in a candid and open manner. Needed changes to the plan should be the result of joint deliberations, reflective of both the examination team's and the taxpayer's respective concerns and resources.

Suggested Action Items

The expectations of both parties regarding process, areas of examination, and timing should be discussed as early as possible. The parties should agree on an estimated completion date and the benchmarks that must be reached during the course of the examination to meet the completion date.

Criteria should be established for follow-up meetings to monitor the status of the examination. The focus of one or more early status meetings should be the development of the audit plan. The specific IRS specialists expected to be involved and the probable timing of their work should be addressed early in the process.

Best Practice: The audit plan should go beyond the minimal requirements in the Internal Revenue Manual. A plan crafted by the examination team with taxpayer input should contain a number of measurements for monitoring progress as the audit proceeds. Such measurements should include, for example, response times for IDRs, target dates for completing various audit areas, beginning and ending dates for each audit specialist, and time-frames for issuing follow-up IDRs.

A final audit planning meeting should take place to review a draft of the final plan. This ensures that the taxpayer has an opportunity to share any information or views that might improve the final audit plan. Further, it promotes buy-in of the plan by the taxpayer which will make the implementation of the plan much more successful.

Lastly, both parties must view the audit plan as a flexible plan of action. Where necessary, the plan should be amended based on actual progress and realistic expectations going forward.

IV. Materiality

Introduction: The concept of materiality does not exist, for the most part, in tax law. It may not, however, be practical for a taxpayer, nor productive for the examination team, to make adjustments during an audit that are minor in relation to the overall size of the taxpayer. Tax returns filed by taxpayers in the CEP Program are voluminous and very complex. In addition, the dollar amount of gross income, deductions, and items in the balance sheet are usually substantial. By relieving both the IRS and the taxpayer from the burden of making minor adjustments, both parties' efficiency and use of resources could be improved. The question is whether it is appropriate to establish a materiality level for making adjustments, either by the examination team or by the taxpayer. If so, how should that level be determined?

Suggested Action Items

At the outset of the examination, the taxpayer and the examination team should attempt to identify areas where it is appropriate to establish a materiality standard. It is recognized, however, that subsequent events could require that earlier agreements be changed.

An understanding should be reached on what type of adjustments would be covered by the standard. It may be appropriate, for example, to exclude permanent differences and items concerning public policy (e.g., illegal payments, fines, and penalties) from a materiality standard.

The taxpayer should disclose the materiality standard used to prepare the tax returns so that the examination team is aware that certain adjustments considered immaterial by the taxpayer were not made. The examination team should consider using that standard, but reserve the right to make relevant adjustments if specific circumstances so warrant.

Best Practice: All participants should continue to be alert to situations that warrant the adoption of a materiality threshold. Situations identified by the individual participants should be fully discussed and every effort should be made to arrive at a mutually agreeable conclusion.

It is encouraged that for complex tax computations, recurring in nature, a "substantially correct" computation may be used for the RAR with the understanding that a precise computation will be made and incorporated into all subsequently filed tax returns. For example, the examination team and taxpayer may agree to approximate a LIFO adjustment using an agreed-upon "short-cut" method rather than requiring the taxpayer and the examination team to go through a very lengthy and time-consuming recalculation for years in which returns have already been filed. Any necessary corrections should be made on the next filed return.

V. Information Document Requests

Introduction: The IDR process is very important to the success of an examination, especially within the Coordinated Examination Program. It places resource demands on both parties. This is the fact finding procedure of the examination where the examination team issues IDRs to clarify data on the return, request additional information regarding transactions, solicit companies practices or procedures, and obtain answers to questions on specific issues. If IDRs are prepared efficiently, it will lessen the burden on both the taxpayer and the examination team.

The IDR Process: It is critical that the IDRs be clear, concise, and communicate the nature and substance of the information requested. The following actions can be taken to improve the IDR process:

Best Practice: At the close of the prior audit cycle, the examination team and the taxpayer should agree on what information will be made available at or before the start of the next examination.

Workpapers should be prepared by the taxpayer with the expectation that they will be reviewed by the examination team. They should contain the relevant facts relating to the transaction and be clear to someone unfamiliar with the transaction.

Areas of inquiry should be discussed with the taxpayer prior to the issuance of any significant IDR. This will provide the taxpayer an opportunity to suggest alternative approaches to securing the information as well as to inform the examination team of the volume of records that it is requesting.

The examination team and the taxpayer need to discuss the scope of the IDRs and consider ways in which the examination team can assist the taxpayer in responding. In some cases, it may be helpful for the taxpayer to make company personnel available to discuss a specific area of inquiry prior to the issuance of an IDR.

Best Practice: When feasible the IDR content should be limited to one issue area. The Team Coordinator should review all IDRs for clarity and completeness before they are given to the taxpayer. It is important for the Team Coordinator to know and understand what information is being requested to be in a position to eliminate duplicate requests for the same information and to ensure that the request is within the agreed upon audit scope.

Best Practice: The Team Coordinator should sign each IDR and initial IDRs from the specialists.

Response Time: It is essential that IDRs be responded to in a timely manner for the IDR process to function properly. The examination team and the taxpayer need to agree upon reasonable response times for IDRs during the Opening Conference or planning meeting. A flexible response time needs to be established on each IDR where the taxpayer will encounter difficulty securing the information. It is important that the taxpayer promptly inform the examination team that an IDR is unclear, or cannot be responded to for any reason. The taxpayer should make every effort to respond promptly with a full and complete response. The examination team has the responsibility to let the taxpayer know whether its response to the IDR is sufficient. If additional information is needed, it should be requested in a timely manner.

IDR Logs: The taxpayer and the examination team should maintain IDR logs. These logs should be periodically shared to ensure that both sides agree upon which IDRs are outstanding. The Team Coordinator should maintain the log for all team members and specialists.

Best Practice: The taxpayer and the examination team should hold periodic meetings during the course of the audit to discuss progress on and the status of outstanding IDRs. The objective should be to keep the audit on track and to resolve any problems. The examination team should inform the taxpayer when an area of inquiry has been concluded.

VI. The Use of New Examination Enhancements

Background: Several new and innovative procedures have been established to improve the examination process and generate significant cost savings for both the taxpayer and the Internal Revenue Service. These processes have been designed to promote the concept of examination currency and create a positive environment for more thorough issue development and resolution. Significant byproducts that result from the use of these initiatives include the preparation of IDRs that are more focused on relevant information through access to contemporaneous information. Dialogue should now take place with taxpayer personnel responsible for preparation of the records, which will improve the factual accuracy of the issue development.

Improved accessibility to data, information, and records not only reduces the cost of record retention, but more important, promotes customer satisfaction and confidence in the IRS's ability to resolve an examination at minimal cost. In the discussion that follows, we will share these initiatives with the expectation that one or more of these will be conducive to improving your examination situation.

Time-Line Case Planning

A CEP time line for an examination involves setting individual target dates for significant case activities within the cycle. The taxpayer should be involved in the development of the time line because the taxpayer's buy-in and commitment are critical. The various activities necessary to deliver the case as planned are monitored and the case is managed by reference to the time lines.

Time lines would be established for phases or a case such as the preparation of the audit plan, issuance of IDRs, responses to IDRs, review of responses, issues, etc. As these goals are being met or not met, case progress can be measured.

Not all cases will close timely and meet the estimated completion date. It is anticipated that for cases where this occurs, an analysis of the planned time to the actual time line will pinpoint when the process condition arose and what factors contributed to the late closing. Discussion can then be held on this problem for purposes of improving future cycles.

Best Practice: To make time line planning effective, everyone associated with the case must be involved with, and committed to the time lines established. The setting of the dates for the time line needs to be accomplished with the taxpayer in an open and involved manner using consensus. The CEP personnel involved with this process should include all case members and their respective managers.

Accelerated Issue Resolution

To resolve issues at the examination level, both the IRS and the taxpayer often have reached agreement on issues in the current examination cycle that effect future years. These agreements were informally extended through an understanding of how the issues would flow in future years. The Accelerated Issue Resolution (AIR) process formalizes this process via Rev. Proc. 94-67. This process can also be used on an informal basis by the taxpayer and the examination team agreeing to the future treatment of an issue.

When an issue recurs, or otherwise will affect items on filed, but unexamined returns, the parties can agree to resolve the issue through all filed years. The AIR procedure calls for a written agreement to be executed and is considered to be final.

Pre-Filing Determinations

The Pre-Filing Determination Procedure will allow a CEP taxpayer to propose one or more issues for consideration by the examination team prior to the filing of a tax return. The procedure is envisioned as an opportunity for the taxpayer and the IRS to agree on the treatment of a specific transaction and is a progression of the letter ruling procedure contained in Rev. Proc. XX-1. If a determination is made prior to, and incorporated in, the return, the taxpayer will have a high degree of assurance that the treatment will be accepted on audit. In situations that the taxpayer takes exception to the pre-filing determination, the taxpayer would not be bound to report the transaction per the determination letter, however, a written disclosure would be appropriate.

Advance Pricing Agreements

The Advance Pricing Agreement (APA) process is a mutual effort by the IRS and the U.S. taxpayer (and where appropriate, the foreign-related taxpayer and its Competent Authority) to execute an agreement on the prospective application of inter-company pricing issues. The APA process represents a significant administrative development with regard to inter-company pricing issues.

The joint effort of an APA addresses concerns about the uncertainties surrounding cross border transactions and the potential for double taxation of earnings. History has shown that the examination process of a transfer pricing case can be time consuming to all parties, while the results can be unpredictable and disappointing.

The key to whether the APA process will result in the resolution of a material number of inter-company pricing matters turns on the willingness and the flexibility with which the IRS, the foreign competent authorities, and taxpayers approach discussions concerning APAs. The APA process provides the flexible ground rules necessary to facilitate such productive negotiations.

After an APA is adopted, the IRS will generally limit audit activity to ascertaining whether the representations made in reaching the APA are accurate, whether the assumptions on which the APA is premised remain valid, whether the pricing methodology established in the APA has been correctly applied, and whether the results contemplated in the APA are achieved in practice.

An APA, where appropriate, may be applied to resolve the taxpayer's transfer pricing issues in previously taxed years if all parties agree. So far, the IRS has been able to apply APA facts and transfer pricing methodology in several cases to resolve examination issues in open prior years The APA, however, is a binding agreement between the taxpayer and IRS on prospective tax years and has no legal effect on filed years.

Early Referral To Appeals

This procedure will allow taxpayers to request the transfer of one or more developed unagreed issues to Appeals while the remainder of the case continues under examination. The purpose of early referral is to resolve cases more quickly. The early resolution of an issue under this procedure should encourage the IRS and taxpayers to agree on other issues in the case. The steps for this procedure are outlined in Announcement 94-41.

The procedure calls for the taxpayer to submit to the Case Manager, a written request that fully describes the taxpayer's position. The Case Manager then sends the request, with a full description of the issue and Examination's position, to the District Director for approval. The District Director notes the district's approval or denial of the request and forwards it to Appeals for consideration. Both the District Director and Appeals must approve a request before the issue is considered by Appeals. In the event that a request is denied, a taxpayer is entitled to a conference to discuss the denial. Assuming the issue is accepted under this procedure, Appeals assumes jurisdiction over the issue while Examination continues jurisdiction and development of the remainder of the case.

Case Manager Settlement Authority -- Delegation Orders 236 & 247

Case Managers now have discretionary authority under Delegation Order 236 to accept settlement offers in CEP cases. A settlement has to have been effected by Appeals with respect to the same taxpayer in a previous tax year. The settlement authority is extended to Case Managers without regard to the amount of liability being compromised. The factors that must be present include:

   The issue is in a CEP case under the jurisdiction of the Examination
   Division;

   A settlement has been effected by Appeals in the same, a previous or
   subsequent tax period;

   The facts in the current period are substantially the same as the facts in
   the Appeals settled tax period;

   The legal authority upon which the settlement was based is unchanged;

   The underlying issue was settled by Appeals independently of other issues;
   and

   The issue was settled in Appeals with respect to the same taxpayer
   including consolidated and nonconsolidated subsidiaries or another taxpayer
   who was directly involved in the same transaction or taxable event.

Delegation Order 247 grants settlement authority to Case Managers for Industry Specialization Program (ISP) issues and International Field Assistance Specialization Program (IFASP) issues. Settlement authority guidelines must be developed before an agreement can be reached. This authority is discretionary and applies to CEP cases under the jurisdiction of the Examination Division. Prior to finalization, the proposed settlement and any related Closing Agreement must be reviewed and approved by the ISP or IFASP specialist Appeals ISP coordinator.

Conclusion

Each CEP taxpayer is unique and maximum flexibility to select the best approach and tools to deal with the individual case must be provided to the taxpayer and Case Manager. Therefore, we have presented these initiatives reviewed as a collage of ideas from which each can select the tools best suited to address the needs of their situation. The CEP examination process requires the joint involvement of taxpayers and the IRS from the onset of the planning process through the resolution of issues stage. Taxpayers must be involved in the planning process for any of these processes to be effective.

By the Illinois District of the Internal Revenue Service and the Chicago Chapter of Tax Executives Institute