Mediating with the IRS.

EXECUTIVE SUMMARY

Under a one-year test program that will end in October, certain taxpayers can elect to mediate a dispute with the IRS instead of risking the hazards of litigation. The mediation test program, which was proposed in Ann. 95-2 and detailed in Ann. 95-86, is open to cases already in the IRS Appeals administrative process and not yet docketed in court. This article explains the new program, the types of cases eligible, the issues to consider in drafting various mediation documents and the advantages and disadvantages of mediation and of serving as a mediator. The mediation procedure for docketed Tax Court cases is also discussed.

With the court system overburdened by excessive litigation, alternate dispute resolution (ADR) has become very popular. Many recognize that instituting a lawsuit is a losing proposition to both parties when the time commitment, stress and legal costs are considered; as a result, disputes are usually sent to mediation or another ADR procedure before being litigated. Until recently, ADR was not used frequently for disputes between taxpayers and the IRS. Although the Service has employed various ADR procedures over the past few years,(1) until now it has not attempted mediation for disputes with taxpayers. This article will address the use of mediation under the new IRS procedures for the Appeals administrative process, and discuss the proposed use of mediation in docketed Tax Court cases.

Of the many different forms of ADR, the best known are arbitration and mediation. In general, arbitration differs from mediation in that the process is binding on all parties; the arbitrator solicits arguments from both sides to gather information useful to his decision making.

Mediation, on the other hand, is a nonbinding process that involves a mediator or neutral third party who acts as a facilitator to guide the parties to a negotiated agreement. The mediator does not render a judgment; he meets with the parties, focuses on the key issues and the parties' interests, identifies potential options and helps the parties find a mutually advantageous solution. The mediator tries to remove emotion from the process and to get the parties to work together to resolve the dispute. It is estimated that over 80% of all mediated disputes are resolved.(2)

Background

The IRS issued a proposed mediation procedure in Ann. 95-2(3) that was discussed at a public hearing on Feb. 23, 1995. Based on the comments received, Ann. 95-86(4) was issued, addressing mediation procedures for issues in the Appeals administrative process and not docketed in any court, during a one-year test period beginning Oct. 30, 1995. The IRS also issued a memorandum to field administrative officers on mediation procedures to resolve docketed, pretrial Tax Court cases,(5) stemming in part from public comments that mediation is appropriate for such cases. In Ann. 95-86, the IRS asserts that mediation as set forth therein is only appropriate for cases involving factual issues (e.g., transfer pricing, valuation and reasonable compensation).

Scope of Appeals Mediation Procedures

The one-year test of mediation under Ann. 95-86 is limited to cases in the Appeals administrative process after initial Appeals settlement discussions are unsuccessful. The IRS Appeals settlement process is, in essence, an ADR procedure similar to mediation; the skilled Appeals Officer seeks a compromise of the controversy with the taxpayer based on the perceived hazards of litigation. This differs from arbitration and litigation, in which the arbitrator or judge alone determines the final outcome.

During the test period, mediation is limited to issues in Coordinated Examination Program (CEP) cases assigned to Appeals Team Chiefs. CEP cases involve very large, complex, affiliated corporations audited by an IRS team; these are high-profile, large-dollar cases.(6) The IRS should consider expanding the scope of cases eligible for mediation during the test period to include other cases (e.g., estate tax cases and cases involving smaller entities); this would provide a more meaningful test of the potential of mediation in resolving tax disputes.

Mediation is not available for certain issues during the test period, such as Industry Specialization Program issues, Appeals Coordinated Issues and issues for which the taxpayer has filed (or intends to file) a request for competent authority assistance. (Competent authority issues involve tax treaties and a taxpayer who needs the U.S. Government to intervene to clarify the appropriate tax treatment.) Mediation is also unavailable for an issue under a simultaneous Appeals/Competent Authority procedure described in Ann. 95-9.(7)

Requesting Appeals Mediation

As mediation is optional, it is likely to fail if one party is an unwilling participant; thus, consultation between the parties is necessary before the taxpayer or the Appeals Team Chief submits a written request for mediation with the Assistant Regional Director of Appeals-Large Case (ARDA-LC).

After approving the request, the ARDA-LC will promptly inform the parties and schedule a conference to outline the proposed process. If the request is denied, the parties are notified and the taxpayer can request a conference with the ARDA-LC to discuss the reasons for denial. In either case, the response time is generally 30 days after the ARDA-LC's receipt of the request.

Written Agreement to Mediate

If the mediation request is approved, the taxpayer and Appeals will enter into a written agreement to mediate. The ARDA-LC will negotiate and sign the agreement on behalf of Appeals. An upper-level officer of the taxpayer or its counsel should sign the agreement for the taxpayer. At a minimum, the agreement should identify the participants, the mediator or co-mediators (or the procedure to be used to select a mediator), which party bears the cost of the mediator, the issues to be mediated, the materials to be submitted to the mediator and a proposed schedule and place for the mediation. Special concerns (e.g., confidentiality, disclosure requirements and other procedural matters) should also be addressed. See Exhibit 1 on pages 283-284 for a Model Agreement to Mediate.

Premediation Requirements

The taxpayer and Appeals are the parties to the mediation; however, other "appropriate" persons (e.g., attorneys, CPAs or experts) may participate. Ann. 95-86's use of the term "appropriate" suggests that the mediator may limit participants to those necessary for negotiation. Two weeks before the mediation each party must notify the mediator and the other party regarding the participants on their mediation team. This allows the mediator to prepare for the mediation and gives all parties time to react to designated participants (if necessary). The parties must designate participants with decision-making authority. The ARDA-LC and the Appeals Team Chief have such authority for the IRS. For a large corporate taxpayer, the chief financial officer may need to participate. See Exhibit 2 on page 285 for a Model Mediation Participants List.

At least two weeks before the mediation, each party must present a written summary of 20 pages or less (excluding pre-existing documents and reports) regarding the items in issue. The mediator may request any additional information needed from either party. All materials must be submitted simultaneously to both the mediator and the other party.

Either party may withdraw from the mediation at any time before settlement by notifying the mediator and the other party in writing.

Confidentiality

The mediation process is confidential; thus, the mediator and all participants to the mediation cannot voluntarily, or through discovery or compulsory process, reveal any information regarding the mediation process or any communication made during such process, including the settlement terms. However, under Sec. 7214(a)(8), any IRS employee must report information regarding violations of any revenue law to the Treasury Secretary, a requirement that supersedes the confidentiality requirement.

In the course of mediation, the taxpayer's tax return and return information will be reviewed by all parties and by the mediator; thus, the taxpayer must acknowledge in writing that all parties to the mediation (including the mediator) may have access to all of this information.(8) See Exhibit 3 on page 285 for a Model Consent to and Acknowledgment of Disclosure of Return and Return Information.

Mediator Selection

The wording of the model agreement in Exhibit 1 suggests that it may be signed by the parties before a mediator is selected. The agreement identifies various mediator selection issues and designates a proposed schedule for the mediation session, recognizing that a specific date, time and location cannot be set before a mediator is selected; it provides that the mediation session is to take place by a certain month, date and year, not on a month, date and year. In practice, the drafting of the agreement and the selection of a mediator may be done concurrently, so that the details of date, time and location are known when the agreement is signed. The process is very flexible.

The mediator selected must be mutually acceptable to the parties and may be either an Appeals representative or a non-IRS employee. At a minimum, the individual must have previous mediation training or experience; co-mediators are also permitted. The use of co-mediators may be necessary if the IRS wants a mediator from Appeals and the taxpayer wants a non-IRS mediator. Co-mediators are also useful in coupling a mediator with technical expertise with one talented in fostering agreements; the disadvantage is the additional cost.

The mediator must not have an undisclosed (personal, official or financial) conflict of interest with the parties; if such conflict exists, the mediator must fully disclose it to the parties in writing. After reviewing the conflict of interest statement, the parties decide whether to allow the mediator to serve.

An obvious conflict of interest exists when the mediator is from Appeals (i.e., an IRS employee). As was discussed, all IRS employees are required to disclose any violation of the revenue laws. The parties must be informed of and acknowledge this duty. Therefore, if an Appeals mediator discovers additional tax issues not under investigation during the mediation, he must disclose them to the IRS.(9) This can be problematic; by definition, a mediator is supposed to be neutral. Although many Appeals personnel are both skillful and reasonable and additional tax violations may never arise, neutrality cannot be guaranteed.

Conversely, a non-IRS mediator is bound by confidentiality and cannot disclose information obtained during the mediation to the IRS. A non-IRS mediator cannot be asked to testify in court regarding the contents of a mediation session, a major incentive to use a non-IRS mediator.

If a mediator or co-mediator is from Appeals, the IRS will bear 100% of that mediator's cost. If the mediator or co-mediator selected is a non-IRS employee, the taxpayer and the IRS share the cost equally. For the taxpayer, this is a small price to pay for neutrality and a reduction in the risk of additional issues being identified by the IRS.

The IRS suggests that the Federal Mediation and Conciliation Service or the Administrative Conference of the United States be contacted if the parties to the mediation cannot agree on a mediator. Also, tax accountants and lawyers with mediation training and experience can be found in CPA firms, law firms and universities.

Disqualification

A mediator is disqualified from representing the taxpayer and any other party in any pending or future action involving the transactions or issues in the mediation. In addition, the mediator's firm is disqualified from representing the taxpayer and any other parties involved in the mediation in any actions before the IRS that involve both the same tax year and the transactions or issues that are the particular subject matter of the mediation. Evidently, this does not preclude future representation of taxpayers before the Tax Court on other issues. The mediator or his firm is not disqualified from representing the taxpayer in any matter unrelated to the subject of the mediation.

If the action involves a different tax year but the same transactions or issues, the mediator's firm is not disqualified if it uses screening procedures that preclude the mediator from any form of participation in the matter (including direct apportionment of the fee therefrom). An indirect allocation of the fee (e.g., salary, partnership share or distribution established via prior independent agreement) does not disqualify the firm.

Example: A partnership agreement states that mediator partner A is entitled to 30% of all partnership ordinary income. A's share of ordinary income is not reduced simply because the income from related services in a different tax year is included in partnership ordinary income for a year following the mediation.

Concluding the Mediation

When the mediation is completed, some issues may be resolved and others unresolved. The mediator must prepare a report briefly summarizing the results and signed by each party and the mediator. See Exhibit 4 at right for a Model Mediator's Report.

For issues resolved by the mediation process, the IRS's regular procedures for Appeals settlements apply, including special matters closing agreements (Form 906, Closing Agreement on Final Determination Covering Specific Matters) and Delegation Order 236(10) (regarding rollover or recurring issues). The result of the mediation process may not be used as precedent in any other proceeding.

The unresolved issues will not be reconsidered by Appeals; they remain unresolved and may be considered in court. Any issues not focused on in the mediation are still eligible for consideration by Appeals.

Mediation in Docketed Cases

The procedures set forth via IRS memorandum(11) for mediation to resolve docketed Tax Court cases parallel those in Ann. 95-86 for mediation in the Appeals administrative process described earlier. The memorandum specifically refers to the announcement as a source of guidance and recommends the use of its attachments with appropriate modifications (e.g., Model Agreement to Mediate, etc.). Issues particular to mediation in docketed Tax Court cases and various differences from Appeals mediation are discussed below.

The first issue addressed by the memorandum is the question of the authority for use of mediation in docketed Tax Court cases. It states: "Although there is no specific Tax Court mechanism for the use of mediation, it appears this type of procedure can be utilized by the parties to resolve a Tax Court case under the authority of Rule 1."(12)

The rationale given for the use of mediation in docketed Tax Court cases is to more efficiently use judicial and IRS resources and to reduce the Tax Court's inventory of cases. However, mediation is not a substitute for established settlement procedures and should not unduly delay discovery or trial. It applies when other settlement procedures (e.g., Appeals) have failed and it is expected to be cost effective. Once a case has been mediated as part of the Appeals administrative process, it may not be mediated again as a docketed Tax Court case.

The parties to the mediation of a Tax Court case are the taxpayer and the District Counsel. An expected participant on the District Counsel's team is a representative from Appeals familiar with the case. However, there should only be one spokesperson for the District Counsel's team, per the memorandum. The suggested length for the mediation is one day.

If the parties are unable to reach an agreement, preparation for trial is to proceed. On the other hand, if the parties agree on any of the issues in mediation, the District Counsel will draft a stipulation to be signed by both parties and presented to the Tax Court, as part of the mediation process or shortly thereafter.

As in Appeals mediation, both parties must jointly agree on a mediator. District Counsel must submit a request for hiring a mediator via a memorandum to the Assistant Regional Counsel (GLS) for the region before the agreement to mediate is drafted. The memorandum suggests that the parties stipulate to attempt to resolve the case by mediation in addition to signing the agreement to mediate. This results in continued supervision by the Tax Court. If the trial is already on the calendar, the parties may want to file a joint motion requesting a continuance from the trial session. The mediation agreement, stipulations and other documents are to be reviewed by the Procedural Branch of the Field Service Division before execution.

Each party must bear 50% of the costs of mediation and the mediator should agree to look solely to each party for one-half of his compensation. The memorandum suggests the use of an appeals officer as a mediator to reduce costs. This implies that the IRS will pay 100% of the cost of an Appeals mediator, as in Appeals mediation.

The mediation process, the mediator's role, eligibility rules for cases and issues, mediator disqualification rules, and confidentiality and disclosure considerations per the memorandum generally reiterate those stated in Ann. 95-86.

Conclusion

The IRS is to be commended for its efforts to use mediation both in the Appeals administrative process and in docketed Tax Court cases. The current mediation procedures are a good start; however, more qualified neutral tax mediators need to be identified. The use of mediators from Appeals poses neutrality and disclosure problems for taxpayers. In contrast, use of CPAs and lawyers with tax expertise and mediation experience can overcome these problems, but at a higher cost.

The success of mediation in other venues points to future success in resolving tax disputes. To assure a proper evaluation of the potential use of mediation in resolving tax disputes, the IRS should consider expanding the scope of cases eligible for mediation during the test period. In addition to large corporate cases, mediation seems appropriate for estate tax cases and cases involving smaller entities.

Table 1 at left identifies the potential advantages and disadvantages to the taxpayer and the tax practitioner of using mediation to resolve a dispute. Table 2 at left discloses the potential advantages and disadvantages to the practitioner seeking to serve as a mediator in a tax dispute.

(1) E.g., Advance Pricing Agreements, expanded settlement authority, advance valuation of art, early referral procedures, the accelerated issue resolution program, prefiling determinations and competent authority.

(2) See Kovach, Mediation: Principles and Practice (West Publishing Co., 1994), p. 77.

(3) Ann. 95-2, IRB 1995-2, 59.

(4) Ann. 95-86, IRB 1995-44, 27.

(5) See IRS Memorandum to Field Administrative Officers from Jennifer S. Turner (10/13/95).

(6) Participants in the public hearing argued that mediation should also be available during the test period for non-CEP cases, but the IRS has rejected this. See "IRS Urged To Broaden Proposed Mediation Program," 66 Tax Notes 1234 (2/27/95); see also "Appeals Officials Outline Dispute Resolution Options," 70 Tax Notes 1218 (2/26/96).

(7) Ann. 95-9, IRB 1995-7, 57; see also Rev. Proc. 96-13, IRB 1996-2, 31.

(8) See Sec. 6103(b), (c) and (n).

(9) Typically, the mediator will hold meetings separately with each party at various stages of the mediation, enabling free discussion of issues. In these meetings, a tax issue not under IRS investigation may come to the mediator's attention; if that mediator is from Appeals, he is required to disclose the issue to the IRS.

(10) Delegation Order 236, 1991-1 CB 313.

(11) See note 5.

(12) Tax Court Rule 1 states that "[w]here in any instance there is no applicable rule of procedure, the Court or the Judge before whom the matter is pending may prescribe the procedure, giving particular weight to the Federal Rules of Civil Procedure to the extent that they are suitably adaptable to govern the matter at hand."