Private letter rulings: when/how/if.

Taxpayers--generally through their CPAs--often apply for Internal Revenue Service private letter rulings to ensure proposed transactions will have the intended tax consequences. Such rulings may enable taxpayers to restructure proposed transactions to avoid adverse tax consequences. Private letter rulings, however, are not always appropriate or beneficial. This article discusses and presents in flowchart form the factors taxpayers and their CPAs should consider before requesting private letter rulings (see exhibit 1, page 63).

MEANING, SOURCE AND EFFECT OF PRIVATE LETTER RULINGS

A letter ruling is a written statement issued by the IRS national office to a taxpayer or the taxpayer's authorized representative interpreting and applying the tax laws to a specific set of facts. Private letter rulings on most tax questions are issued through the IRS associate chief counsel (domestic division). Private letter rulings for exempt organizations and pension plans are issued through the associate chief counsel (employee plans and exempt organizations division).

A letter ruling generally is binding on an IRS district office for purposes of determining a taxpayer's liability. A ruling is not binding on the IRS or the taxpayer if

* It contains misstatements or omissions of material fact. For example, assume X and Y apply for and receive a private letter ruling allowing them to enter into a tax-free reorganization to form a parent-subsidiary group. However, the ruling request does not explain fully the consideration used to effect the reorganization. Accordingly, on audit the IRS may find the ruling nonbinding because of the omission of a material fact.

* It involves a different tax. For example, a married couple negotiating a divorce in a community-property state secure a private letter ruling on whether a particular item is an income interest for federal income tax purposes. If the spouse with the income interest dies before the divorce is final, the ruling is not binding on the IRS in determining the federal estate tax on that spouse's estate because the ruling relates to the income tax.

* The taxpayer fails to comply with a condition of the ruling. For example, as part of a ruling request a taxpayer demonstrates compliance with the statutory requirements for a merger. In the ruling, the IRS says it will approve the request only if the taxpayer also meets state law requirements. If the taxpayer fails to do so, the ruling is nonbinding. Because a letter ruling is the IRS's application of the tax law to the particular transaction described in a ruling request, it is "a holding of the IRS on that transaction only," so one taxpayer may not rely on a letter ruling issued to another taxpayer (revenue procedure 93-1).

Only the national office can revoke a letter ruling (typically because of statutory, judicial or administrative changes in the tax law). If an IRS district director or chief- appeals office, thinks a previously issued letter ruling should be modified or revoked, the taxpayer is informed--except in cases involving fraud and jeopardy or termination assessments. The taxpayer has 10 calendar days to reply in writing regarding any disagreements. After determining the facts and considering the taxpayer's arguments, the district director or chief-appeals office decides whether to recommend revocation of the letter ruling to the national office. Such a revocation generally will not affect the taxpayer who relied in good faith on the ruling and complied with its facts and conditions.

WILL THE IRS ISSUE A PRIVATE LETTER RULING?

When taxpayers or their CPAs believe it beneficial to secure a ruling, they first must determine whether the IRS will rule on the transaction. As a matter of policy, the national office answers individuals' and organizations' inquiries about the tax effects of their acts or transactions or about their status for tax purposes "whenever appropriate in the interest of sound tax administration." The IRS supplements the general policy statement with situations in which it will not rule (see exhibit 2, page 65). Also, in the following situations the law conditions favorable tax treatment on favorable rulings, effectively making rulings mandatory:

1. Proposed changes in accounting method (submitted on form 3115) or accounting period (submitted on form 1128).

2. Fiscal years of partnerships, S corporations and personal service corporations.

3. Elections not to defer gain or loss on intercompany transactions (Internal Revenue Code section 1502).

4. Election extensions of applications for relief under regulations section 301.9100-1.

If the appropriateness of requesting a ruling is not clear from the law or published guidelines, the taxpayer or the taxpayer's representative may telephone the appropriate national office technical branch to ask whether the IRS will rule on a particular issue. Although national office officials ordinarily do not discuss substantive tax issues with taxpayers or their representatives before a ruling request is received (because oral opinions and advice are nonbinding), an IRS technical representative (tax law specialist) can say whether the IRS will rule on a particular transaction and discuss procedural matters. The taxpayer's name and identifying number generally must be furnished for even this limited information.

In some areas, the IRS establishes threshold requirements for favorable rulings and operating rules to follow in issuing rulings. Exhibit 3, page 66, lists these areas and the revenue procedures where the guidance may be found. Taxpayers fearing adverse rulings obviously should consult these sources before deciding to secure private letter rulings.

COST OF A PRIVATE LETTER RULING

Cost is a factor in deciding to apply for a private letter ruling. Taxpayers incur professional fees to have requests prepared and the IRS charges fees for rulings, opinion letters, determination letters and similar requests. Revenue procedure 93-23 provides a fee schedule for specific rulings that fall under these general categories:

* Rulings issued by the associate chief counsels (domestic, international and employee benefits and exempt organizations).

* Prototype individual retirement accounts or annuities and simplified employee pensions (SEPs), including salary reduction SEP letters.

* Exempt organization rulings.

* Employee plan determinations, notification letters and advisory letters.

* Exempt organization determination letters.

* Other determination letters.

Exhibit 4, page 67, lists the fees for ruling requests submitted to the associate chief counsel.

TIMING

Since securing a private letter ruling involves some delay, taxpayers should request rulings only if there is enough time to obtain them before completing the proposed transactions. The national office strictly adheres to a policy of processing ruling requests in the order they were received. A good business reason must exist for the IRS to process a request out of order. Unfortunately, what is considered a good business reason by the taxpayer may not be so considered by the IRS. In seeking expedited treatment, a taxpayer must submit a separate letter showing the good business reason. The acts of third parties (for example, foreign governments), market conditions and undue economic hardship help, and in fact may be necessary, to obtain expedited treatment.

On receipt, ruling requests are reviewed to determine whether they comply with required procedures. Nonconforming requests are acknowledged and the requirements that have not been met are pointed out to the taxpayer or his or her representative. If a ruling request lacks essential information, the appropriate information must be supplied within 30 calendar days from the request date or the request will be closed. Information supplied after the 30-day period results in a reopening of the request, but the request loses its original position and is treated as received on the date the information was received.

The national office's ability to give an early indication of how the IRS will rule, if at all, on certain ruling requests may mitigate the risk of not receiving a timely ruling. Within 21 calendar days after receiving a request branch IRS personnel contact the taxpayer or the taxpayer's representative to discuss informally the procedural and substantive issues involved in it. Although branch personnel's informal opinions are not binding, they are permitted to say whether

* They will recommend that the IRS rule favorably, adversely or not at all.

* Further information about the transaction should be submitted.

* A tentative conclusion cannot be reached because of the nature of the transaction or issue.

If less than a fully favorable ruling appears likely, IRS branch personnel may offer to meet with the taxpayer and suggest modifications to the transaction that might warrant a favorable ruling. The taxpayer, however, is entitled to a conference under the conference rules if an adverse ruling (to any extent) is contemplated.

SAVING TAX DOLLARS

The need for a ruling increases for transactions involving substantial sums of money. A ruling on such transactions often is an "insurance policy" that may be used as a selling point or a hedge against promoter or professional liability. In other cases it may be imprudent to proceed without a ruling. For example, the board of directors of a public company considering terminating an overfunded pension plan and establishing a new one to siphon off excess plan assets needs to secure a ruling on the new plan's tax status to shield itself from employee and shareholder negligence charges.

A favorable ruling decreases the risk of controversy with an IRS agent on a subsequent audit. In addition, during the course of discussions on a ruling request, the IRS may. recommend changes in the proposed transaction that actually help the taxpayer achieve the desired tax effect. Also, if one IRS employee raises a question about a transaction, other IRS personnel probably will raise the same question later. Accordingly, a ruling request may point out danger spots while the transaction still is in proposed form. The taxpayer then may either modify or abort the transaction, thereby reducing or eliminating the risk of losing the money involved.

In some cases, a substantial amount of tax can be saved by requesting a ruling. For example, an insurance company was formed as an unincorporated association to establish a group self-insured workers' compensation program under a particular state's laws. This nonlife insurance company had two income sources: investment income and underwriting gains. As a small nonlife company, this taxpayer could elect, under IRC section 831(b), to pay tax only on investment income. Such treatment is beneficial for taxpayers with underwriting gains, although excluded income still is subject to the alternative minimum tax. The election is a serious detriment if the taxpayer has underwriting losses because it is precluded from offsetting such losses against investment income.

The company in question suffered from the section 831(b) election because it had underwriting losses. From 1987 through 1991, the taxpayer paid 7.7 times more tax than it would have if the election had not been made. The taxpayer filed a change of accounting method application to revoke its election and was told the revocation had to be effectuated through a ruling request. The resulting ruling was favorable to the taxpayer, allowing it to change its accounting method (see LTR 9322027).

RESTRUCTURING TRANSACTIONS BEFORE IT'S TOO LATE

If a proposed transaction cannot be restructured to meet conditions the IRS may impose, the taxpayer faces several risks. (1) Unless withdrawn, the ruling will be adverse, and generally there is no review of adverse rulings. (2) As previously discussed, a withdrawal is not a safe haven because the taxpayer's audit risk may increase. (3) The IRS may raise collateral issues that are not easily answered but still subject the taxpayer to the additional risk of an adverse ruling or additional audit exposure. (4) A ruling may be issued with a caveat, either because of the particular factual situation or as a matter of form adopted in the particular ruling branch, that will be a red flag for the agent undertaking a subsequent audit. The taxpayer and the CPA clearly must weigh these risks against the benefits of receiving a favorable ruling before filing a ruling request.

INCOMPLETE STATEMENT OF FACTS OR TAX AVOIDANCE 

A complete statement of facts is necessary to apply for a ruling; otherwise, the ruling may not be binding. In some cases, however, it is not possible to submit one--for example, because the taxpayer's records were destroyed by fire, never were kept or were incomplete. In other cases, the taxpayer has the facts but refuses to release them, believing the IRS will raise questions on a tangential or completely unrelated issue on close examination of these facts. In either case, a request generally should not be submitted.

The IRS generally does not rule on the results of transactions lacking a bona fide business purpose or having as their principal purpose the reduction of federal taxes. But if a transaction has substance and is for tax avoidance, the IRS may issue an adverse ruling to ensure it is not carried out as contemplated.

SENSITIVE INFORMATION

IRC section 6110 provides that, with certain exceptions and deletions, the text of any written determination (including a letter ruling) and any background file must be open to public inspection. Background files include requests for rulings, supporting written materials and any related communications with persons outside the IRS (other than the Justice Department in the case of pending civil or criminal suits) received before determinations are issued.

If all information contained in a ruling request (including competitive information) was made public, taxpayers might be reluctant to request rulings. Congress did not intend this in providing for public disclosure. Accordingly, section 6110(c) exempts seven categories of information from disclosure and requires the IRS to delete identifying details and other information exempt from public disclosure under the Freedom of Information Act:

1. Names, addresses and other identifying details.

2. National defense or foreign policy information protected by an executive order.

3. Information specifically exempt from disclosure by statute.

4. Trade secrets and commercially or financially privileged or confidential information obtained from a person.

5. Information that would constitute a clearly unwarranted invasion of personal privacy.

6. Information contained in or related to reports prepared by an agency responsible for the regulation or supervision of financial institutions.

7. Geological and geophysical information and data, including maps, concerning wells.

Despite these safeguards, interested parties may piece together information to guess a taxpayer's identity. Taxpayers clearly must consider this risk when determining whether to request private letter rulings.

COMPLEX DECISION

The decision to request a private letter ruling is a complex one. Such rulings provide a measure of certainty about the tax effects of significant transactions and their value should not be underestimated. Taxpayers and their CPAs must examine all factors involved in seeking a ruling. This is the only way they can hope to assess all the risks associated with making such a decision.

EXECUTIVE SUMMARY

* PRIVATE LETTER RULINGS from the Internal Revenue Service can help taxpayers confirm the tax treatment of proposed transactions before they are undertaken. In some cases, the IRS can suggest modifications. In others, however, private letter rulings are not appropriate or beneficial.

* A LETTER RULING GENERALLY is binding on an IRS district office in determining a taxpayer's liability. It is not binding if it contains misstatements or omissions of material fact or concerns a different tax. Rulings relate to specific transactions only and cannot be relied on by other taxpayers.

* THE IRS ISSUES private letter rulings when appropriate in the interest of sound tax administration. It issued guidelines listing situations in which it will not rule. In other cases, the law conditions favorable tax treatment on favorable rulings, effectively making rulings mandatory.

* THE COST OF OBTAINING a letter ruling includes CPA and attorney fees as well as fees charged by the IRS. The time it takes to obtain a letter ruling also is a factor taxpayers must consider in deciding whether to request one.

* PRIVATE LETTER RULINGS and supporting documents are available for public inspection. However, steps are taken to maintain confidentiality of taxpayers' identities and any trade secrets or privileged information.

EXHIBIT 2

When the Internal Revenue Service will not rule

1. A request involves an income or gift tax transaction that was completed and reported on a return.

2. A request involves an issue under the jurisdiction of a district office or appeals office.

3. A request involves only part of an integrated transaction.

4. A request involves the tax calculations, actuarial factors and factual matters related to a living person's (advance) estate tax matters.

5. A request involves applying the tax laws to members of a group.

6. A request does not comply with revenue procedure 91-1.

7. A professional staffing corporation (loan-out corporation) or subscriber is the employer of individuals (under the common-law rules applicable in determining employer-employee relationships) and (a) the loan-out corporation hires the subscriber's employees and assigns them to the subscriber or (b) the loan-out corporation assigns individuals to subscribers for more than a temporary period (one year or longer).

8. There is no bona fide business purpose for a transaction or it has tax avoidance as its principal purpose.

9. The IRS is considering whether to accept or contest an adverse decision.

10. A request involves alternate plans or hypothetical situations.

11. A request involves the federal tax consequences of any proposed federal, state, local or municipal obligation.

12. A request addresses whether reasonable cause exists under subtitle F of the Internal Revenue Code (procedure and administration).

13. A request seeks to determine whether a proposed transaction will subject a taxpayer to a criminal penalty.

14. A request seeks to determine a matter that is primarily one of fact (for example, market value of property, debt versus equity).

15. A request seeks to determine the tax effect of a transaction to be consummated at some indefinite future time.

16. A request deals with the question of whether property is held primarily for sale to customers in the ordinary course of business.

Source: Revenue procedure 93-1.

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ASKING FOR TROUBLE

Sometimes the factors that normally affect a taxpayer's decision to secure a private letter ruling--other than whether the Internal Revenue Service will rule-- are irrelevant. In some cases, the taxpayer either (1) insists on a ruling or (2) refuses to request one.

Taxpayer insists on a ruling. Taxpayers may insist on a ruling simply because they want to minimize potential disputes that may arise if the IRS examines their tax returns.

Taxpayer refuses to request a ruling. Taxpayers may refuse to secure a ruling because they either are sure the law favors the positions taken on their returns or are unwilling to risk an adverse ruling. Some taxpayers fear an adverse ruling because they believe their transactions cannot be restructured to meet the conditions the IRS may impose for a favorable ruling.

If circumstances change, ruling requests may be withdrawn by submitting a letter to the same address to which the request was sent. A withdrawal, however, is not considered a safe haven because the IRS national office may share its views with the district director whose office will have audit jurisdiction over the return. That district director may use this information in a subsequent examination of the return. Moreover, even when a request is withdrawn, the IRS retains all taxpayer correspondence and may later decide to publish a revenue ruling or revenue procedure using those facts.

RAY A. KNIGHT, CPA, JD, is professor of accounting at Middle Tennessee State University, Murfreesboro. LEE G. KNIGHT, PhD, is professor of accounting at Middle Tennessee State University.