Reflections on practicing tax in today's world.

Introduction

Over the last five years, the Internal Revenue Service steadily has increased its emphasis on taxpayer compliance. The IRS initially targeted corporate tax shelters. The last two IRS Commissioners broadened that target by emphasizing across-the-board tax noncompliance by individuals, businesses of all sizes, and even tax-exempt entities. As a result, the IRS has gone from an agency that five years ago, in the wake of the 1998 IRS Restructuring and Reform Act, was either too intimidated or distracted to pursue audits and investigations to an agency that today is increasingly, and sometimes surprisingly, aggressive in its efforts to find, punish, and thereby deter what it considers to be noncompliant taxpayers.

Today, examination teams from the Large and Mid-Size Business Division often audit aggressively, frequently use summonses and third-party summonses, occasionally request tax accrual workpapers, and increasingly propose penalties for audit adjustments. Last year, Congress passed legislation that increased penalties significantly and provided for more public disclosures. In some cases, the IRS has indicated a willingness to make criminal referrals of companies and their tax executives. Recent changes to Circular 230 (prescribing rules for practicing before the IRS) signal an IRS determination to sanction tax professionals who, to paraphrase Commissioner Everson, become the architect of their clients' attempts to circumvent the tax laws.

In short, we practice tax today in an increasingly demanding regulatory environment. But as demanding as tax practices may have become, few, if any, tax practitioners were prepared for the actions in late August by the prosecutors in the Southern District of New York in a grand jury investigation of KPMG. In what the IRS described as "the largest criminal tax case ever filed," the prosecutors announced a deferred prosecution agreement under which KPMG agreed to the filing of a 1-count, 34-page criminal information charging KPMG with conspiracy to defraud the IRS, to commit tax evasion, and to aid and assist in the preparation and filing of false tax returns. KPMG accepted responsibility for violations of law, agreed to pay $456 million in fines and penalties, and committed to comply with a broad range of remedial requirements and guidelines for the future. In exchange, the government agreed (assuming KPMG complies with the agreement through the end of 2006) to dismiss the criminal information. (1)

The prosecutors also filed a 44-page indictment of 9 individuals, 8 former KPMG professionals and a former attorney at Sidley, Austin, Brown & Wood. The individuals' indictment is similar to the KPMG information in its allegations of conspiracy to defraud, commit tax evasion, and aid and assist in filing false tax returns. The indictment also alleges obstruction of IRS and Senate investigations, false responses to document requests and subpoenas, and false statements and testimony. (2)

On October 17, 2005, a grand jury in the Southern District of New York indicted 10 more individuals in the KPMG case and filed a 70-page superseding indictment of all 19 individuals. (3) The prosecutors have given repeated indications of expanding even further their so-called tax shelter grand jury investigations. Certainly, the IRS has manifested its intent to expand further its compliance and enforcement programs and activities at all levels to deal with what it perceives to be a continuing problem of widespread tax noncompliance.

The toughening attitude of the IRS and the Department of Justice toward compliance and the enforcement of the tax laws presents substantial risks for corporate taxpayers. For the most part, these risks are civil risks involving penalties and disclosure sanctions that can be expensive and damaging to a company's reputation. In a limited number of situations, however, criminal risks may be involved. For that reason, it is important that companies deepen their understanding of the basic principles of the criminal law applicable to the tax area and sharpen their awareness about how these principles may apply to tax planning, record retention, return preparation, and audits.

In other words, the government's emphasis on tax compliance and its increasingly aggressive actions to detect and deter noncompliance are important and deserve to be taken seriously by each of us as we advise and assist large companies in their day-to-day tax planning, compliance, and interactions with the government. That said, there is a danger in overreacting to these events, particularly those arising out of the actions in the Southern District. Senior IRS executives have emphasized that the KPMG case presents a unique situation in light of its broad range of allegations spanning a six-year time period and KPMG's vigorous defense of the propriety of such activity before the IRS, the courts, and Congress, despite a detailed record of e-mails and other communications indicating a serious debate within KPMG about the tax merits of the transactions preceding an aggressive sale of the transactions to the public. (4)

In any event, there are helpful lessons to be learned from recent events about how to manage a company's tax planning, compliance, and audit activities to minimize the risk of becoming a future target of aggressive governmental actions. This article sets forth some initial reflections about what these developments may mean to all of us who work with large companies in the federal tax area. It is not intended to speculate about the merits of the recent indictments, nor to suggest that the government is trying to criminalize aggressive tax planning or the defense of such planning. Rather, its purpose is provide some perspective about the government's increased emphasis on compliance and enforcement of the tax laws and to suggest some possible ramifications for advising clients in the future.

Tax Planning Activities

For tax planning purposes, tax practitioners should weigh and balance the need to try to maximize the tax benefits to which a company is entitled in its tax planning against the desirability of minimizing or avoiding the exposures that might attract aggressive governmental actions. In doing so, one thing is pretty clear: After a decade or more of tax planning that relied on "plausible" business purposes, tax practitioners should return to tax planning that relates to real business transactions that have clear business purposes. In this context, there should be a full and open discussion of whether there is a place for pre-packaged tax savings transactions, i.e., generic tax savings transactions developed by some tax professionals without regard to any specific business or investment transaction.

The problem with pre-packaged tax transactions in most cases is that, because of their tax savings, companies and their advisers may be tempted to try to make them part of otherwise legitimate business transactions into which they do not easily fit. Pre-packaged tax transactions by definition, of course, are not developed for a particular company's situation, and often the documentation and implementation that accompanies them are not well done or tailored to a particular company's situation. As a result, when the IRS appears on the scene, there usually is little or no credible evidence to support the position that the tax transactions were done for any reason other than the tax minimization or avoidance. The recent indictments suggest that if a company goes too far in trying to justify and defend these tax transactions to the IRS, company representatives may be deemed to cross the line with statements, acts, or omissions that prosecutors later may target as false, fraudulent, or obstructions of justice.

In short, transactions that non-tax, business executives do not understand and cannot credibly explain as being part of the company's overall business or investment planning are simply too risky in today's regulatory climate. There are too many tax, financial, securities, and other disclosure requirements--and the dollar and reputational risks for not complying with them are too great--to make pre-packaged transactional tax planning a prudent strategy. This is especially the case since the future portends even greater cooperation and information sharing within the federal government--between the IRS and other federal regulatory agencies--to deal with such activities, as well as cooperation and information sharing by state, local, and even foreign governments. The reality of today's tax environment is that one of the ways a company's tax adviser can add value is to be a risk manager who is willing to say "no" when it is appropriate.

Tax Compliance and IRS Audit Activities

For purposes of corporate tax return compliance activities, recent developments suggest the wisdom of avoiding hide-the-ball strategies in preparing tax returns and instead making straight forward presentations in the return and erring on the side of full disclosure of all reportable transactions. The economics of the recently-enacted tax penalty sanctions for failing to disclose justify a full-disclosure approach. (5) The interplay between the financial and tax reporting requirements of the new FAS 109 rules and new schedule M-3 to Form 1120 reinforce a full-disclosure approach. (6) The badges-of-fraud approach of IRS Criminal Investigation Division personnel and the prosecutors emphasize the risk of a hide-the-ball approach. (7)

At the IRS audit level, particularly in audit cycles covering the last five to ten years, tax executives may wish to focus on past tax issues having potential penalty implications and be watchful for IRS audit developments involving these or other potentially sensitive matters. Tax executives may also find it desirable to reinforce their working relationships with their LMSB exam teams, territory managers, directors of field operations, and industry directors. In today's climate, alleged over-aggressive transactions are being escalated to higher levels within LSMB (or the Office of Chief Counsel or other functions in the National Office), which may not always be the best strategy from the taxpayer's standpoint. Stated another way, a good working relationship with a company's LMSB exam team may offer the best opportunity for resolving audits and limiting the number of issues raised.

It is certainly true that, on certain matters today, a company's LMSB team may have more IRS personnel looking over its shoulders than in the past. As a result, an LMSB team may be asked to do things that, left to their own devices, they might not do. They retain discretion, however, about what audit issues to raise. One example: a LMSB exam team may be required to request a company's tax accrual workpapers, but when the company turns over its workpapers, the LMSB team still has discretion to decide how many and which issues to audit.

In today's environment, more than ever, companies should seek practical solutions at the lowest levels of the IRS. To that end, companies should build on the trust and confidence of their LMSB exam team. For example, a company should take the time to explain to its LMSB team why the company did or failed to do certain things, even if the company believes the team will still make adjustments or even impose penalties. One of the lessons that might be drawn from the KPMG matter is the importance of having and executing a sound strategy for how a company goes about agreeing to disagree with the government. There still are ways you can try to work things out, even in the worst situations, if you maintain the proper relationship with the government representatives on the other side of the table. There are real advantages to treating the IRS team members with respect, being straight with them, and not trying to take advantage of them.

Maintaining the trust and support of LMSB, however, may not be easy. For example, if you assert attorney-client privilege or work product as a basis for not disclosing information, or if there is a significant book-tax difference between the way in which a transaction is reported for tax purposes and the way it is reported for financial purposes, LMSB auditors increasingly view either of these situations with suspicion and distrust.

There are many, often conflicting demands on LMSB teams to ferret out noncompliance while maintaining audit currency by completing each audit cycle on time. Resources are limited at all levels of the IRS because the agency is being stretched by ever-increasing demands. Finding ways to help LMSB in this environment, even as companies seek to address their own problems, can pay dividends. For example, when LMSB completes the pending pilot of the Compliance Assurance Program (in which corporate taxpayers are audited on a real-time basis throughout the year) and makes the new program more widely available, (8) companies may find that LMSB will have more flexibility to resolve issues before the tax return is filed than it currently has in the traditional audit program after the return is filed. Again, the point is that the changed tax regulatory and financial reporting environments may require tax practitioners to think in ways totally different from what previously has been the accepted wisdom. In the final analysis, however, the IRS will often treat taxpayers differently, depending upon whether the IRS views them as compliant or noncompliant taxpayers.

Potential Long-Term Implications of Other Recent Developments

Looking beyond the short-run implications of the recent tax compliance developments at the IRS and in the Southern District of New York, it is important to focus upon longer-term trends across the federal government that may put today's tax compliance emphasis into a broader perspective about what we may expect for the future.

At the federal level, there clearly is an increased focus on the revenue and expenditure effects of the country's changing demographics as our baby boomers begin to retire. Coupled with the rising costs of our healthcare programs and the costs of our defense and homeland security programs, the ongoing cost of Social Security and Medicare means that the annual budget for the rest of the federal government, including our tax system, is likely to remain flat or decrease in the future, regardless of increases in agency workloads. In light of the fiscal constraints, Congress is likely to expect the IRS to even more zealously protect our country's revenue base and to deter any threat to that revenue base from aggressive tax planning.

Despite Commissioner Everson's focus on tax noncompliance and his often-repeated promise to return $8 for every additional dollar that the government invests in the IRS, the agency's budget seems unlikely to increase significantly in the future. Faced with this prospect, the IRS has begun to evaluate what kind of operational strategy it should pursue to deal with an increasing workload, relatively flat or declining resources, and an increasingly complex tax law with which taxpayers appear less able or willing to voluntarily comply.

Federal regulatory agencies other than the IRS already have adapted to this challenge of ensuring continued compliance without increasing agency costs by adopting new compliance and enforcement programs designed to encourage self-regulation by the private sector. Agencies like the Securities and Exchange Commission, the Department of Justice (in its enforcement of the Foreign Corrupt Practices Act), and the Customs Service at the Department of Homeland Security have required companies and their outside professionals to identify and address potential areas of non-compliance by developing and submitting specific action plans for agency approval. Often if a company wishes to take advantage of a new agency program--such as the new Customs program to fast-track products through Customs--the company must convince the agency that the company can police itself. Furthermore, if a company identifies a non-compliance event, it is required to investigate the non-compliance, notify the federal agency about the noncompliance, waive all privileges, turn over all internal investigation reports, and assist with the implementation of all remedial actions imposed by the federal agency. In many cases, the internal controls and disclosure provisions of the Sarbanes-Oxley Act serve to backstop the agency's regulatory requirements. If a company fails to cooperate, the sanctions are severe and the supervisory powers of these federal agencies to require cooperation are substantial. Because no other alternative to encourage compliance on a cost effective basis has been identified by the regulatory agencies, the use of the self-regulatory approach is spreading across the federal government.

In the tax area, the IRS has used a combination of carrots and sticks to encourage self-regulation by companies. Carrots include the Pre-Filing Agreement program, the Limited Issue Focused Examination (LIFE) audit program, and even skipping audit cycles for compliant taxpayers. Sticks include the tax shelter disclosure rules and regulations over the last four years, the tax accrual workpapers disclosure rules, the increased use of penalties and related SEC disclosures, and the recent Circular 230 changes, all of which have similar purposes, to encourage taxpayers and their tax advisors to self-regulate, in part by disclosing certain potentially troublesome transactions to the IRS, with the significant sanctions for failing to do so.

At one level, the recent actions in the Southern District of New York can be seen as another sanction if a taxpayer does not satisfy government expectations with respect to its disclosures and compliance obligations. Significantly, however, the terms of KPMG's remedial requirements and guidelines under the deferred prosecution agreement may presage a new type of technique to ensure ongoing compliance by a major taxpayer. (9) The IRS appears to be finding ways to reward taxpayers it views as compliant, and there is little doubt the IRS treats more harshly taxpayers it views as noncompliant.

Consider the possibility that IRS may go even further than its present programs to reward compliant taxpayers and punish noncompliant taxpayers, to require a company's outside auditors and attorneys to help the company periodically assess and report not only areas of potential weaknesses but also actual noncompliance events, accompanied by privilege waivers and the reports of the professionals' internal investigations, and in cases of severe noncompliance, to hire outside overseers to develop and oversee specific action plans to restore the company's tax compliance. Some may believe these kinds of changes would go too far, particularly since foreign-based competitors may not be subject to these kinds of compliance policies in their countries. As understandable as such a reaction may be, the present more aggressive compliance actions by the IRS may be precursors of things to come as the federal government seeks to find more ways to protect its revenue base without increasing its costs in order to cope with the escalating demands of its entitlement, security, and defense programs.

If the IRS finds that it is under increasing pressure to perform its tax compliance functions but lacks the funding to adequately deal with rising non-compliance, the IRS may follow the lead of other federal regulatory agencies and look even harder for ways to encourage self-regulation in order to maintain or increase tax compliance. In light of the increasing demands to lower governmental costs and protect the federal revenue base, if the IRS is able to increase revenue at the same or decreased cost to the federal government, it should surprise no one that the Administration and the Congress may become willing to permit, facilitate, and even encourage the IRS to do so. Whether or not this should happen or will happen, tax executives should be aware that many of today's efforts by the IRS to increase tax compliance are in line with a general governmental trend to shift more of the responsibility and cost for compliance to the private sector.

In the face of an increasingly aggressive IRS tax compliance program, when a company takes a hard look at its own federal tax planning, compliance, and audit programs and decides upon its future strategy to remain competitive in the industry from the standpoint of it tax and tax compliance costs, it may be helpful to better understand these developments and their potential effect.

(1) See IRS News Release IR-2005-83, at 1 (August 29, 2005, Statement of IRS Commissioner Everson), TNT Doc. 2005-17973; KPMG-Deferred Prosecution Agreement (August 26, 2005), TNT Doc. 2005-17995.

(2) See Sealed Indictment (S.D.N.Y. August 24, 2005), TNT Doc. 2005-17997.

(3) See Superseding Indictment (S.D.N.Y. October 17, 2005), TNT Doc. 2005-21082.

(4) See, e.g., 2005 TNT 181-2 (September 20, 2005).

(5) See, e.g., IRC [section] 6662A.

(6) See Proposed Interpretation of FASB Statement No. 109, July 14, 2005 Exposure Draft, Accounting for Uncertain Tax Positions.

(7) The traditional "badges of fraud" have included concealment of income, fictitious deductions, allocation of income to fictitious parties or relatives, and the maintenance of false books.

(8) See 2005 TNT 218-3 (November 14, 2005).

(9) See KPMG-Deferred Prosecution Agreement, TNT Doc. 2005-17995.

LAWRENCE B. GIBBS is a member of the law firm of Miller & Chevalier Chartered and is a former Commissioner of the Internal Revenue Service. He is a recipient of Tax Executives Institute's Distinguished Service Award, and this article is based on a keynote speech given on October 24, 2005, at TEI's 60th Annual Conference in San Diego, California. Mr. Gibbs expresses his appreciation to the following colleagues at Miller & Chevalier for their assistance in the preparation of this article: Kathryn C. Atkinson, Jay L. Carlson, Phillip L. Mann, Sturgis M. Sobin, and Andrew T. Wise.