The LMSB Division blazes IRS restructuring trail.

The Large and Mid-Sized Business (LMSB) division emerged in June 2000 with the promise of radically changing the relationships between the IRS and its largest taxpayers--the approximately 250,000 entities with assets in excess of $5 million. As it approaches its first anniversary, LMSB has pushed forward some innovations that have drawn support from its constituency and will likely be adapted for use in the other three divisions. While LMSB's first-year efforts have earned positive reactions from many, huge challenges remain for it and for the Service's overall restructuring. Practitioners will continue to be challenged to interpret the many new signals coming from the IRS and to navigate their clients through its many new processes.

The Small Business/Self-Employed Division (SBSE) faces challenges even more daunting. As heir to most of the field enforcement and a substantial part of customer service personnel, SBSE has to confront some of the most complex transition issues.

IRS Restructuring

The Service spent a massive amount of time and money this past year in moving the human, physical and financial assets from their functional and geographical roots to the four new customer-based divisions. As the one-year mark approached, the old boxes had been replaced by new structures. Nearly 100,000 employees were reassigned to the new organizations. Assistant Commissioners, Regional Commissioners, District Directors, Division Chiefs and District Counsel have given way to Industry Directors, Area Directors, Territory Managers, Industry Counsel, Area Counsel and a variety of other new positions.

On the surface, the new structures appear to have settled in place. However, on close examination, the IRS is still wrestling with hundreds of transition issues. In addition to the gargantuan effort involved in restructuring virtually every facet of the organization, it has also pressed to fulfill the many additional mandates of the Internal Revenue Service Restructuring and Reform Act of 1998, to improve its overall customer service and convince Congress that it possesses the capability to accomplish the long-awaited systems modernization.

PFAs: An Early Success

The LMSB division has advertised its interest in fundamentally altering the relationships between the IRS and taxpayers. One of the guiding principles of the restructuring has been to encourage pre-filing initiatives, which address questions and potential conflicts earlier and less expensively.

During 2000, the LMSB conducted a pilot of a pre-filing agreement (PFA) initiative (see Tax Practice & Procedures, "Update on New IRS Resolution Programs," TTA, January 2001, p. 62). The theory behind the initiative was that both taxpayers and the government would benefit from resolving issues up-front--prior to filing a return--rather than years later when the return is under audit. This theory is most persuasive, when the choice is between solving a problem now or solving it later when key personnel and records may be less available. Not all taxpayers have been persuaded that the new ways are for their benefit. Some, influenced by reports of the decline in the Service's enforcement activity, have concluded they are better off playing the audit lottery--betting that the IRS will not raise the issue on audit or, if it does, it will not have the capacity to see it through. Other taxpayers have welcomed the opportunity to secure certainty on the treatment of an issue before it ever goes on the return.

In a congressionally mandated report made public on April 6, 2001, the Service evaluated its PFA pilot. According to the report, it received 19 applications, spanning all five of the LMSB industry segments. The IRS accepted 12 applications and completed seven PFAs by the end of 2000. Four PFAs were still in process when the report was published and one had been withdrawn. The seven PFAs executed involved the following issues:

* Valuation of assets--valuation of a covenant not to compete: The Coordinated Examination Program (CEP) examination team and the taxpayer agreed that no amount was allocable to a covenant not to compete in a purchase transaction.

* Valuation of assets--valuation of patents contributed to a charity: The CEP examination team and taxpayer reached a determination on the valuation of patents based on their market value.

* Methods of accounting--accounting for a contract newly entered into, using an accrual method instead of a long-term contract method proscribed under Sec. 460: The examination team determined that an accrual method was the appropriate method and that an accounting method change under Sec. 446 was not required because the change in treatment resulted from a change in the underlying facts.

* Method of accounting--change in method of accounting for depreciable property that the taxpayer believed had been misclassified: The examination team agreed with the taxpayer's revised classification and with the taxpayer's proposal to automatically change its method of accounting for depreciation. The team and the taxpayer reached agreement on the appropriate Sec. 481 adjustment.

* Expense vs. capitalization--determination of the amount to be capitalized in a large repair expense account using a statistical model: The issue was resolved using a statistical methodology that had been used in an earlier audit, and an agreement was reached on the portion of the account that would be subject to capitalization.

* Stock-basis computation--computation of tax basis of stock acquired in a reorganization transaction that qualified under Sec. 368 (a)(1)(B): The report indicates that the examination team agreed with the taxpayer's computation of stock basis under Sec. 362(b).

* Investigative costs--treatment of costs incurred to acquire a business: The taxpayer proposed that certain of the costs were investigatory in nature and therefore deductible under Sec. 162. Based on the principles contained in Rev. Rul. 99-23, the examination team and the taxpayer agreed on which items were Sec. 162 costs and which were Sec. 263 costs.

The report did not explicitly identify the issues surrounding the four in-progress PFAs, but from speeches and other press accounts, it appears that all four involve the research credit.

The Service calculated that it took from 110 to 228 days (with an average of 166 days) to complete a single PFA. In addition, the total number of hours of "direct examination time" expended by taxpayers and the IRS for the seven completed PFAs was 1,976 and 1,114, respectively.

After determining the pilot a success, the Service issued Rev. Proc. 2001-22, making the PFA program permanent. Under the permanent program, PFAs are now available to all LMSB taxpayers, including those not under examination. The criteria for a PFA under the permanent program are similar to the pilot:

* Suitability of the issue presented for the LMSB PFA program;

* The direct or indirect impact of an LMSB PFA on other years, issues, taxpayers or related cases;

* The availability of IRS resources;

* The ability and willingness of the taxpayer to dedicate sufficient resources to the LMSB PFA process;

* The likelihood that the PFA may result in two or more persons taking contrary positions on an item or transaction (whipsaw);

* The time remaining until the due date of the return to which the PFA relates; and

* The overall probability of completing the process and entering into a PFA by the due date for filing the taxpayer's return.

A taxpayer is not entitled to a conference to appeal a decision not to go forward with the PFA process. A taxpayer not selected for the PFA program remains eligible for other procedures for early resolution, including the Accelerated Issue Resolution program (see Rev. Proc. 94-67).

Under IRS Delegation Order No. 262 (Rev. 1), dated March 3, 2001, the Commissioner and Deputy Commissioner of LMSB, LMSB Industry Directors and LMSB Directors of Field Operations have the authority to enter into and approve pre-filing agreements described in Rev. Proc. 2001-22 (and any successor revenue procedure). Under Rev. Proc. 2001-22, the LMSB Industry Director (or his designee) with jurisdiction over the taxpayer will make the final decision whether to proceed with the PFA.

The Service is actively promoting the use of PFAs. Certain managers within the LMSB have performance objectives aimed at encouraging taxpayers to use them. Predicting how widespread PFAs will become is difficult. There is no recipe for determining when a PFA is a good idea. Those who have successfully entered into PFAs have been complimentary about both the process and the substantive result. Others have shunned PFAs, believing there was more risk than reward in highlighting issues to the IRS. Ultimately, whether a taxpayer pursues a PFA is a combination of substantive and environmental considerations. For some taxpayers, the certainty associated with settling an issue in the pre-filing stage would be valuable--it may materially affect the treatment of a specific transaction for financial reporting purposes, and may even affect the dynamics of a particular merger or acquisition. Other taxpayers would be more comfortable confronting an issue (if at all) within the confines of what they might see as the more predictable audit process.

IIR Pilot

While PFAs are aimed at individual corporate taxpayers that seek certainty about how standard legal principles apply to particular transactions, the LMSB's new Industry Issue Resolution (IIR) program is aimed at groups of corporate taxpayers that have struggled with specific existing administrative guidance. Under the IIR, industry groups are encouraged to identify instances in which existing administrative guidance is administered inconsistently, is out of step with current business practices or is at the center of protracted examination contention between the Service and taxpayers in a specific industry segment.

On Dec. 11, 2000, with the publication of Notice 2000-65, the IRS invited applicants for a pilot IIR program. It received 24 applications from businesses, tax practitioners and associations, which suggested that there are issues common to many large-business taxpayers. The applications addressed issues within all the industry segments, with Financial Services and Healthcare attracting the most, with nine proposals. Taxpayers from the Retailers, Food and Pharmaceutical industry submitted six applications, Heavy Manufacturing, Construction and Transportation supplied five, while the Communications, Technology & Media industry and Natural Resources industry each contributed two applications.

On April 26, 2001, based on the guidelines listed in Notice 2000-65, the Service announced its selection of seven industry issues for the IIR pilot program:

1. Allowance for depreciation on certain golf course improvements;

2. Clarification of the conformity election by banks for bad debts;

3. Taxability of demonstrator automobiles provided to salespersons;

4. Reporting of payments to employees who own heavy equipment used by their employers;

5. Treatment of local impact fees and similar costs on low-income housing tax-credit property in determining basis;

6. Determination of recoverable reserves of oil and gas for cost depletion purposes; and

7. Allocation of cost of restaurant smallware packages between allowable expenses (Sec. 162) and capitalization (Sec. 263).

The selected IIR issues will be worked on by teams comprised of personnel from LMSB, IRS Chief Counsel and Treasury. Each team will be led by an LMSB Director of Field Operations from the industry segment with jurisdiction for the taxpayers affected. The specific rules of engagement will be worked out as the pilot program unfolds, but the Service has made clear its intention to seek maximum engagement with the stakeholders affected. However, the IRS has also made clear that it reserves the right to determine the precise form of guidance, as well as the ultimate substance of that guidance.

One distinct advantage of being selected for the IIR program is the assurance that issuance of the resultant guidance will be a guaranteed priority in the IRS/Treasury business plan. In the past, issues addressed through programs like the Market Segment Specialization Program could, become bogged down at the point of guidance issuance, because the project might not have been identified early enough to be included.

The Service has set Nov. 30, 2001 as its target for completing the IIR pilot. If the pilot proves successful, the program will become permanent. IIR issue resolution requires resources from the Service, Chief Counsel and Treasury. Because these resources would otherwise be devoted to other business-plan priorities, a permanent IIR program is likely to cover only a limited number of issues at any given time.

New Audit Process

LMSB's next target for innovation is what it is calling the "post-filing process"--otherwise generally already known as the audit process.

LMSB is currently circulating three questions among large taxpayers, encouraging them to fuel the audit redesign effort through their responses:

1. What tax administrative issue, policy or procedure currently causes the most difficulty during an audit?

2. What could LMSB do in the near term to speed up the audit process and achieve greater currency?

3. How could LMSB get certainty that a tax return is accurate without performing an audit?

The IRS plans to retool the LMSB audit process in 2001.

LMSB's early impact on its constituent taxpayers has provided some of the most tangible evidence of the progress of overall IRS restructuring efforts. While LMSB has admittedly taken only its first steps on a planned path that it believes can fundamentally improve its performance, it has succeeded in creating a sense of forward momentum.

SBSE Restructuring Pushes Forward

The SBSE faces daunting challenges in creating for itself a sense of forward momentum similar to that of LMSB. As the heir to most of the field enforcement and a substantial part of the customer service personnel, SBSE has had to confront some of the most complex transition issues.

Examination and collection personnel, accustomed to a district structure within which they were supervised by functional (collection or examination) division and branch managers, now report to cross-functional territory managers and area directors who oversee far-flung geographical jurisdictions.

The new lines of authority extend from group managers through territory and area managers, which feed directly into the National Office. On one level, the direct reporting structure promises nationwide consistency. On another, it may strike field agents and officers as overcontrol by Washington. Complicating matters further is the fact that there are a variety of organizations within SBSE--all operating through somewhat parallel area and territory substructures.

Unlike the old frame of reference, in which a District Director oversaw most IRS activity within a geographical area, the new SBSE structure may result in multiple centralized chains of command, affecting taxpayers and issues within a specific geographical area. Two examples help outline SBSE's structural challenge. In the first circumstance, the 16 Compliance Area Directors appear to be in control of all audits and collections within their defined geographical areas. This is true insofar as the actual supervision of work-in-progress is concerned. However, two separate organizations--both of which report directly to Washington, and are not supervised by the Compliance Area Director--are actually responsible for selecting the work done by the agents and officers and for closing and reviewing the quality of their work.

The second circumstance that demonstrates SBSE's structural challenge is found in the parallel responsibilities held by the new Taxpayer Education and Communication (TEC) structure. TEC is overseen by eight Area Directors, who are responsible for outreach, education and communication within the same customer segment that SBSE's Compliance Area Directors oversee audit and collection activity. Managing the boundaries between outreach resources designed to improve future compliance and compliance resources examining past and current compliance will likely be one part science and one part art.

Just in case SBSE was not sufficiently challenged by the complexity of restructuring, it has also become embroiled in the public debate over the drop-off in enforcement activity. One part of the solution will be found in the IRS's authority to hire new personnel, provided in the fiscal-year 2001 budget and in the fiscal-year 2002 administration proposal. If the hiring effort succeeds, several hundred agents and revenue officers that have been diverted to other assignments will be able to return to examinations and collections. Being able to recruit agents and officers also means that SBSE can build up its new TEC organization and replenish some of the personnel losses in compliance, which have gone unabated for most of the last decade.

SBSE Going Forward

SBSE has many challenges facing it. It began as the most complicated facet of the IRS restructuring, and remains as such. Taxpayers and their advisers will likely find that SBSE initiatives mirror those introduced by the LMSB. SBSE will also, for some time to come, likely encounter a myriad of coordination and communication challenges as it tries to complete its repositioning of personnel and responsibilities.

FROM MICHAEL P. DOLAN, NATIONAL DIRECTOR, IRS--POLICIES & DISPUTE RESOLUTION, WASHINGTON NATIONAL TAX, KPMG LLP, WASHINGTON, DC

Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC