The arbitration alternative.

The IRS is conducting a two-year pilot program under which a taxpayer and the IRS Office of Appeals can jointly request binding arbitration in certain cases. According to IRS announcement 2000-4, the program, which began in January, allows taxpayers to request binding arbitration for unresolved factual issues--asset valuation or reasonable compensation, for example--already in the appeals office administrative process.

RESOLVING UNRESOLVED ISSUES

The IRS Restructuring and Reform Act of 1998 created IRC section 7123(b)(2). The act required the IRS to establish a program allowing taxpayers and the appeals office to ask for binding arbitration on certain issues that are unresolved at the conclusion of (1) appeals procedures or (2) unsuccessful attempts to enter into an IRC section 7121 closing agreement or a section 7122 compromise.

CPAs will find arbitration is not available for

* Cases in which it is not appropriate under the statutes listed in the announcement.

* Issues involving the substantiation of expenses under IRC sections 162 or 274.

* An issue designated for litigation or docketed in any court.

* An "industry specialization program" issue or an issue where the IRS has decided a coordinated response is necessary to ensure consistent taxpayer treatment.

* A foreign tax treaty issue for which the taxpayer has filed a request for, or intends to seek, "competent authority" assistance.

* An issue for which the taxpayer has requested the "simultaneous appeals/ competent authority" procedure described in revenue procedure 96-13, section 8.

HOW IT WORKS

The taxpayer and the appeals office first must try to negotiate a settlement. If the negotiations are unsuccessful, the parties together may request binding arbitration to resolve factual disputes. For example, the parties could ask an arbitrator to determine whether, based on the applicable code and regulations, the compensation a company pays its president is reasonable.

For the pilot period, arbitration is optional. The taxpayer and the IRS assistant regional director of appeals-large case (ARDA-LC) must formally agree to it in writing. The taxpayer or appeals office may request arbitration after both parties agree to it. The taxpayer sends a written request to the team chief/appeals officer responsible for the case, who then prepares a written recommendation for action. The request and recommendation are forwarded to the appeals officer's immediate supervisor, whose decision is reviewed by his or her manager and forwarded to the ARDA-LC for final determination. The national director of appeals, Office of Alternative Dispute Resolution and Customer Service (Office of ADR&CS), is consulted before the IRS makes a final decision.

ARDA-LC generally makes a final determination within 30 calendar days from the date the team chief/appeals officer receives the request. ARDA-LC promptly informs the Office of ADR&CS and the appeals team chief (or appeals associate chief and appeals officer) of the decision. The team chief, in turn, promptly informs the taxpayer. If the request is approved, the Office of ADR&CS schedules an administrative conference with the taxpayer to discuss the arbitration process. If the IRS denies the request, the taxpayer may request a conference with ARDA-LC; there is no formal appeal procedure.

Arbitration binds the parties to the arbitrator's findings. A factual issue is eligible for this process if it can be resolved solely on a finding of fact and if the parties agree to the arbitrator's interpretation of law, regulation, ruling or other legal authority. The taxpayer and the appeals office must agree to be bound by, and not appeal, the arbitrator's findings.

The arbitrator and either party must communicate (including requests for and transfers of documentation and information) through an administrator unless both parties are present. The administrator will be from the appeals office, the Office of ADR&CS or the organization providing the arbitrator. The arbitrator and administrator will discuss with the parties the rules and procedures--among which are that no ex parte communication can take place between either party and the arbitrator.

THE ARBITRATION AGREEMENT

The parties negotiate an arbitration agreement at an administrative conference provided by the Office of ADR&CS. The agreement should be concise and focus the arbitrator on the prescribed tasks of finding facts and preventing ex parte communication between the arbitrator and the parties. It should also limit or describe the information the arbitrator is to consider. The agreement may indicate the tax treatment of the arbitrator's findings or clarify any issue that could arise in computing a tax deficiency or overpayment resulting from the fact-finding.

The agreement also should address the following:

* The participants in the arbitration process.

* The selection of IRS or non-IRs arbitrators in general.

* If someone from the IRS appeals office is to serve as the arbitrator, a conflict-of-interest statement and a statement that the national appeals office (Office of the National Chief, Appeals) will pay all expenses associated with that arbitrator.

* If the parties select a non-IRS arbitrator, a statement that the taxpayer and the national appeals office will share all expenses associated with that arbitrator.

* The criteria for selecting an arbitrator, such as experience and industry knowledge.

* The factual issues the parties have agreed to arbitrate.

* The site, date and agenda of the arbitration session.

* A statement that appeals office procedures apply. If the arbitrator renders a decision on all or some issues, the appeals office will use established procedures to close the case, including preparing a specific-matters closing agreement (form 906). Each party relies on the other party's agreement to be bound by the arbitrator's decision.

Confidentiality. In executing the arbitration agreement, the taxpayer consents to the IRS'S disclosure of the taxpayer's returns and return information incident to the arbitration, to any participant or observer identified in the list of participants and observers. Under section 7214(a)(8), IRS employees who have knowledge or information about the violation of any U.S. revenue law must report such knowledge or information in writing. The arbitration agreement must state this duty; the parties, in turn, must acknowledge it.

Disqualification and withdrawal. The arbitrator is disqualified from representing the taxpayer in any pending or future action involving the transactions or issues that are the subject of the arbitration. Under certain circumstances, this prohibition will not extend to the arbitrator's firm. With the parties' consent, the arbitrator may suspend the arbitration process at any time to allow the parties to reach a final settlement before the scheduled arbitration session.

The arbitrator's report. At the conclusion of the arbitration process, the arbitrator prepares a brief written report and submits a copy to the administrator. The report contains findings of fact only. The arbitrator's findings are not binding, nor do they otherwise control the parties for tax years not covered by the arbitration. Except as provided in the arbitration agreement, neither party may use the findings as precedent.

TO ARBITRATE, OR NOT?

CPAs can play an important role in the new IRS arbitration procedures. This includes advising a client whether arbitration is the appropriate way to resolve the issue or issues in question or whether to pursue litigation. The CPA should point out to the client the possible hazards of each alternative. If the client chooses arbitration, the CPA can help him or her select an IRS or non-IRs arbitrator and the expert witnesses who will participate in the process.

TESTING, TESTING

The pilot procedures are effective for arbitration requests made during the two-year test period that began January 18. IRS announcement 2000-4 contains a model arbitration agreement, list of participants and observers and arbitrator's report, which CPAs and their clients will find useful in electing and preparing for the arbitration process.

LESLI S. LAFFIE, JD, LLM, is the technical editor of The Tax Adviser. Ms. Laffie is an employee of the American Institute of CPAs. Her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.