The many faces of dispute resolution.

A complex tax law, global economy, international competition and the financial penchant for improving after-tax income will cause disagreements between taxpayers and tax administrators. This is costly to both the government and taxpayers; time and human resources are expensive. With less than 25% of large corporate audits and only 1% of proposed audit dollars agreed on in the late 1980s, the IRS has recognized the need to improve the dispute resolution process and has developed several programs.

Background

The Service made changes in the early 1990s that encouraged examiners to resolve "factual disputes" and obtain agreements with taxpayers. By 1995, the large corporate audit case agreement rate increased from less than 25% to over 75%; the percentage of audit dollars agreed on improved to 25%. Today, roughly 65% of large corporate audits and 23% of large corporate proposed adjustments were agreed on in 2001-2003. The Service continues to struggle with agreements and the time span of audits. Although agreement rates have improved, the time needed to complete examinations has not. Large corporate audits still take an average of five years to complete; the Office of Appeals (Appeals) process to finalize them takes an average of more than two years--very similar to the timeframes of the early 1990s.

The Service has introduced a variety of initiatives intended to bring disputes to a prompt conclusion. Their success, while dramatic for individual corporate taxpayers, has not significantly improved the overall system. The corporations that take advantage of the initiatives receive prompt attention, but apparently at the expense of others, as the average timeframes have not changed significantly.

Programs

Industry Issue Resolution (IIR) program (Rev. Proc. 2003-36). This program intends to identify contentious industrywide issues and resolve them with specific guidance. IRS and Treasury personnel solicit the public to identify issues that arise frequently and to recommend resolutions. They study and analyze each issue and produce guidance in the form of a revenue procedure. While, thus far, they have released about 10, the process is time- and resource-consuming for both the Service and industry representatives.

Considering the views of many parties and trying to satisfy everyone's needs have proved to be a challenge, and outcomes are not always perceived as improvements. The volume of issues (about 150 IRS coordinated issues alone) far outstrips resources. The program accepts fewer than 10 issues a year. It has successfully resolved the few studied, but needs to produce much more guidance. The IIR program has potential, but IRS resource limits prevent it from having a significant effect.

Pre-Filing Agreements (PFAs) (Rev. Proc. 2001-22). This program allows taxpayers to identify issues and reach agreement with the IRS before filing. The program has merit, because both sides accept the return, potentially saving a lot of time. A number of successful PFAs have been completed, but strict criteria for eligibility have limited this program. It has accepted fewer than 100 issues, a very small part of the thousands examined each year, and is time-consuming. Overall, while interesting, provocative and beneficial to those who use it, the PFA program has not yet made substantial changes to the audit process.

Limited Issue Focused Examination (LIFE) (IR 2002-133). As the newest initiative to accelerate the audit process, LIFE is supposed to limit the scope of audits and obtain cooperative agreements for conducting them. This includes bruiting the kind and number of issues based on "materiality," and identifying and agreeing to the documents and records required, in advance. If the IRS accepts that every issue and document does not need to be examined and that every dollar of tax does not need to be assessed, LIFE has a potential for success. However, the Service must permit and support the process in most audits.

Delegation Orders 236 and 247. The IRS delegated formal settlement authority to Office of Examinations (Examinations) managers in bruited circumstances. Although a manager's authority is restricted, the delegation orders provide avenues for resolving cases at a lower level. The managers can settle recurring issues that have already been settled in Appeals and settle coordinated issues based on Appeals settlement guidelines. Both issues are troublesome; delegation orders provide a sensible way of resolving them more quickly. However, the authority has been sparsely used, perhaps because of factual differences between years and evolving legal positions.

Early referral to Appeals (Rev. Proc. 99-28). This procedure (in place since 1992) allows taxpayers under examination to request the transfer of a developed, unagreed-on issue to Appeals, while Examinations continues to develop the other issues in the case. This intends to permit earlier resolution of individual issues and audits. Although several hundred issues have been successfully resolved through this program, it has had a minimal effect on expediting the overall audit process.

Accelerated Issue Resolution (AIR) agreement (Rev. Proc. 94-67). This program allows issues raised, developed and agreed to during a corporate audit to be finally resolved for all open years through a closing agreement. It almost seems self-evident: if a taxpayer and the Service resolve an issue, why should it be raised and disputed again in the future? AIR agreements have been used advantageously a number of times, but the number of issues resolved with them is very few relative to the many examined. Both taxpayers and the IRS appear unsure of agreements for any years not currently on the table, perhaps because the facts and law continually change. The Service has also placed restrictions on the process by limiting the eligible issues.

Fast-Track Mediation (FTM) (Notice 2001-67). In this process, an Appeals Officer is introduced into the examination process to bring the examiner and the taxpayer to agreement on the facts while the issues and case are still under Examinations' jurisdiction. The Appeals Officer can also propose a settlement (under hazards of litigation), to which both sides must agree. A very short time frame (120 days) exists to reach agreement. FTM has been successful in quickly resolving issues and bringing cases to prompt conclusions. Resources devoted to achieving 120-day resolutions under FTM, however, are taken directly away from traditional Appeals cases, causing the time spans of those cases to increase, perhaps correspondingly.

Mutually Accelerated Appeals Process (MAAP) (IR 2000-42). This process expedites the movement of large cases through the Appeals process via a formal agreement for both sides to devote additional resources (e.g., primarily staffing) to the work plan. MAAP can work as envisioned only if the IRS has resources to devote to increase staffing activity, which it does not. The program's practical effect is that cases electing MAAP move more quickly, while others move more slowly.

Comprehensive Case Resolution Program (Notice 2001-13). This program was a creative, but failed, initiative designed to resolve unagreed-on issues at all levels of the audit/appeals/litigation process, in one effort. It was supposed to bring together all IRS functions (Examinations, Appeals and the Office of Chief Counsel) and all of the tax years in their combined jurisdictions to one resolution table, to jointly work out a settlement for all years and issues. Although the IRS extended the program, it did not approve any participants. It placed strict rules on the process, which limited the program's potential.

Other programs. Some of the processes to expedite case resolution hold promise, but their current form has been limiting their reception. For example, Mediation (Rev. Proc. 2002-44) and Arbitration (Ann. 2002-60) are available at the end of unsuccessful appeals. Both of these programs are supposed to bring third parties into the resolution process in a final effort to avoid even more lengthy litigation. There have been too few successes and, overall, resolution of disagreements has been very minimal. Both programs suffer from strict rules and limits that need liberalizing.

Barriers to Success

Additional authority given to examiners to resolve cases was by far the most successful approach to improve overall audit agreement rates. However, when large amounts of money are at issue, significant improvement has been lacking, Further, contrary to expanding examiners' decision-making authority, issue coordination and counsel involvement have diminished success. The restriction of examiner authority should cause taxpayers to look for other avenues of resolution; the initiatives described above may present opportunities. Many creative procedures are available, with admirable goals of reducing contention and bringing disagreements to fast and acceptable ends. Successes, however, have been elusive so far and limited to taxpayers that actively seek ways to resolve their disputes with the IRS.

The reasons for limited success are varied and include:

* Lack of resources--the IRS does not have sufficient staffing to provide good customer service and efficiently improve compliance activities.

* Treating the symptoms rather than the disease--the disease is the tax system's complexity; the Code can promote controversy.

* The predisposition of the IRS in approaching any questionable tax issue--IRS examiners perceive themselves as "protectors of the revenue" and are adversely influenced by the credibility issues they often encounter.

* IRS conservatism, perhaps driven by fear of criticism or failure--the IRS as an organization is subject to political oversight that inhibits risk-taking.

* A general goal of taxpayers to minimize worldwide taxes--taxpayers must seek every opportunity for reducing taxes to remain competitive.

* The proliferation of settlement tools may discourage settlement--multiple disjointed settlement opportunities may actually forestall resolution.

The many IRS initiatives introduced, tested and adopted over the last 10 years have not yet improved agreement rates for the audit system as a whole or affected the average time of resolving disputes; they have only provided relief for taxpayers actively pursuing them. To change the time-consuming and unpleasant system of never-ending audits and dispute may require a simpler tax system, an adequately staffed and risk-oriented tax organization and an open-minded public.

The bottom line for the IRS dispute resolution process is that it works very well in getting the Service and taxpayers to agree on more issues at lower levels--but only when taxpayers know their options and how to use them. The IRS audit process needs to embrace resolution programs more fully and expand the benefits across the board. Programs that have shown success should be integrally incorporated into the system. In the meantime, taxpayers and their representatives should aggressively pursue the opportunities made available by the Service to increase agreements and reduce the time needed to reach them. The dispute resolution system is still slow, but it is better.

FROM JOHN J. MONACO, CPA, PRICEWATERHOUSECOOPERS LLP, WASHINGTON, DC, AND TIMOTHY DREYER, J.D., PRICEWATERHOUSECOOPERS LLP, JACKSONVILLE, FL

Mark H. Ely, J.D., CPA

Partner

Washington National Tax

KPMG LLP

Washington, DC