What to do when facing a substantial tax deficiency.

All corporations and individuals are subject to Internal Revenue Service audits of their tax returns. The larger the enterprise, the more likely that audits of each tax year will be conducted.

Historically, audits of taxpayers have been conducted by IRS agents. Two significant changes to this practice have occurred recently. First, the IRS has begun to employ its own attorneys to augment its audit of certain key issues to make sure that the necessary taxpayer documents are obtained and that taxpayer/employee interviews are conducted where the IRS needs additional information. Second, the IRS has greatly increased its support of its Industry Specialist Program, which focuses on what the IRS regards as the important tax issues affecting major U.S. industries.

in the normal IRS audit circumstance, adjustments are frequently proposed, negotiated and agreed to at the audit level by a company's in-house tax staff. if matters are not resolved at the audit level, proposed adjustments to a company's tax liability can be protested to the Appeals Div. of the IRS. If a company is unsuccessful at that level, it must resort to litigation.

There are circumstances where the IRS proposes large deficiencies which are not likely to be resolved favorably at the audit level. This article explores what actions company officials should take when confronted with a large proposed tax deficiency which is not likely to be resolved at the audit level.

Handling significant tax controversy matters requires a specialist with a further subspecialty. Not only should company tax personnel seek out an experienced tax adviser, they should look for a tax adviser with substantial experience in all aspects of tax controversy practice- from negotiating with an IRS agent, to preparing a Protest Memorandum to the IRS Appeals Div., to, if necessary, handling the litigation of the tax issue(s) in dispute. Simply put, if the IRS is going to use an augmented audit arsenal, including its attorneys, taxpayers should answer the IRS efforts with equal or greater firepower.

But before going all the way to the courthouse steps, there are guidelines that company officials should follow in dealing effectively with the IRS. Some of these are:

Determine the IRS Position: A company's tax staff and advisers should determine exactly the nature of the proposed deficiencies being asserted as well as what facts and legal precedent the agent is relying upon. Auditing agents normally provide corporate taxpayers with a description of proposed adjustments before the conclusion of the audit. Ordinarily, many of these proposed adjustments can be resolved with the company conceding some and the agent backing off on others. For larger issues where the agent suggests an unwillingness to negotiate or settle on a satisfactory basis, these descriptions of proposed deficiencies serve as a starting point for the company's opposition to the proposed adjustment.

Learn the facts: By making an early effort to focus upon the IRS position, taxpayers begin the necessary process of identifying what facts the IRS agent is relying upon, what favorable and unfavorable facts the agent is not yet aware of, and, ultimately, what additional facts should be presented to the agent. Efforts to mislead agents are hardly ever successful. If an agent is genuinely interested in resolving an issue favorably, efforts to apprise an agent of favorable facts may cause the agent to drop a proposed adjustment.

Gathering Facts: Systematic review of the facts includes the gathering of all relevant documents and interviewing those individuals who have first-hand knowledge of the underlying facts. It is important to refresh recollections a short time after a transaction rather than to wait a few years and hope that memories will be as clear or that relevant documents will still be available. Where sensitive issues will be discussed in an interview, it is important that these interviews be conducted by lawyers so that the taxpayer can take advantage of the protections provided by the attorney-client privilege, where available.

Legal Research: To complete the initial picture, it is essential that the agent's legal conclusion be reviewed by experienced tax advisers. This review should include an objective evaluation of the likelihood that the company will prevail on an issue at each stage of the tax controversy process: audit, appeals or litigation. When a 25% settlement is available at Appeals, it is important that a taxpayer know whether it has a 25% or a 75% chance of prevailing in litigation.

It is also the case that the probity of legal precedent differs at each level of the tax controversy process. A revenue agent is far more likely to be persuaded by a regulation or IRS ruling on point than by case law. While appeals officers, unlike revenue agents, are able to consider 'litigation risks' in their settlement negotiations, they too are more easily impressed with an IRS revenue ruling which makes clear that the IRS has already agreed to the favorable treatment of an issue.

By contrast, courts are not as impressed with revenue rulings as they are with case law unless, of course, the ruling is favorable to a taxpayer. While a revenue ruling is a pronouncement of the agency of the government charged with interpreting and enforcing the tax laws, courts have frequently held that an IRS ruling is merely the opinion of an attorney or group of attorneys who work for one party to the controversy.

Develop a Negotiating Stratey: Since the usual circumstance is that the company, and not the IRS, is most familiar with the facts, the company and its advisers should be careful about gratuitously providing the IRS agent with information or documents unless it is first determined that the materials will (a) not raise more questions than they answer and b) be likely to have a positive impact on settlement negotiations.

Another factor which we have noticed is the IRS perception regarding how serious a taxpayer is about his position. The avowed mission of the Appeals Div. of the IRS is to settle cases, not pass them on for litigation. If the appeals officer perceives that a taxpayer has no stomach for litigation, however, the appeals officer will be more aggressive in his or her dealings with a taxpayer. To this end, it is a common practice for IRS personnel to do a "Lexis" search of the taxpayer and the names of its representatives to see how many times they have been to court and how successful they have been. if the IRS representative knows that a taxpayer is prepared to go to court, the IRS negotiating dynamics frequently change. Appeals officers are graded low if a high percentage of their cases are not settled and go on to litigation. A taxpayer which has its tax litigator present at a conference with an agent or appeals officer may have an advantage that a taxpayer without such representation does not have. Courtroom' tax lawyers are also more attuned to the litigation process and, as a result, are less likely to disclose information which is unnecessary to the settlement process and which may be misconstrued by an opponent or a court.