Streamlining the audit process TEI member follow-up responses: August 7, 2002.
1. The first topic is the issue of materiality. We'd like to know what thoughts you might have on the content or scope of a materiality standard within LMSB. This standard does not necessarily need to be a quantifiable number. In fact, the design team has already identified many pitfalls to a numeric standard.
(a) In addition, do any of your members have any key concepts for materiality or experiences where some type of standard was effectively established?
(b) Also, if some type of materiality standard was set at the beginning of an examination, would the taxpayer be willing to apply this standard for affirmative issues and/or claims, and thereby forego any issue that fell below the established standard?
Response #1: Given the diversity in the size of taxpayers, a quantifiable number would be difficult to derive. On our last cycles, we set materiality numbers for timing differences. For rollover effects within the audit cycle (e.g., 1998 adjustment reversing in 1999), we agreed on a number below which timing difference would not be pursued. We also agreed on a smaller number for issues that reverse in the year following the cycle (e.g., 2000 for the 1999 adjustment). Permanent differences are still in play, but an informal basis exists for deciding to pass on the ones that show small potential. For small permanent differences, I will not make an affirmative claim. To make this work, the taxpayer must also show some restraint. (This issue was raised a few years ago by an IRS agent when I spoke at a CEP educational program. He questioned why only the IRS should concede smaller issues. It's a good question.)
Response #2: I would like to address the topic of materiality in a tangential way. If a taxpayer has an audit cycle of three years or less and the audit adjustment being proposed would turn completely within that particular audit, why not have a rule that the IRS will not make that particular audit adjustment, regardless of the amount of the proposed adjustment? If that is not possible, perhaps we could use the same rationale for proposed audit adjustments that are $1,000,000 or less--a higher threshold would be better. This idea is a materiality issue of an indirect kind.
Response # 3:
(a) No, our examination team reports it does not have a materiality standard. This involved attempting to set a $100 threshold for requested support on several hundred pages of cost detail.
(b) Yes, if the agreement is honored by the examination team without exception.
Response #4: In TEI's Santa Clara Valley Chapter, the Chapter IRS Administrative Affairs Committee worked with the IRS on establishing acceptable capitalization thresholds for more than one year and came to no solution. We ultimately scrapped the project. Perhaps our problem was that we were trying to identify a quantifiable number for capitalization based on business size and capital spending, etc.
I believe my IRS team has a materiality standard that it has not disclosed to me. I can share one experience where we established a materiality level in testing for capitalizable items that were expensed. First, I was able to convince the IRS to look at only the R&D supplies, which were the only permanent differences. The team decided to review all expenditures that were expensed over $100,000, sample those between $10,000 and $100,000, and not review anything below $10,000. This saved both parties quite a bit of time.
In response to the question regarding foregoing any issue that fell below the established standard, we would honor such an agreement.
Response #5: On our examination, we do not include timing differences that turn within the cycle. In at least one situation, we convinced the agent to include the net present value of an item that was income in the cycle and a deduction in later years. That is probably not possible very often, but it prevented carryover adjustments. We also use a materiality threshold for all items (IRS and taxpayer) in the $500,000 range. The driving factor for us has been to keep the computational issues at the end of the examination as simple as possible. Having numerous small offsetting adjustments just makes reconciliation terrible.
Response #6: Over ten years ago, I entered into an agreement with the IRS Coordinator that prohibited both the IRS and the taxpayer from proposing any adjustment of less than $100,000 of taxable income. That agreement worked very well, except in one instance where the Coordinator insisted upon making a smaller adjustment because the IRS had invested so much time and effort on that particular issue. In later cycles with a different Coordinator, I tried to enter into a similar agreement, although I wanted it in writing and based on the present value tax effect (rather than taxable income). I even created a spreadsheet program that could be used by both the taxpayer and the IRS to compute the present value tax effect. The Case Manager indicated a willingness to enter into such an agreement but there was resistance from the support audit team and from representatives from the Petroleum Industry Program (PIP). Eventually, all the IRS was willing to do for those later cycles was to eliminate adjustments against the taxpayer only if there was an adjustment of a similar size in the taxpayer's favor that would also be eliminated. Since adjustments were only eliminated in those rare instances where an offsetting adjustment of similar size was identified, very few adjustments were eliminated. More important, since every tiny adjustment had to be written up and compared to other adjustments for potential offsets, I'm certain it cost both the taxpayer and the IRS more time than if they had set up all adjustments.
2. The second topic involves the possible consequences for not abiding by the agreed upon issue focused examination process. Only a limited number of significant issues will be reviewed in this type of exam which will, in most instances, reduce the cycle time on the case. This streamlined process requires the full cooperation of the taxpayer. For example, such cooperation could include timely responses to IDRs, participation in the planning process and regular meetings with the audit team, computations of rollover and recurring issues with supporting documentation, submission of claims within a specified time frame after the opening conference, provision of workpapers and presentations to audit teams on the identified significant issues. We recognize that the Service cannot require certain actions by a taxpayer. However, in instances where that taxpayer has voiced a commitment to the issue focused exam process, but fails to live up to this commitment by cooperating with the examples provided above, what should the consequences to the taxpayer be?
Response #1: Being a cooperative and respected taxpayer has many benefits. "Renege" is a bad word for the IRS to attribute to a taxpayer. If a taxpayer fails to honor a commitment, it risks the wrath of extended audits, summonses, a bad reputation right up to Appeals, etc. The IRS still has lots of power. What should the consequences be? No sympathy from those who live up to their commitment.
Response # 2: Either party should be able to withdraw from the process. Consequently, such a withdrawal would be considered in allowing the taxpayer to use any other new program that would be offered requiring IRS consent. If the withdrawal is by the IRS, the taxpayer must take that into account in dealing with its audit team. The effect on the nature of the ongoing relationship probably would be an adequate incentive.
Response #3: The taxpayer should be able to opt out of any specialized program, similar to the pre-filing agreement program, etc. The consequences are obvious: The audit will be extended and have a larger scope. Most of the examples you mentioned are normally provided by our company and would not be a problem. The only problem I can foresee is unreasonable requests by the IRS.
Response #4: Past suffering at the hands of the examination team should be an adequate penalty. Determine first what the consequences to the examination team should be (and commitment to hold them accountable) and then we'll spend time evaluating the equivalent consequences.
Response #5: Taxpayers are skeptical that the IRS will be able to implement limited or significant issue exams at the field level. Many taxpayers indicate that, although they are very timely on IDRs, they are called to task when the odd IDR is just a few days late, while at the same time their agents feel no need to meet the time commitments they made. Agents show no concern about taking several months after the agreed timeline date to write up 5701s, issuing more IDRs and raising new issues long after the timeline date has expired, and missing the cycle closing date by six months or more. Taxpayers that have tried new and cooperative approaches, such as giving presentations to the agents on large transactions and processes, participating in audit planning, and providing computations on rollover items, have seen little change in the agents' behavior. The agents' show no sense of urgency or materiality. Although open communication exists with certain agents, the agents that cling to the old secretive approach and continually miss deadlines appear to suffer no repercussions.
Before adding to the list of things that taxpayers can do to make audits quicker and easier for agents, and worrying about how to punish taxpayers who fail, the IRS should show that it is willing and able to conduct an issue-focused audit in a timely manner. Then, if along the way the taxpayer causes delays, the time savings of the shorter anticipated audit will be forfeited.
Response #6: We have something close to this situation now. We are thoroughly involved with the planning of the examination (including issues), we give presentations, and then we meet with the agents every two weeks throughout the process. Each side explains every discrepancy from the norm and brings any new developments to light as soon as possible. We process NPAs throughout the cycle and give feedback as often as necessary on issues as they are developed. I believe (hope) that this continual communication makes it difficult to get too far off track without confronting the problem--which we have not (so far) had to do. This has worked for three cycles and included very contentious issues. Two out of the three examinations were agreed cases.
I am quite concerned, however, about the effect of having a new team for the next cycle. We have had terrific team continuity for the past three cycles, and ! have already been warned that this will change with the next examination. Having IRS agents who are familiar with large case and know something about your company is very important. I don't think you could do this with inexperienced agents.
Response # 7: Issue-focused examinations may save significant time and effort for both taxpayers and the IRS. If the taxpayer and the IRS agree to an issue-focused examination, there must be a good faith effort by both parties to fulfill all their commitments in that regard. There are almost certain to be disagreements, however, concerning the adequacy of IDR responses and other matters. Also, one party may fail to live up to its commitments due to factors outside of its control. If there are significant negative consequences, beyond simply withdrawing from the process and having a more extensive examination, then taxpayers and the IRS will find it very difficult to agree to terms for an issue-focused examination.
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|Date:||Sep 1, 2002|
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