Editor: Mary Van Leuven, J.D., LL.M.
Procedure & Administration
Why does the IRS audit whom it audits? For years, commentators seeking to explain the IRS's so-called Large Case Program have invoked the famous answer of Willie Sutton, a renowned bank robber, who upon his capture in 1934 was asked why he targeted banks for his larceny. "Because," Sutton is apocryphally said to have quipped, "that's where the money is."
The truth, however, may just as accurately lie in an old joke whose origin can be traced to at least a decade before Sutton's arrest. On May 24, 1924, an editorial writer for the Boston Herald, inveighing against political corruption, recounted the story of an impaired man whom the police quizzed about his actions when he was found around midnight on his hands and knees near a street corner, "groping about":
"I lost a $2 bill down on Atlantic Avenue," said the man.
"Then why are you hunting around here in Copley Square?" asked the puzzled officer.
"Because," said the man, "the light's better up here."
Does the IRS continually examine the returns of large companies because that is "where the money is," or because the professionalism of their tax staffs and their comparative transparency shine a brighter light on them—and their potential tax exposure—than on other taxpayers? Regardless of why the IRS has for nearly five decades focused on large corporations, one thing is clear: In a world of constrained resources, it is not merely helpful to think smarter about auditing large corporations, it is essential.
As part of its ongoing efforts to reengineer the examination process, the IRS's Large Business & International (LB&I) Division is focusing on new ways to identify large businesses for examination. This item summarizes recent IRS Advisory Council (IRSAC) recommendations on the factors the IRS should consider when risk assessing large business taxpayers.
Risk assessment has long been a part of the IRS's examination process, but for half a century the IRS has proceeded from the assumption that the largest business enterprises deserved scrutiny without regard to their particular tax profile (other than size). In 1966, the IRS established the Coordinated Examination Program—now called the Coordinated Industry Case (CIC) Program—to audit the nation's largest and most complex corporations, generally those with assets exceeding $250 million. The current Internal Revenue Manual (IRM) calls for LB&I to divide its audit caseload into two components-large Coordinated Issue Case (CIC) taxpayers and smaller Industry Case (IC) taxpayers (IRM §220.127.116.11). While IC taxpayers are generally audited for a single cycle by one or two revenue agents (with the audit usually taking less than 12 months), CIC taxpayers are examined by a team of agents pretty much continuously.
In assigning companies to one or the other program, LB&I currently uses a points system that considers factors such as the gross assets of the entity and all effectively controlled domestic and foreign entities; the gross receipts of the entity and all effectively controlled domestic and foreign entities; the number of operating entities; the number of separate industries involved; the number of team members and specialists required; and the estimated support work required of other agents (IRM §18.104.22.168 and Exhibit 4.46.2-2). The points system is not absolute; the IRS can classify a taxpayer as CIC if its return is sufficiently complex, even if it does not meet the point criteria.
Currently, the CIC-IC distinction is undergoing a makeover. At a Tax Executives Institute conference in March 2012, the IRS's then-deputy commissioner for service and enforcement, Steven Miller, announced a review of the CIC examination process with an eye toward modernizing the tax agency's risk assessment capabilities. The goals of the review, Miller said, are to conserve resources and improve IRS case development and resolutions. More significantly, by relying on "transparency tools" such as Schedule UTP, Uncertain Tax Positions, and the Compliance Assurance Process (CAP) program, the IRS hopes to moderate LB&I's focus on CIC taxpayers and thereby free up resources for other compliance priorities. In summary, Miller concluded, the IRS wants "to spend less time with compliant taxpayers" and "to reduce the time spent looking for issues and increase the time spent understanding and resolving them."
Fine-Tuning the IRS's Risk Assessment Methodology
In seeking to improve its programs and results, the IRS has long benchmarked its efforts with those of tax administrators in other countries, both individually and through collaborative efforts such as the Forum on Tax Administration of the Organisation for Economic Co-operation and Development (OECD). The IRS also has sought IRSAC's input and advice. Chartered under the Federal Advisory Committee Act of 1972, P.L. 92-463, IRSAC is a successor to the Commissioner's Advisory Group (CAG), which was first organized in 1953.
In its current form, IRSAC is composed of professionals (20 in 2014) with diverse experience within the tax system. It is organized into four subgroups—LB&I, Small Business/Self Employed, Wage and Investment, and the Office of Professional Responsibility. The subgroups regularly meet with IRS personnel to provide the Service independent advice and to act as a sounding board for IRS functions that want to vet certain issues. IRSAC also provides the IRS an annual report with recommendations on issues that it considers to be of greatest significance.
Apropos the IRS's goals "to spend less time with compliant taxpayers" and "to reduce the time spent looking for issues and increase the time spent understanding and resolving them," in 2013, the management of the IRS's LB&I Division asked IRSAC's LB&I subgroup "to recommend risk assessment techniques that may be employed as part of the audit selection process" (2013 IRSAC LB&I Report).This request followed up on IRSAC's 2012 recommendation that, in refining its strategy, the IRS assign greater weight to the overall post-Sarbanes-Oxley governance and risk management environment in public companies. In IRSAC's view, the substantial enhancements that have been made to governance, controls, and documentation should help the IRS conduct its risk assessment in a more efficient and less burdensome manner.
IRSAC's 2013 LB&I subgroup embraced the assignment. In its report, the subgroup concluded that since both the IRS and large business taxpayers have limited resources, "each would benefit from the IRS risk assessing taxpayers and their filed tax returns prior to examination":
The current Compliance Assurance Process (CAP) program has proven that full disclosure and transparency are beneficial both to the IRS and to taxpayers in resolving issues. By risk assessing taxpayers in advance of examination, many taxpayers would require a much more limited inquiry or review by the IRS. The examination process could become more focused both as to taxpayer selection and the extent of IRS review.
The subgroup analyzed the risk assessment efforts of tax authorities in the United Kingdom and Australia, noting that each country assigned a risk rating—from high to low—to large taxpayers and that the rating, "while not public, is shared with the taxpayer and is reviewed annually to determine the continued appropriateness of that rating. Those taxpayers with higher risk ratings receive a much more extensive review of their tax return filings."
The subgroup next turned to the challenges of implementing a risk assessment protocol in the United States, starting with the need to train IRS agents in risk assessment methodologies, including, for example, determining the efficacy of a taxpayer's information reporting technology. It made two general recommendations: First, any proposed risk assessment methodology should be jointly developed and evaluated using a select group of taxpayers currently participating in the CAP program. These taxpayers, the subgroup correctly noted, "have a demonstrated level of transparency and desire to improve the examination process, and importantly, a working relationship with the IRS."
Second, the subgroup recommended that the initial request for risk assessment information should be in the form of a "yes or no" list of indicators that is part of the filed tax return. Such a checklist could be a section of Schedule UTP that would be required for all taxpayers. Based on the responses to the initial questions, the IRS could make further inquiries.
The subgroup suggested 17 risk assessment factors—many of which speak to the oversight of companies' tax function by their board of directors—including:
- The amount of guidance and oversight provided by the board of directors (e.g., as a result of the chief tax officer's meeting periodically with the board or a designated subcommittee, such as the audit committee); the board's providing guidance to management on the level of tax risk to be taken by the company; and whether appropriate review and sign-off procedures are in place for material transactions.
- Whether the taxpayer has a history of aggressive tax planning.
- Whether the company has reported a material weakness or financial restatement relating to the tax function.
- Whether there has been a significant change in tax department personnel.
- Whether the taxpayer has performed a documented tax risk assessment.
- Whether Schedule UTP indicates a lack of adequate descriptions, the presence of questionable positions, or the disclosure of large amounts.
- Whether the taxpayer has been involved with major tax planning initiatives during the year (such as a research tax credit review).
Regardless of whether the IRSAC subgroup's recommendations are adopted, the largest companies will remain subject to IRS scrutiny. Around the same time as Miller's 2012 remarks, LB&I Commissioner Heather Maloy reported that LB&I "will always have some type of presence among companies with the highest assets and the highest income" (Bennett, "IRS to Retain Presence With Big Taxpayers as Efforts Go Forward on Model, Maloy Says," 75 Daily Tax Report G-7 (April 19, 2012)). That said, the 2013 IRSAC report marks a step forward in the IRS's potential implementation of a risk assessment of large businesses that provides a defined and known risk assessment classification. As envisioned by the IRSAC LB&I subgroup, the IRS would modify its examination selection criteria to focus on taxpayers displaying a high level of risk of noncompliance or aggressive tax reporting and then focus its limited resources on taxpayers and issues that warrant its attention, as identified through the new risk assessment protocol.Citing CAP as a prime example, the subgroup concluded that open and transparent interactions between taxpayers and the IRS have many benefits for both parties. Thus, the information disclosed on Schedule UTP can help the IRS focus on the technical merits of disclosed taxpayer filing positions rather than spending significant time and resources attempting to identify them. Moreover, if accompanied by an expansion of the IRS's own transparency (say, by publicly disclosing areas of examination focus in advance), the changes would allow taxpayers to prepare by having information, systems, and processes in place to satisfy the IRS's requests for information (should there be an examination) and ensure that they are properly reporting the information on their tax returns in the first place.
In January 2014, the author was appointed to the IRS Advisory Council, but this item addresses IRSAC recommendations made before his appointment and is based only on publicly available information.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. The information contained in this item is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This item represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.