Posted tagged ‘Audit’

Cleaning Up After The Elephants – A Practical Reminder On Document Preservation Policies and Litigation Holds In Tax Disputes

September 2, 2013

By Phil Karter

Any corporate tax executive who has ever been involved in contesting an audit adjustment knows all too well how unfavorable documents relating to the subject of the adjustment – particularly improvident comments reflected in email correspondences – can be an ongoing impediment to resolving a tax dispute from the audit phase right up to and through litigation with the IRS or Department of Justice.  When such documents exist, even where taken out of context, the government will zealously sink its teeth into them like a junkyard dog, making the prospects of reaching a reasonable settlement or gaining an IRS concession all the more difficult.  One can’t fault the government for taking a hardline position.  Precedent reflects that this is a good strategy, particularly in economic substance cases, as demonstrated by the numerous times these unfavorable documents work their way into the text of court opinions as the factual underpinning for an adverse finding against the taxpayer.  Like a Dickensian character, they will come back to haunt you again and again.

The solution, of course (conveniently ignoring the practical realities of many understaffed and overburdened tax departments), is for the tax function to do a better job of policing both document production and retention policies, particularly outside of its own direct jurisdiction and normal supervision.  Non-tax business justifications pervade so many tax disputes that it is incumbent on the tax executives to ensure that these justifications are not only well-documented, but consistently followed in practice after the transaction is put into place.  The tax folks are, after all, the ones ultimately on the front lines defending the non-tax business justification.  As they say, it’s like cleaning up after the elephants in the circus parade – unpleasant but necessary.

In the course of this process, it is important to remain mindful that once documents are created, particularly in connection with a transaction where future litigation may reasonably be anticipated, a duty to preserve via a litigation hold may override a company’s normal document destruction policies.  See e.g., Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir.2001)  (duty to preserve evidence “arises not only during litigation but also extends to the period before the litigation when a party reasonably should know that the evidence may be relevant to anticipated litigation.”)  Indeed, the failure to put a litigation hold in place can have deleterious consequences, from waiver of attorney work product protection (see e.g., Samsung Electronics Co., Ltd.. v. Rambus, Inc., 439 F. Supp. 2d 525 (ED Va. 2006) (rev’d on other grounds, 523 F.3d. 1374 (Fed. Cir. 2008)), to IRS challenges regarding the completeness of a taxpayer’s Schedule UTP disclosures (which does not require reserves to be recorded for positions “expected to be litigated”), a topic I have written about before.  Simply put, it is difficult to persuasively argue that an issue was reasonably anticipated to be litigated (e.g., for work product protection or UTP purposes), where there is a failure to implement a litigation hold predicated on that very anticipation.

Earlier this month, U.S. District Judge Shira Scheindlin (S.D.N.Y.), author of the landmark Zubulake opinion on electronic discovery, raised the stakes further when she ruled, in Sekisui American Corp. v. Hart, 2013 WL 4116322 (S.D.N.Y. Aug. 15, 2013), that a party who failed to preserve electronically stored information (ESI) by not implementing an adequate litigation hold was subject to an adverse inference about the content of such evidence.  The ruling was notable because it bucked the trend of courts to overlook a party’s destruction of ESI in the normal course of its business practices, notwithstanding the obligation the party may have had to implement a litigation hold to preserve such documents.  (See Fed. R. Civ. P. 37(e), requiring “exceptional circumstances” to impose sanctions.)  In Sekisui, Judge Scheindlin imposed the adverse inference sanction (in addition to monetary damages) even without finding any malevolent intent or substantial prejudice to the opposing party.  The court simply ruled that the failure to implement a litigation hold was enough to constitute a willful intent to destroy documents.

It doesn’t take a great deal of imagination to appreciate that a ruling invoking an adverse influence as a result of the failure to preserve documents can be fatal, an even more likely outcome in a bench trial where the judge making the ruling is also the trier of fact.  At the very least, being slapped with such a sanction will preclude any benefit of the doubt that documents interpreted negatively by the IRS may be accorded a more favorable interpretation by the trier of fact.

I have heard – certainly more than once – government counsel advocate to a court words to the effect that “memories fade but documents never lie.”  It is true that the odds of prevailing in a tax dispute are not helped by poor recordkeeping practices, by which I include both shoddy documentation as well as carelessly policed documentation containing ill-conceived content readily subject to misinterpretation and misuse.

If nothing else, the ruling of an influential jurist like Judge Scheindlin should heighten tax departments’ sensitivities about monitoring company recordkeeping practices from the outset of a transaction.  These efforts should be quantitative in terms of fully apprehending the documents to be generated and maintained, and qualitative to reduce the risk that problematic documents are generated carelessly and maintained thoughtlessly.  No less thought should be put into the timely implementation of litigation holds to ensure that company records – hopefully those that will help it carry the day in a tax dispute – are adequately preserved, particularly when the ramifications of their destruction can exponentially increase the likelihood of an unfavorable outcome.

Musings in the Aftermath of the First Schedule UTP Filing Season

December 8, 2011

By Phil Karter

As reported earlier this week in the tax press, the recently completed initial filing season for Schedule UTP produced at least one major surprise in the eyes of IRS officials, who had anticipated a much greater number of items listed on the average Schedule UTP than actually materialized.  In fact, the IRS’s predictions were off by a wide margin, with the number of disclosed positions of the 1,500 or so Schedule UTPs filed averaging only slightly more than three items per schedule for CIC taxpayers, and less than two items for non-CIC taxpayers.  Pre-filing expectations of item disclosures had been many multiples higher, perhaps even reaching as high as 100 or more separately stated positions.  Although such predictions may have been wildly optimistic from the IRS’s standpoint, one must now wonder whether the apparent failure of the first filing season to meet the Service’s anticipated disclosure bonanza will hasten efforts to extend the penalty regime to specifically target what are viewed as incomplete or inadequate disclosures on Schedule UTP. (more…)

Small Businesses, Schedule UTP, and High-Wealth Audits

December 7, 2011

By Jonathan Prokup

Peter Pappas at the Tax Lawyer’s Blog takes note of a recent report from TIGTA regarding audits of small corporations (those with less than $10 million in assets, according to the IRS).  As Mr. Pappas says, language from the report suggests that Treasury may consider the closely held nature of many small businesses to be an indicator of a propensity to structure transactions to avoid taxes.

Many corporations in the United States are considered closely held because they are owned by one shareholder or a closely knit group of shareholders. As such, these shareholders typically have a significant amount of control over managing and directing the day-to-day operations of the corporation. This, in turn, provides opportunities to improperly structure transactions that reduce the amount of income taxes owed by the small corporation or its shareholders.

In effect, the report identifies a principle that the government has long applied to large companies as well: transactions among related parties that do not involve third parties deserve particularly close scrutiny.  This principal is applied to taxpayers of all sizes in a variety of contexts, including transfer pricing and the economic substance doctrine.  More relevant to Mr. Pappas’ primary point, though, this statement tends to confirm a trend within the Treasury Department towards targeting small and medium-sized businesses and their owners for examination. (more…)

So It Begins: The Final Schedule UTP Is Out

September 27, 2010

By Jonathan Prokup

The Internal Revenue Service on Friday released the final version of the much-anticipated Schedule UTP (and accompanying instructions) as well as additional guidance about changes that had been made the schedule.  At the same time, the IRS also announced an expansion of the Compliance Assurance Program (CAP) as well as some other minor matters.  In the face of much criticism of the draft Schedule UTP and instructions, the IRS made a numbers of significant adjustments; however, several issues remain unresolved.

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LMSB’s Quality Examination Process – Ensuring its Application is “Fair and Balanced”

July 14, 2010

By David L. Bernard

TaxBlawg’s Guest Commentator, David L. Bernard, is the recently retired Vice President of Taxes for Kimberly-Clark Corporation, a past president of the Tax Executives Institute, and a periodic contributor to TaxBlawg.

In case you missed it, the IRS recently introduced a new approach to its audit management process, called the Quality Examination Process (“QEP”), and is effective for all LMSB corporate tax audits initiated on or after June 1, 2010. This replaces the Joint Audit Planning Process which was developed in partnership with the Tax Executives Institute in 2003. QEP has many of the same features of the 2003 process, but is much more comprehensive and in that respect is an improvement. However, the Joint Audit Planning Process was good in many respects, it was simply never used consistently throughout LMSB.

Surveys of LMSB taxpayers reflected the inconsistent application of the former process, with some reporting that they had never heard of it and others reporting little or no involvement in the development of the audit plan (a primary requirement of the process). This frustrated the leaders within LMSB because they had continuously stressed the importance of the process in their communications to the field. After obtaining input from several constituencies, LMSB decided it was time to come to market with a new and improved process. The question is whether taxpayers will feel that the results are an improvement over their past experiences.

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IRS Teaming Up on Wealthy Taxpayers

June 28, 2010

As a follow up to my colleague George Connelly’s earlier post concerning the IRS’s recently announced “Global High Wealth” Industry Group, I offer some further thoughts on what the IRS is attempting to do with this new group focusing on wealthy individuals.  The IRS recently announced that the group has issued its first batch of audit letters and the audits of wealthy individuals will soon commence.

The IRS has created the group in the LMSB division, which generally handles audits of the largest corporations under a “team” audit concept.  A team audit means that the IRS assigns several agents to the case, including, where appropriate, specialists in areas like international taxes, financial products, and employment taxes, as well as engineers and economists.

The IRS is concerned with very wealthy individuals who own multiple entities using complicated structures to avoid U.S. federal income taxes.  The individuals may be operating foreign businesses or may have foreign investments through foreign trusts, partnerships, or corporations.

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