Posted tagged ‘IRS Audits’

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.

The IRS Can Summons California For Property Transfer Records

December 20, 2011

As noted by Janet Novack at forbes.com, Judge England of the District Court for the Eastern District of California last week issued an order permitting the IRS to serve a “John Doe” summons on the California State Board of Equalization.  The summons seeks the names of residents who transferred property to relatives for little or no considerations.  The IRS hopes that the information it receives will identify individuals who should have, but did not, file Forms 709 – Gift Tax Returns. (more…)

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…)

Using Non-Tax Sources To Fight Tax Battles: Are You Exposed?

June 9, 2011

By Jonathan Prokup

In the last two weeks, various news sources have reported on a previously low-profile IRS initiative to use state land-transfer records to identify potential omissions in reporting gifts of real estate.  (Via TaxProf here and the WSJ here.)  According to the reports, the IRS is using information received from at least 16 states to identify transfers of real estate the value of which exceeded the $13,000 threshold for filing a gift tax return.  As a result, the IRS is pursuing taxpayers who made such transfers but failed to file returns.

Although this particular example of the IRS building an enforcement case through the use of non-tax sources targets individuals, corporate tax professionals should not rest too easily.  Most corporate taxpayers might not be engaged in such outright noncompliance as failing to file returns.  Nevertheless, the volume of non-tax information that is available in the public domain – especially for large, public companies – poses  potentially analogous risks to corporate taxpayers  for the positions taken on their tax returns. Beyond the traditional sources of non-tax information, such as SEC filings and court documents, news articles and press releases proliferate over the Internet.  Likewise, companies may face a new potential source of trouble in the proliferation of social networking sites.  From LinkedIn resumes to Facebook profiles, information that reflects upon a company grows by the day.

(more…)

Tax Blawg Report on IRS National Employment Tax Research Project

May 6, 2010

The IRS National Employment Tax Research Project has started.  On November 9, 2009 the IRS announced its first employment tax research project in 25 years.  Under the program, which will last from 2010 through 2012, the IRS will audit 6,000 employers randomly selected from all employment tax filers.  It is our understanding that the initial letters for the first 2000 employees selected to be part of the study have gone out and the audits will commence in May, 2010.  The IRS will focus on historic areas of non-compliance including (i) the misclassification of employees as independent contractors, (ii) executive compensation, including stock options, (iii) fringe benefits (and whether taxable fringe benefits have been properly reported in employees income), and (iv) return filing compliance, including the filing of W-2s, 1099s, 940s and 941s.

Since the age-old issue of employee versus independent contractor is going to be a significant part of the study, employers selected as part of the program should conduct a review of any independent contractor issues that the company might have. If the company has a significant number of workers that are treated as independent contractors, the company should conduct a review of the status of the independent contractors under the common law “control” tests and the 20-factors listed by the IRS in Rev. Rul. 87-41.  The company should marshal its evidence to support the classification of workers as independent contractors to face any potential challenge by the IRS.

Even if a company is not selected as part of the IRS’s National Research Project, the company is not necessarily off the hook.  The IRS is increasing is enforcement efforts in the employment tax area so employment taxes are likely to be the focus in the audit of any company with a significant number of workers, particularly in cases in which the company treats large numbers of workers as independent contractors.

For more information on the IRS’s National Research Project or on any employment tax issues, contact Kevin Johnson at kjohnson@chamberlainlaw.com

I was recently interviewed on the subject by Employee Benefit Adviser News which you can listen to here.


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