VideoCompanies that choose to litigate have several options as to where to file their lawsuit (see "How Tax Cases Play Out" at the end of this article). They can file in the U.S. Tax Court, the U.S. Court of Federal Claims, or the federal district court nearest the company's headquarters. The choice of venue hinges on many factors, say lawyers. Cash flow is one: a company can defer paying its taxes if it files in U.S. Tax Court, but it will also face less-favorable odds, as the court's judges are generally tax experts. By contrast, federal district courts require companies to pay taxes up front and then seek a refund, but they have traditionally offered better odds to plaintiffs.
What makes a good case for trial? "The best way to defend any planning transaction is to make it as simple as possible," something easily explainable to a layperson, says Lawrence Gibbs, IRS commissioner from 1986 to 1989 and now a partner at law firm Miller & Chevalier. "Complexity is really the biggest concern," he says, since it automatically makes the IRS suspicious.
That simplicity will come in handy when it's time to round up witnesses, too. Experts say the ideal witness in a tax case is a business executive who can explain why the tax benefits were merely the side effect of an essential business transaction. But the best witnesses are typically "scared to death," because the transactions they are asked to defend are so complicated, says Gibbs. (Tax and finance executives "don't tend to be very credible," notes Gibbs, because they obviously have a vested interest in the tax side.)
Then there is the issue of documentation. Supporting opinion letters that come from the same accounting or law firm that sold a tax shelter will not be very persuasive, says Gibbs. Other documents may contain damning details. In BB&T's case, the court noted that not only had an internal assessment of the deal concluded it was "tax-driven," but that Sodra's tax advisers had also characterized the deal as a purely financial transaction that did not affect its interest in the plant.
Still, some companies settle even when they believe they have a defensible case. "Many companies that are able to litigate are reluctant to do so," comments Gibbs, in large part because they don't want to run the risk of incurring a tax penalty, not to mention negative publicity. Under current policy, tax penalties can accrue automatically depending on the amount in dispute, even if a company has paid its taxes in full and is seeking a refund. As a result, the IRS's take from corporate penalties has nearly tripled, from a net $335 million in 2002 to $939 million in 2007.
Sunk costs may also induce companies to settle. FASB Interpretation (FIN) 48, which requires companies to assess the strengths of their tax positions and reserve for any amount they think they might lose, makes it more likely that a company has already set aside money for tax payments in dispute. That lessens the sting of actually paying them, at some level, and also makes a restatement less likely, further reducing the costs of folding the tents.
The administrative annoyance of maintaining proper reserves and adding interest to them is also an incentive to settle. "Thanks to FIN 48, many companies are trying to get through their cases, even if they think they're going to win, so that they don't run the risk of having interest accruals to tax reserves," says Gibbs.
For that matter, a CFO may well decide to settle if the disputed transaction preceded his or her tenure at the company. "The people who are left behind to clean up the mess often don't want to go to the mat, because it wasn't their transaction," says Korb. "We hear that a lot."
Pressing for More Information
Still another reason some companies may shy away from court is that recent disclosure rules have given the IRS powerful tools for probing the most sensitive tax-related documents. Since 2005, companies have been required to file M-3 schedules, which reconcile book and tax accounting and spell out differences between temporary and permanent credits. In previous years, IRS agents "would look at SEC tax accounting, but not really understand it," says Cheryl Anderson, director of federal income tax for Ryan, a tax advisory firm. "Now they do." That means it's harder to get easy wins in negotiations, such as agreeing to abandon a temporary tax credit in one year and then using it in another.
FIN 48 itself could also cause more problems. So far, the disclosure it requires about uncertain tax positions has proved less helpful to the IRS than originally feared, in part because companies are not required to distinguish among federal, state, local, and international taxes. However, there's little to stop the agency from asking for more detail.
In some cases, the IRS will even ask a company to release its tax-accrual work papers that explain the company's thinking about a transaction, a category that could include FIN 48 documentation as well. So far the agency has requested work papers from some 140 companies involved in tax shelters. Two companies, Textron Corp. and Regions Financial, are fighting those requests in court.
But even if they win their cases, the IRS won't be deterred from seeking work papers from other companies, say experts. "It would be oversimplifying to say that every company in the First Circuit [where Textron's appeals case is being heard] would be safe if the court affirms Textron's position," says Latham & Watkins's Kafka. Both cases, he notes, "have a very specific set of facts" not likely to occur at other companies.
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