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The IRS is taking a tough line on tax cheats.
Kris Frieswick, CFO Magazine
January 1, 2006
Since taking the helm at the Internal Revenue Service in 2003, commissioner Mark Everson has been threatening to crack down on tax cheats by aiming the agency's biggest guns at large corporate taxpayers and rich individuals.
Now Everson's tough stance is beginning to show results.
The IRS audited one in five of the largest corporate taxpayers — those with assets of more than $10 million — in 2005, twice the rate of 2002. The agency's audits are now faster, more timely, and more targeted. So-called additional recommended taxes — those taxes added after a corporate audit — climbed to $32.2 billion in 2005, the agency says, double the amount posted in 2004. Enforcement revenue from audits of corporations and individuals soared to $17.7 billion in 2005 from $10.7 billion in 2003, reflecting the agency's tough stance on abusive tax shelters. Some 1.2 million individual income-tax returns were audited in the fiscal year ended September 30, up 20 percent over the previous year. All in all, IRS collections from heightened enforcement efforts rose to a record $47.3 billion, up 10 percent from a record $43.1 billion in 2004. Everson says his agency is making progress at closing the $300 billion net tax gap, the shortfall between taxes owed by individuals and corporations and taxes paid. Five years ago, the gap was $350 billion.
Enforcement is likely to intensify even more this year. The IRS budget for 2006 is $10.7 billion, of which $4.7 billion will go to enforcement efforts, an increase of about 7.8 percent over 2005. The IRS may be taking a page from the playbook of state tax authorities, who themselves have emphasized strict enforcement because raising tax rates is so politically difficult. Everson says he is pleased at the success of the crackdown because it ultimately strengthens taxpayer confidence in the overall fairness of the system. "Nobody wants to feel that you can get away with something if you're rich or a big corporation," he says.
Combating abusive tax shelters will remain a top priority for the IRS in 2006, says Everson. The agency's settlement initiatives have been remarkably effective over the past two years. Since 2004, the agency has taken in $5.5 billion under a variety of programs that require full payment of taxes and reduced penalties. Still, Everson says his agency will be watchful of new tax-shelter schemes. "If equity valuations improve and people have big incentives to reduce taxable earnings, there will be more attempts by attorneys and accountants to create these deals," he says. "They'll be different, but we won't let our guard down." In 2006, Everson says, the agency also will focus on illegal uses of tax-exempt bonds and trusts, questionable transfer-pricing practices, offshore accounts, and nontangible charitable donations.
The IRS says it made progress this year toward resolving two of the biggest complaints made by corporate taxpayers: that audits were slow and, as a result, costly. For those in the Coordinated Industry Case program (large companies with a team of agents on-site conducting continual audits), the average length of time the team took to complete an audit dropped to 29 months in 2005 from 37 months in 2003. For companies assigned a single agent to oversee filings, called Industry Case companies, the average length of time dropped to 13 months in 2005 from 16 months in 2003.
Enforcement agents are focusing on more-recent tax returns as well. For large companies undergoing continual audit, the IRS says 71 percent of its 2005 audits involved returns filed within the last two tax years — 2003 and 2004. That's up from 63 percent of its 2004 audits. Taxpayers need "to know sooner rather than later if their tax position is consistent with our interpretation of the law," says Deborah Nolan, commissioner of the IRS Large and Medium-Size Business (LMSB) Division.
Corporate tax executives are beginning to see evidence of the agency's new emphasis on speed and efficiency in audits. "There's a real increased pressure to produce documents faster...[and] a much greater sense of urgency from our team leader," says Mike Tilton, vice president of tax at Best Buy Co., the consumer-electronics retailer based in Richfield, Minnesota. Nicholas Anthony, vice president and general tax counsel for American Standard Cos., concurs. "Our auditors are asking us to provide more-detailed backup to support positions we've taken," he says. American Standard, a $10 billion manufacturer of household and automotive products, also has IRS auditors continually posted at its headquarters in Piscataway, New Jersey.
In a recent survey by CFO, 43 percent of the 117 respondents said they think the IRS is more aggressive in enforcement than it was three years ago. Although not a majority, this reflects a growing consensus among executives of small and midsize businesses, those with revenues of up to $500 million. Twenty-nine percent said that the IRS's enforcement efforts are costing them more in federal taxes. Only 25 percent of respondents have adopted more-conservative tax strategies during that time as a result, though, and, of those, most said the biggest factor was stricter corporate governance in the wake of scandals such as Enron and Computer Associates. In any case, CFOs are watching the agency's efforts with a new wariness. "It hasn't changed much of what we're doing," says Bruce Sedlock, tax director for Allegheny Energy Inc., an electric utility in Greensburg, Pennsylvania. "We're just doing it in a more structured manner."
Flushing Out the Cheats
In addition to its enforcement efforts, the IRS also has instituted several new rules and disclosure requirements aimed at flushing out companies that may still be using questionable tax strategies. Among them is Schedule M-3, which requires large corporations to disclose transactions that produce a significant book-tax difference. (A significant book-tax difference exists if the treatment of any item for federal income tax purposes differs by more than $10 million on a gross basis from the treatment of the item for book purposes in any tax year.) Schedule M-3 forces corporate taxpayers to provide vastly more-detailed information to the IRS than was previously required. M-3 was first required for corporations filing Form 1120 starting with the tax year ending on or after December 31, 2004.
In its efforts to round up tax cheats, the IRS is also getting some help from the Financial Accounting Standards Board. The board recently issued Proposal 109, which stipulates that in order to show the net financial benefits of a tax position, the treatment must have a "probable recognition threshold," which is commonly interpreted as at least a 70 percent likelihood of being upheld. Previously, the wording was "more likely than not." If 109 is approved, says Thomas Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants, FASB and Schedule M-3 will have given the IRS a new window into aggressive tax strategies.
Among the most significant changes in the tax rule book is the Treasury Department's revised Circular 230, which is likely to have a profound effect on corporate tax strategies. Circular 230 imposes a new, more-stringent set of rules on attorneys, accountants, and other professionals who provide tax advice. The circular became effective in mid-2005. The new rules cover not only formal written tax opinions, but also virtually any written communication that contains advice regarding tax-minimizing transactions. Although the impetus behind the new rules was to combat abusive tax shelters, the revised rules were drafted so broadly that they could be applied to many ordinary transactions.
Strict New Standards
Under existing tax law, if a taxpayer files an incorrect tax return, penalties can be avoided if the taxpayer can prove there was "reasonable cause" for making the error. Historically, taxpayers often claimed the reasonable-cause exemption by saying they had relied on the guidance of a tax adviser or lawyer. Circular 230 sets new, stricter standards of due diligence for any opinions that tax advisers give clients regarding listed transactions, which may include arrangements that have no real economic purpose other than dodging taxes.
For the first time, advisers can bar clients from using their opinions to support a reasonable-cause exception. That shifts the legal responsibility for tax position to the taxpayer and heightens the risks of aggressive tax strategies. (In-house tax advisers are not covered by this rule.)
Corporate tax executives, including Best Buy's Tilton, say the new requirements have boosted their workload substantially, though it may lessen somewhat as executives become more familiar with the forms. Even the IRS is finding M-3 a bit overwhelming. Commissioner Nolan concedes the agency is currently "getting systems up to speed" in order to properly mine all the new data that is pouring into the agency. The IRS recently delayed M-3 filing requirements for property, life, and casualty insurance companies until they file returns for tax years ending on or after December 31, 2006. S-corporations and limited liability partnerships will not be required to file the M-3 until 2006.
The IRS has also been lagging on a task of critical importance to corporate tax executives: guidance on new rules. The agency issued guidance on only 60 percent of the 349 items it identified as priorities in 2005 (it had set its goal at 75 percent). One issue that concerned corporate taxpayers last year was the lack of clarification on the repatriation provision of the 2004 American Jobs Creation Act, which affects companies with foreign units. The program allows a special one-time dividends-received deduction on the repatriation of certain earnings of foreign operations.
The new law is extraordinarily complicated. Because it expired at the end of 2005, corporate taxpayers were eager to get guidance early so they could devise repatriation plans. The IRS issued some guidance, but many tax executives were left waiting anxiously for months for more-explicit directions from the agency. That meant they had to scramble to take advantage of the program or forgo it entirely.
In the increasingly conservative legal and regulatory climate, lack of guidance is a costly problem for corporate taxpayers. "Companies may feel compelled to seek and pay for legal opinions on what the law means," says Timothy J. McCormally, executive director of the Tax Executives Institute Inc., in Washington, D.C., which has 5,700 members in the United States. "These transaction costs are difficult to quantify but are still significant." In the absence of guidance, some taxpayers may choose an interpretation of the rules that the agency may ultimately decide is wrong. Says McCormally: "That creates conflicts that take time and money to resolve."
Lure of a Pension
As its crackdown on corporate taxpayers intensifies, the IRS is scrambling to beef up staffing of its LMSB division, in part by seeking to lure experienced tax executives away from Corporate America. The IRS is wooing the most promising candidates — those with five years or more of corporate experience — with a compensation package that includes an $85,000-a-year salary, benefits, and — that new rarity in the corporate world — a pension. Currently, the agency's full-time technical enforcement staff numbers 4,855, up 6 percent since 2003.
However, the agency will face a big problem in the next few years. The LMSB Division has some of the most experienced and technically expert workers in the agency, but a "significant" percentage is nearing retirement, says commissioner Nolan. She adds that she has been using "every single speaking engagement in front of professional organizations as an opportunity to recruit."
As the agency bears down on corporate taxpayers, some companies are girding for battle. That's one reason why the phone is ringing more frequently at TaxSearch Inc., a tax executive recruitment boutique on Sullivan Island, South Carolina. "I'm staffing a lot of tax-controversy experts right now as companies prepare for the coming wave of tax disputes," says Tony Santiago, president of TaxSearch. Until recently, only the largest companies with the most aggressive tax positions have had controversy experts on staff. Such specialists are expensive to hire; Santiago says the average total cash compensation for tax lawyers with controversy expertise is about $225,000 to $300,000. CPAs with controversy expertise can command total cash compensation as high as $140,000 to $200,000.
Santiago says he has placed three tax-controversy specialists with clients in the past six months alone. Meanwhile, other clients are mulling the possibility. Before the recent hiring surge, Santiago had placed only two experts in the last 3 years. "I'm seeing more plans for hiring in that area than I have in 10 years," he says.
Kris Frieswick is a freelance writer based in Boston.