The rollout of the long-awaited Internal Revenue Service Large Business and International (IRS LB&I) compliance campaigns has left CFOs and financial executives with many questions. What are these campaigns? How do they work? When will they start? How can companies prepare for them?

George Farrah

George Farrah IRS

Effective now, these compliance campaigns are a new approach to enforcement by the IRS. The service says they will help it to identify issues representing a risk of non-compliance and make the greatest use of limited resources.

In the first wave, the IRS will focus on 13 specific “issues of concern” that span a broad range of topics, including partnerships, related-party transactions, and various industry-specific tax issues.

Essentially, the IRS plans to enforce taxpayer compliance by reorganizing its own resources to focus around these specific issues of concern. This marks a deviation from its historical approach, in which the tax returns of large corporate taxpayers were routinely reviewed to uncover issues.

At a March 7 webcast hosted by KPMG, IRS staff members identified the potential treatment streams of a campaign as “soft letters” (warnings), changes in forms, examinations, and published guidance. Soft letters, they said, will be sent to taxpayers when they notice specific issues on a taxpayer’s return and they will give taxpayers an opportunity to amend their returns.

IRS officials have explained that in spite of the new campaign approach, audits will retain many of their traditional features. Exam processes and procedures will largely stay the same.

Escalation, starting with the case manager, remains within the taxpayer’s toolkit, and the service’s subject-matter experts working on any campaign issues will be made available to the taxpayer through such channels. (An escalation is an inquiry that has to be escalated to a subject-matter expert when an IRS customer service representative can’t resolve the inquiry.)

Early resolution processes like Fast Track will still be available, and each year will wrap up on a single revenue agent’s report, although multiple  5701s (notices of proposed adjustments) could be issued, as they are today.

Expansion to beyond the 13 “issues of concern” currently identified is likely. “We’re currently working on a number of potential campaigns,” said Kathy Robbins, director of the Enterprise Activities Practice Area for IRS LB&I, on the recent webcast. “I think I can tell you there’s a high level of certainty that there will be more campaigns announced in the upcoming months.”

 More than Just Audits

The campaigns go beyond audits. The IRS positioned its new approach as part of its move “towards issue-based examinations and a compliance campaign process.” Most issues will be implemented in whole or in part via issue-based exams. But some have a goal of developing published guidance or the issuance of soft letters to compel greater compliance.

Companies should be prepared for local field teams to reach out on issues that may apply. But the point of the contact might be to start a dialogue and not necessarily to audit the issue (at first, anyway).

The IRS won’t routinely tell a taxpayer that an audit is the result of an IRS campaign, but the taxpayer may ask.

Mid-Markets and Small Businesses

The largest taxpayers probably weren’t surprised to see repatriation structures show up on the IRS’s initial list. These issues routinely show up on the tax battleground occupied by the largest U.S.-based multinationals.

But interestingly, the IRS indicated it would focus the campaigns on repatriation issues affecting mid-market taxpayers. While the IRS won’t pin down exactly what “mid-market” means in this context, a good general guideline is taxpayers in the $10 million to $250 million asset range.

Similarly, the IRS noted that in investigating related-party transactions among commonly controlled entities, its focus would also be on mid-markets. It’s unclear what is driving the focus on companies of that size, but mid-market taxpayers engaging in any such transactions should be ready to support related tax-return positions.

Another surprising campaign addition is the one focused on shareholders of S corporations, a classification often reserved for small businesses. Statistically S corps have not been audit targets. But that may soon change under the new IRS campaign targeting S corporation shareholders who claim losses and deductions that exceed their basis.

Specific Industries Targeted

Several campaigns also target specific industries. It’s unclear why these taxpayers rose to the top of the IRS’s heap. But it’s evident that CFOs of companies in these industries need to ensure they have sufficient evidence to support their company’s tax return claims. The industry-focused campaigns include:

  • Energy Credits. This campaign ensures that taxpayers claiming an energy credit for their advanced energy projects have been approved by the Department of Energy and allocated a credit by the IRS.
  • Multi-Channel Video Program Distributors (MVPD’s) and TV Broadcasters. Multi-channel video programing distributors (MVPDs) and television broadcasters that distribute channels and subscriptions packages frequently assert that they are the producers of a qualified film and therefore eligible for the IRC Section 199 deduction. That deduction is typically reserved for manufacturers of tangible goods in the United States. To ensure compliance, the IRS has developed a strategy to validate the use of Section 199 deductions by broadcasters and MVPDs.
  • Deferred Variable Annuity Reserves & Life Insurance Reserves. This campaign provides guidance to address uncertainties on issues important to the life insurance industry. The issues include amounts used to determine tax reserves for both deferred variable annuities with guaranteed minimum benefits and life insurance contracts.
  • Micro-Captive Insurance. This campaign aims to thwart taxpayers from incorrectly reducing aggregate taxable income using contracts treated as insurance contracts and a related company that the parties treat as a captive insurance company.
  • Land Developers. This campaign aims to ensure that land developers with more than $10 million of annual gross receipts are correctly using the completed contract method (CCM) of accounting. CCM is only allowed under a home construction contract.

Foreign MNCs Aren’t Immune

In theory, most of the campaigns could apply to the U.S. subsidiary of a foreign parent. But one is specifically focused on foreign corporations themselves who do business in the United States and have failed to file their 1120-Fs. This campaign will directly affect foreign companies if their U.S. compliance efforts have been falling short. So the CFOs of such companies should be ready to show evidence of their good-faith compliance efforts.

Another area that may bubble up on the list of headaches for foreign-based MNCs doing business in the United States is the campaign related to U.S. distributors of goods sourced from foreign-related parties.

A common example is a U.S. subsidiary distributing goods sourced from its offshore parent. The IRS is concerned that the U.S. entity’s taxable income may fall short of what would be expected, considering the functions the distributor performs and the risks it assumes. A CFO of such an entity should ensure its organizational transfer pricing policy stands on firm footing and the group has good documentation that the policy was followed accordingly.

This is Just the Beginning

Based on its release notes, the IRS is seeking industry input and is open to discussions with the tax community to help them identify future campaigns. The webinar series, which began on March 7, will likely mark a first step in that process.

While the details of the next round of campaigns aren’t yet apparent, the IRS has made clear that its campaign-based approach is here to stay. Thus, companies in all industries and of all sizes — even small- and medium-sized businesses — must be prepared to defend their tax positions on these issues and stay nimble and alert for the next shoe to drop.

George Farrah is editorial director-tax and accounting for Bloomberg BNA.

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