Recently, the Large Business and International division of the IRS (LB&I) announced the reorganization of its tax examination/audit groups in order to more effectively make use of its ever-declining budget. As part of its post-restructuring procedures, the IRS will be issuing so called "soft letters" which can provide proactive corporate taxpayers with the opportunity to avoid lengthy tax examinations. For example, if a corporate taxpayer replies to a soft letter with sufficient factual information and a well-articulated legal position, the IRS may concede the issue without a lengthy audit or additional contact. We highly recommend that corporate taxpayers contact their Withers tax advisor should they receive an IRS soft letter.
LB&I is in charge of tax compliance for all corporations, subchapter S corporations, and partnerships with assets greater than $10 million (i.e., nearly all business entities). Previously, most LB&I tax examinations were for general tax compliance and were conducted on an enterprise-wide basis. This practice was found to be frequently inefficient. Now, LB&I will focus on tax positions that have been statistically proven to result in higher tax revenue through the use of a customized methodology for each issue.
Importantly, these new procedures can provide the proactive corporate taxpayer with the opportunity to avoid lengthy tax examinations and mitigate the risk of the imposition of penalties by properly responding to an integral part of campaigns, namely IRS communications known as “soft letters.” Further, taxpayers who have taken any of the positions that are the subject of any of the campaigns may be well served by reviewing such positions in light of the increased scrutiny that such positions are receiving.
New LB&I Campaigns
In connection with the general theme of doing more with less, LB&I has initially announced 13 issue specific compliance “campaigns”. A campaign may be thought of as a holistic means of dealing with certain tax positions that have been the subject of abuse. A campaign may consist of any number of specialized “treatment streams.” Further, each campaign includes details on which of those treatment streams the IRS plans to utilize in order to address each campaign most efficiently. Treatment streams can include:
- Issue-focused/issue-based tax examinations;
- Increased IRS agent technical training;
- Utilization of the technical expertise of agents more effectively;
- Development of additional published guidance and forms;
- Practitioner outreach; and
- Soft letters to:
- Material Advisors
Although the campaign program is in its infancy, we believe that corporate taxpayers have significant opportunity as a result of this IRS shift and, more particularly, their use of soft letters. The IRS has reported that soft letters will generally contain the following:
(i) the reason why the Taxpayer is receiving the letter (i.e., what issue was spotted by the IRS);
(ii) the legal justification for the IRS position that is contrary to the one taken by the taxpayer;
(iii) a request that the taxpayer voluntarily self-correct (by filing an amended return or responding to the notice by giving the IRS permission to change the tax owed); or
(iv) a request that the entity file an original tax return (in the case of 1120-F non-filing).
At present the IRS has designated 13 campaigns, with their issues described briefly as:
- Form 1120-F Non-Filer - Foreign companies that have enough contact with the U.S. are often required to file Form 1120-F. LB&I has determined that a number of foreign entities are not filing as the law requires. Of particular note is that LB&I will use a number of external data sources to identify foreign companies and encourage them to file. If the companies do not take appropriate action, LB&I will move to an examination to determine the correct tax liability.
- Related Party Transactions - Transactions between commonly controlled entities that provide taxpayers a means to transfer funds to related pass through entities or shareholders with a tax benefit.
- S Corporation Losses Claimed in Excess of Basis - The law limits a shareholder’s losses and deductions to the amount of its basis in an S corporation. LB&I has found that shareholders claim losses and deductions where they do not have sufficient stock or debt basis to utilize these items.
- Inbound Distributor - Distributors of goods sourced from foreign, related parties have shown losses or only small profits on their U.S. tax returns, that are not commensurate with the functions performed and risks assumed. In many cases, the U.S. taxpayer would be entitled to higher returns in arms-length transactions (i.e., improper IRC Section482, Transfer Pricing).
- OVDP Declines-Withdrawals - Addresses applicants to the Offshore Voluntary Disclosure Program who applied for pre-clearance into the program in order to disclose their unreported offshore assets but were either denied access to OVDP or withdrew from the program in order to participate in an IRS examination/audit.
- TEFRA Linkage Plan Strategy - As partnerships have become larger and more complex, LB&I has regularly revised processes to assess tax on the terminal investors. This focus is expected to also link the new partnership audit rules that are planned to come into large scale effect in 2018.
- Basket Transactions - Addressed to structured financial transactions described in Notices 2015-73 and 74, where an attempt to defer and treat ordinary income and short-term capital gain as long-term capital gain is made by treating a derivative as open until an event occurs, and, therefore, delays gain recognition. The gains are deferred until the contract terminates, at which time the overall net gain is reported as a Long-Term Capital Gain.
- Land Developers - Large land developers that build in residential communities may be improperly using the Completed Contract Method (CCM) of accounting. A developer, whose average annual gross receipts exceed $10 million, may only use the CCM under a home construction contract.
- Repatriation - LB&I is aware of different repatriation structures being used for the purpose of tax-free repatriation of funds into the U.S. in the mid-market population. It has also been determined that many of the taxpayers do not properly report repatriations as taxable events on their filed returns.
- Micro-Captive Insurance - This campaign addresses transactions described in transactions of Interest Notice 2016-66, namely those where a taxpayer reduces its income using contracts that it treats as insurance contracts and a related company treated as a captive insurance company. Each entity claims deductions for insurance premiums. These contracts are treated inconsistent with an arm's length transaction and business practices in the absence of tax advantages.
- Deferred Variable Annuity Reserves & Life Insurance Reserves IIR - To develop guidance to address grey areas important to the life Insurance Industry including the proper amount to be taken into account in determining tax reserves for both deferred variable annuities with Guaranteed Minimum Benefits, and Life Insurance contracts.
- RC 48C Energy Credit - To ensure that only those taxpayers who are qualified to take this credit are claiming it.
- Domestic Production Activities Deduction, Multi-Channel Video Program Distributors (MVPD’s) and TV Broadcasters - Taxpayers are asserting that they are qualified to utilize certain activities in claiming the DPAD while the IRS claims that they are not.
See: IRS Announcement on the launch of compliance campaigns - https://www.irs.gov/businesses/large-business-and-international-launches-compliance-campaigns
Currently, soft letters have been designated for the: Form 1120-F Non-Filer; Basket Transactions; Land Developers - Completed Contract Method (CCM); and RC 48C Energy Credit campaigns, but should they prove successful, their use is expected to be expanded into other areas. Additionally, soft letters will likely play a part in the new campaigns that the IRS is developing.
We believe that the manner in which a corporate taxpayer reacts to the receipt of a soft letter can provide valuable benefits. A well-reasoned response may serve to limit the risk of a soft letter evolving into a full tax audit/examination and can also mitigate the potential for incurring tax penalties. In certain circumstances, replying to a soft letter with factual information and the taxpayer’s legal position, could lead the IRS to concede the issue without a lengthy audit or additional contact.
As with all IRS communications, the receipt of a soft letter must be taken seriously. We highly recommend that you contact your Withers tax advisor without delay in the event that you receive a soft letter or determine that you have taken any tax positions that are the subject of the above campaigns.