United States

The IRS is hiring law firms to assist with tax examinations

Is this the new way the IRS will audit?

TAX ALERT  | 

It appears the IRS has been hiring law firms to assist in tax examinations. Recently, Microsoft filed a complaint against the IRS using the Freedom of Information Act (FOIA) to learn more about the IRS's $2.1 million engagement with a litigation law firm that was hired by the IRS to assist in an examination of Microsoft. The complaint may expose new IRS auditing techniques that have not previously been made public. Specifically, the complaint aims to help Microsoft understand how the hired third party is being involved in the IRS's examination process.

Traditionally, the federal tax examination process has been strictly a governmental function performed by the IRS. The concept of using a third party to perform an examination is new and is generating several questions. Largely, should the IRS be allowed to outsource a tax examination? If so, how much of the examination can be outsourced? Are individual taxpayers subject to third-party examiners or only corporations? While hiring a professional to assist the IRS on a specific item in an audit is relatively common (e.g., hiring a valuation firm to assess the fair market value of property), it is not common to have the IRS outsource the examination process, which is much broader in scope by comparison.   

The role of private contractors with taxpayer audits is evolving. Earlier this year, the IRS issued temporary regulations (T.D. 9669) to clarify how third parties may be used in the summons process. Effective for summons interviews conducted on or after June 18, 2014, third parties hired by the IRS may be included as persons designated to receive summoned books, papers, records, or other data and to take summoned testimony under oath. These "certain other persons" (i.e., third parties) are privy to taxpayer information to the extent necessary for purposes of tax administration1 and are able to fully participate in a summoned person's interviews.2 For instance, participating includes: receipt, review and use of summoned books, papers, records or other data; being present during summons interviews; questioning the person providing testimony under oath; and asking a summoned person's representative to clarify an objection or assertion of privilege.3  The preamble states that the IRS will hire third parties with specialized knowledge, skills or abilities that the IRS officers or employees assigned to the case may not possess. 

However, the preamble makes clear that the IRS remains responsible for the "inherently governmental functions" of the examination of books and witnesses. Further, an IRS employee will always be present when a third-party contractor asks questions of a summoned witness. But where is the line drawn to determine which functions are inherently governmental?  Microsoft is obviously concerned that a line has been crossed in regard to how the IRS has hired a third-party law firm to assist in the Microsoft examination. Commentators seem to agree that the examination of a tax return should be a core governmental function, like the collection of tax.4

When it comes to an IRS tax audit, even the most honest taxpayers are generally uneasy with handing over personal information to the government, let alone handing the information over to a third party. The complaint filed by Microsoft will provide insight on how the IRS is using third-party contractors to assist in the tax examination process. If the complaint is successful, it will highlight new examination methods and the IRS's intentions behind those methods. Undoubtedly, the case will continue to gain more wide-spread attention, and it will be interesting to monitor how Congress or the courts react. Consult your tax advisor if you are under an IRS examination.

1 Section 6013(n)
2
Prop. Reg. section 301.7602-1T(b)(3).
3
Id.
4
See IRS Makes Novel Use Of Outside Contractors - To Audit Microsoft

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