United States

Network approach replaces tiered issues in IRS exams


Since 2006, the IRS' Large Business and International (LB&I) division has been using a tiered issues approach to manage issues and examinations. The objective was to identify issues that carried the highest risk of noncompliance, especially those involving potentially abusive tax shelters, and address those issues consistently across industries and taxpayers. The practice involved separating examination issues into three tiers, and prioritizing them according to compliance risk, from Tier I (highest risk, with significant impact on more than one industry) to Tier II (risks involving emerging issues that need clarification) to Tier III (risks for a single industry).

Tiered issues approach
Reasonable in theory, the tiered issues approach did not work very well in practice, either for the IRS or for taxpayers. The existence of a Tier I issue generally required an examination, without consideration of whether there was noncompliance with the Code. Thus, entirely legitimate tax deductions could lead to an examination and subject the return to examination approaches used with aggressive tax shelters. Simply taking a deduction earmarked as of "high strategic importance" to the IRS could trigger an examination, such that no issue resolution or settlement could occur without the approval of various subject matter experts.

A good example of this was the Section 199 Domestic Production Activities Deduction (DPAD), which allows a deduction to businesses manufacturing within the U.S. and which is computed as a percentage of production revenue. The IRS designated the DPAD as a Tier I issue and placed virtually any return with that issue under examination. The reason for DPAD's designation within Tier I was to allow the IRS the opportunity to study the issue in various contexts. Thus, legitimate tax deductions and abusive tax shelters were thrown into the same pile, while the number of companies at risk for audit grew larger and larger.

A key feature of the tiered issues approach was the use of Industry Director Directives (IDDs) to control the development and often outcomes of tiered issues. The Industry Director is an IRS executive who controls the activities of agents and their managers in one of six industries around which LB&I is organized. The Director reports directly to the Commissioner of LB&I and has been delegated the authority to make key decisions on issues within his or her industry. Those decisions may include what field examiners should look for, what position they should take when proposing adjustments to a return, the imposition of penalties and in some cases, the final decision or resolution of an issue.

The IDDs are the marching orders issued by the Industry Director that agents must follow when setting up and resolving issues. Where an IDD applied, it was not uncommon to hear an agent say that they had no discretion in how the issues would be managed or resolved. The net effect of this system was to place decision-making authority beyond the control of the local examiners who were conducting the audit. Case resolution could not be inconsistent with the IDD, and taxpayers often had to take their case to Appeals to resolve an issue that had been resolved similarly by LB&I for years. The result was case management backlogs, delays and other bottlenecks presided over by examiners with little or no discretionary authority.

Knowledge management approach

To address these problems, the IRS recently decided to abandon tiered issues in favor of a more collaborative and efficient approach. On
Aug. 17, 2012, LB&I Commissioner Heather C. Maloy announced that tiered issues were immediately de-tiered, and associated IDDs were withdrawn.

The new knowledge management approach involves issue-focused networks consisting of Issue Practice Groups for domestic issues (IPGs) and International Practice Networks for international ones (IPNs). These are essentially teams of counsel, subject matter experts, technical advisors and other national IRS resources knowledgeable in a topic or industry. Although the involvement of experts and the sharing of knowledge may sound similar to the tiered issue process, it isn't. The IPGs and IPNs are advisory teams, rather than decision-makers, and their advice is discretionary rather than mandatory. Examiners can draw upon these resources as needed, but are not required to coordinate decisions with them or secure their approval when deciding to set up, forgo or resolve an issue. Case development and resolution is now back in the hands of the local examination teams and their managers.

The overall intent of the new approach is to foster collaboration and information-sharing across LB&I. It is also designed to foster better communication between examiners and taxpayers' representatives and to transfer knowledge and experience between examination teams and specialists within LB&I and between LB&I and its counsel. Technical analysis and information contained in the withdrawn IDDs may still be consulted by the networks; also, examination tools that accompanied the issuance of the IDDs will be available to the networks to provide to LB&I. For a limited time and for historical reference purposes, tiered issue resources will remain on the IRS public website, as will the LB&I Commissioner's announcement that the tiered issue program is over.

Special impacts on banks

The withdrawal of two IDDs may leave some banks confused as to how certain tax issues will be treated in the future. However, just because an IDD has been withdrawn does not mean that the underlying technical analysis supporting an issue will change. The LB&I team is likely to still pursue the issues, but they will now be free to resolve the issue as they see it.

Two IDDs in particular deserve further consideration. Here's a closer look at the impact of withdrawal of two IDDs relevant to banks:

1. Tier II issue - interchange and merchant discount fees

There has been a longstanding controversy over tax treatment of interchange and merchant discount fees. Some banks and credit card issuers took the position that the fees are Original Issue Discount (OID) eligible for favorable tax treatment; the IRS frequently challenged that view. Capital One Financial Corporation challenged the IRS on the OID issue in Tax Court and won. The Tax Court found that credit card interchange fees are interest and can be treated as OID, subject to deferral under section 1272(a)(6).

After much consideration, the IRS issued IDD - Directive 2 on
Nov. 22, 2010, announcing that it was no longer going to challenge whether the fees created or increased OID. Instead, the IDD directs field agents to examine the OID computations and evaluate whether banks had changed accounting methods for recording the income. Thus, although the IDD is now withdrawn, the IRS will likely follow the guidance from the IDD to focus on the OID computation and look for a change in accounting method, but not challenge whether the income was interest subject to OID.

2. Tier II issue - non-performing loans

This IDD dealt with how examiners should identify and treat the accrual of interest income on non-performing loans. Specifically, it involves when a bank can stop accruing interest on these loans for tax purposes, how accrued but unpaid interest should be treated and how subsequent payments received after a bank places the loan in nonaccrual status should be treated. It directs field examiners to follow Rev. Rul. 2007-32 and Rev. Proc. 2007-33, and requires coordination with a banking technical advisor.

Even though the IDD has been withdrawn, banks will still see the IRS raising issues under the guidance of Rev. Rul. 2007-32 and Rev. Proc. 2007-33. This issue became a coordinated issue in 1991; however it later became a Tier II issue to improve IRS-wide coordination of the issues that arise with nonperforming loans. The withdrawal of the IDD may impact the coordination of the issue, but the IPG for banking and financial services will provide support to LB&I teams who request it, and it is likely that this longstanding issue will retain its vitality in the future.

For more information

For more information or assistance with this topic, please contact Patti Burquest, managing director of Tax Controversy Services, Patti.Burquest@rsmus.com or at 202.370.8236.