Tax reform is here to stay (at least for the foreseeable future). The Internal Revenue Service (IRS) may receive additional funds to implement the new tax law. With lowered tax rates, accelerated expensing and forced repatriation of foreign earnings comes an increased risk of an IRS audit. This brave new tax world has left so many questions that tax advisors’ phones have been ringing off the hooks! But as the end of the 2017 year and first quarter of 2018 dust settles, be mindful of the IRS audit to come.
The first round of examinations will focus on what taxpayers did in 2017 in expectation of tax reform. Given the 14 percentage point corporate rate differential between 2017 and 2018, there was an incentive to accelerate deductions and defer income last year. Atypical activity may serve as a red flag and trigger IRS scrutiny. For example, numerous taxpayers accelerated their deductions for bonus compensation to ensure that the liability to pay bonuses in 2018 was fixed and determinable by the end of 2017. In previous years, there was not a big incentive to manage these deductions, but they are suddenly worth 14 percentage points more. Taxpayers may have implemented strategies in 2017 to manage their foreign earnings and profits (E&P) and cash levels in anticipation of deemed repatriation under tax reform. Similarly, taxpayers may have engaged in accounting methods and taxable year changes with tax reform planning considerations in mind. There were many other positions and transactions that taxpayers took in 2017 in anticipation of tax reform.
So what can you do now to put yourself in the best possible position when the IRS opens an examination of your 2017 return? The short answer: be prepared.
- Prepare an audit ready file, and document, document and then document some more. Every position you took in the wake of tax reform should have its own file within which all of the relevant documents are included—step plans, board resolutions, corporate minutes, important emails, valuations, etc.
- If you are subject to tax on a repatriation of foreign E&P, expect that your E&P studies will be scrutinized. Document the assumptions made and the information relied upon. Memorialize the methodologies used for the calculations. Have all calculations ready to produce to the IRS.
- Before you file your 2017 return, consider obtaining a tax opinion from a tax advisor. A tax opinion may constitute “reasonable cause” which is a defense to most income tax penalties. Make sure the opinion comes from an independent and competent tax advisor. If the opinion writer played a major role in developing the transaction, in some cases it may be advisable to get an opinion from a different advisor for penalty protection purposes.
- Preserve your data. If you had any turnover in 2017, consider whether you want to preserve those employees’ data. It may be in your best interests to capture a departing employee’s information if they worked on any transaction or aspect implicated by the change in the tax law. Additionally, you may be required to preserve data to the extent that you expect litigation. Work through these issues with your general counsel’s office.
- Develop your position for what you did and why you did it. Having a clean and clear narrative, buttressed with documents and data is helpful when responding to questions from the IRS. Inconsistencies in story or messaging invites suspicion and further inquiry which will use up limited internal resources.
- Don’t blow privilege! To withhold documents and information under a claim of attorney and tax practitioner-client privilege, there must be: (a) a communication; (b) made in confidence; (c) with a lawyer or federal tax advisor (i.e., accountant); and (d) that seeks or gives advice. Privilege is easily waived, however, whenever a privileged communication is shared with someone who is not within the protected status. Moreover, waiver extends not only to the communication exposed, but to all other communications regarding the same subject matter (i.e., all advice on the same transaction). To protect privilege, we suggest maintaining separate files for advice and protected communications that can be accessed only by specified employees on a need-to-know basis. If you are anticipating litigation on a transaction, also be aware of the further protection provided by the work product doctrine.
- Consider whistle blowers and shareholder derivative actions. Preparing for an IRS audit should also train your attention on any potential liability outside of tax. Making sure that you limit access to transaction documents and legal and tax advice is crucial to manage potential liability. Review your internal reporting protocols, and make sure they pass HR muster. If an employee has an issue with a reporting position, there should be an established mechanism for that employee to report the issue internally to someone outside the line of report. If a red flag is raised, take it seriously and consider consulting with an outside advisor regarding the merits of the position.
Practice Point: We expect that the IRS will scrutinize the 2017 returns of taxpayers who had significant positions affected by the new tax laws. But with preparation, your chances for a successful resolution will be greatly enhanced.