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July 17, 2012

For years, the collective wisdom has been that flow-through entities such as partnerships and S corporations are rarely audited. We still regularly hear that comment in the marketplace. However, this is no longer the case. In fact, several years ago the IRS identified high-wealth individuals as an area of audit emphasis, and the partnerships in which many of these individuals invest have also come under additional scrutiny. At a time when the IRS appears to have entered an increasingly aggressive audit cycle, a recent series of high-profile IRS-favorable court decisions, such as Canal, Reddam and Blum , have the potential to further embolden the IRS. In all three of these cases, the judges' opinions were particularly critical of all parties involved, and the IRS assessed the maximum penalties available even though the taxpayers had relied on formal opinions from the Big 4 accounting firms that prepared their tax returns.

While one may understand the hard line the IRS has taken on transactions it considers particularly abusive, in our experience, this hardline approach is not limited to audits of similar transactions. In particular, our practice has noticed that audits of wealthy individuals have taken on a more confrontational tone from the outset. The IRS's recent approach seems to apply the same skeptical manner with which it approached the OPIS (offshore portfolio investment strategy) transactions in Reddam and Blum and the highly structured real estate gain deferral transaction in Canal to client-specific routine tax planning. An offshoot of this attitude, among other things, seems to be a willingness to assess penalties much more frequently than in the past.

Another of the practical consequences of this changing environment seems to be the application of a "one size fits all" approach to audits that the IRS believes will lead to a "fair" or consistent result across taxpayers. The current approach to examination favors a highly scripted process with a particular emphasis on procedural requirements as opposed to a more flexible approach that relies on the judgment and experience of auditors. In many cases, partnerships and S corporations present unique challenges for the agents as a result of their ultimate impact on individual tax returns. Unfortunately, the combination of this approach to the examination process coupled with inexperience in the flow-through area may lead to more audits that remain unresolved at the examination level. This forces the taxpayers to ask the IRS appeals office to address multiple issues that may not have been escalated to that level in the past.

Given the increasing number of unresolved audits at exam, coupled with the frequency with which penalties are asserted as a matter of course, clients would be well advised to consider their overall approach to the documentation of tax positions and of the calculations of items reflected in their returns. Our recent experience has confirmed that, in many cases, auditors expect more documentation than many taxpayers or courts have considered necessary to meet their burden of proof. The old adage that an ounce of prevention may well be worth a pound of cure seems to apply to IRS examinations.

Of particular concern when it comes to documentation are the circumstances under which any reliance opinions are issued and by whom they are issued in instances where penalty protection is required. In all three court cases mentioned above, the courts noted that the opinion drafted by the taxpayer's tax preparer was inadequate for penalty protection for a variety of reasons. While each case was different, a general theme suggests that an opinion written by the firm that promoted or structured a transaction will be viewed with skepticism by both the IRS and the courts.

While much debate surrounds the question of when general tax planning becomes a promoted strategy of the type that precludes the firm from providing a reliance opinion, taxpayers would be well served to think carefully about whether to solicit the opinion of another firm in cases where the tax position results in a deferral or reduction of tax representing a material item on the tax return.

Alvarez & Marsal Taxand Says:
Based on published statistics on audits of high-net-worth individuals and our experience, income tax audits are on the rise. Given the current political climate and the prevailing mood within the IRS, it is our guess that audits of high-wealth individuals and flow-through entities will continue to rise in the near term and that more and more of these audits will not be resolved at the examination level for the reasons outlined above. As a result, we recommend that clients analyze their documentation procedures in order to be well prepared when the time comes to defend their tax positions. As has always been case, and perhaps increasingly so today, the best way to control the audit process is to be prepared with as much documentation as possible from the outset.

Footnotes:
Canal Corp., 135 T.C. No. 9 (2010); Reddam v. Comr., T.C. Memo. 2012-106; Blum v. Comr., T.C. Memo 2012-16.

Author:

Tyler Horton
Managing Director, Washington DC
+1 202 688 4218

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

 
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in nearly 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.

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