The Industry Issue Focus (IIF) Program was

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1 Handling Tiered Issues Under the IRS s Industry Issue Focus Program By Matthew D. Lerner and Amanda Pedvin Varma Matthew Lerner and Amanda Pedvin Varma summarize the key aspects of the IRS s Large and Mid-Size Business Division s Industry Issue Focus Program, describe taxpayer and practitioner criticisms of the program and suggest approaches to resolve tiered issues successfully. The Industry Issue Focus (IIF) Program was implemented in March 2007 by the Large and Mid-Size Business Division (LMSB) of the IRS. Under the IIF Program (also referred to as Issuing Tiering 1 ) the IRS identifies certain compliance issues and then prioritizes ( tiers ) each issue based on stated factors, including the prevalence of the issue and the compliance risk raised by the issue. Although some taxpayers and practitioners ion have expressed concerns that the program has negatively affected the audit process, taxpayers ay and practitioners can help mitigate these perceived dnega negative effects and improve their chances of achieving a successful resolution on of a tiered issue by understanding the program and taking a proactive approach to planning and controversy. This article (1) summarizes the key aspects of the IIF Program; (2) describes taxpayer and practitioner frustration with the program; (3) suggests approaches that taxpayers and practitioners can take to resolve tiered issues successfully; and (4) provides a case study of how taxpayers and practitioners can use materials compiled by the IRS to improve their handling of tiered issues. Matthew D. Lerner is a Partner at Steptoe & Johnson LLP in Washington, D.C. Amanda Pedvin Varma is a Tax Associate at Steptoe & Johnson in Washington, D.C. Overview of Industry Issue Focus Program LMSB officially implemented the IIF Program in March According to the IRS, the IIF Program partially is a response to two of its major challenges. First, the IRS asserts that it must be able to respond to the continually changing business environment. Business is increasingly globalized. International transactions, from cross-border payments to structured finance transactions, raise complex and unsettled issues. In addition, many businesses have sophisticated tax teams that t the IRS views as being one step ahead. The IRS asserts that its second major challenge is that it is constrained by limited resources. For example, individual agents may be responsible for scores of corporate tax returns, which are often long and complex. The IRS believes that the IIF Program will help it achieve several objectives. First, the IIF Program may allow LMSB to concentrate on higher-risk issues across industry lines. By concentrating limited resources on certain higher-risk issues, LMSB may increase coverage of noncompliant taxpayers, at least on the most important issues. Second, the IRS believes that the IIF Program is designed to give LMSB flexibility to respond to changes in business practice. A prevalent and complex issue may be designated 2009 M.D. Lerner and A.P. Varma CORPORATE BUSINESS TAXATION MONTHLY 21

2 Handling Tiered Issues initially as a higher-tiered issue, but may be put in a monitoring stage as the IRS is able to develop guidance and strategies for resolving the issue. The IRS also may deploy resources where needed. Third, the program is designed to promote consistency. Under the IIF Program, LMSB may resolve issues that are common to several different industries in a consistent fashion. The Three Tiers 22 An issue may be designated as a Tier I, Tier II or Tier III issue. Tier I issues are considered to be of high strategic importance to the IRS and generally have a significant impact on one or more industries. In addition, a Tier I issue typically involves a large number of taxpayers, has a significant monetary value to the IRS, has high visibility and/or represents a substantial compliance risk. Tier I issues are divided into two categories: compliance issues and shelter issues. According to the IRS, Tier I compliance issues do not necessarily relate to abusive transactions or practices rather, they have been designated as Tier I because the issue is of high importance to the IRS. The current Tier I compliance issues (that have not yet been placed into monitoring status, as described below) are Code Sec. 118 abuse; 2 research credit claims; domestic production deductions; mixed service costs; cost sharing/offshore hore transfer of intangibles; foreign earnings repatriation; foreign tax credit generators; and U.S. withholding ho ing agents reporting and withholding on U.S.. source FDAP income. 3 The Tier I shelter issues include all transactions ac listed by the IRS as abusive tax shelters ers and transactions, as well as redemption bogus optional basis and distressed asset/debt transactions. When LMSB believes that a resolution strategy for that issue has been fully developed, it may move the issue from active status to monitoring status in the same tier. 4 LMSB states that [w]hile issues in monitoring status may no longer require the focused attention of an Issue Management Team, they still need to be managed in accordance with established guidance whenever they appear on a tax return. 5 According to the IRS, an issue will be considered eligible for monitoring status when the relevant Issue Management Team (described below) has (1) identified the returns likely to contain the issue; (2) provided necessary direction to the field; (3) issued appropriate procedural guidance and a legal position; (4) developed a resolution strategy; and (5) determined that there is no need to continue the heightened level of oversight. 6 As of April 21, 2009, the following Tier I issues have been placed in monitoring status: Code Sec. 118 universal service fund; 7 Code Sec. 118 bioenergy payments; Code Sec. 118 environmental remediation; Code Sec. 936 exit strategies; backdated stock options; government settlements; international hybrid instruments; and mixed service costs (Phase I). Tier II issues typically represent issues that the IRS views as having potentially high compliance risk. According to the IRS, Tier II includes emerging issues where the law is fairly well established but a need exists for further development, clarification, direction and guidance on LMSB s position. 8 The following issues are classified as Tier II issues: casualty loss: single identifiable property/capital vs. repairs; cost sharing stock-based compensation; enhanced oil recovery credit; extraterritorial income exclusion effective date and transition rules; gift card deferral of income; healthcare accounting issues: contractual allowance; interchange and merchant discount fees; nonperforming loans; specified liability losses; super completed contract method; and upfront fees, milestone payments and royalties in biotech and pharmaceutical industries. Tier III issues represent issues that the IRS views as high compliance risks in particular industries and require unique treatment in that industry. The following are classified as Tier III issues: Communications, Technology and Media carriage/launch fees paid to cable/satellite/ television operators by programmers/content providers; and amortization of intangibles for licensed program contract rights. Financial Services real estate mortgage investment conduits; and premium deficiency reserves.

3 Heavy Manufacturing and Transportation uniform capitalization for automobile dealerships; and loyalty programs in service industries. Natural Resources and Construction delay rentals; and Code Sec. 198 expensing of environmental remediation costs. Retailers, Food, Pharmaceuticals and Healthcare cost segregation studies; and vendor allowances. LMSB gathers potential tiered issues from several sources, such as field agents and discussions of current developments. Potential Tier I or Tier II issues are presented to LMSB s Compliance Strategy Council for review and approval. In deciding how to classify the issue, LMSB considers several factors, including whether the issue spans multiple industries, the scope of the issue, how resource-intensive it is and how many taxpayers are affected by the issue. If an issue is approved as a tiered issue, the issue is assigned to an Issue Owner Executive (defined below) to develop a compliance strategy. IIF Personnel To fully understand how the IIF Program functions, it is important to understand the roles of the specific IRS personnel who administer the program. Key positions in the IIF Program include [T]he prog Issue Owner Executives es promote c (IOEs), Issue Management Teams (IMTs), Issue Specialization Teams (ISTs) and the exam teams. An IOE is chosen when an issue is designated as tiered by the LMSB Compliance Strategy Council. The IOE is responsible for creating an action plan for a particular tiered issue. He or she also facilitates requests for legal advice and guidance and selects the members of the IMT. An IMT usually includes an LMSB technical advisor and/or specialist, an Appeals technical guidance coordinator, LMSB industry counsel, a National Office Chief Counsel representative and other members as necessary. The IMT is responsible for developing LMSB s strategy on a tiered issue, providing direction and guidance to the field, facilitating development and resolution of significant issues and developing the audit techniques to be used for a particular issue. The IMT also evaluates whether the issue needs to be addressed through litigation and identifies the best case or cases for factual and legal development. When appropriate, the IMT coordinates with Appeals. According to LMSB, the IMT does not necessarily get involved in specific cases except to discuss how they affect LMSB s overall strategy on that issue. An IST typically is formed for complex, timeconsuming or widespread tiered issues. The IST contains senior agents, revenue agents and specialists. It assists the examination team as necessary, which may include drafting information document requests (IDRs), examining taxpayer records, drafting Forms 5701 and 886, and participating in meetings with taxpayers. The exam team typically issues to the taxpayer IDRs, summonses, proposed adjustments and other specific documents that have been developed by the IST or IMT. The exam team also handles the nontiered issues of the taxpayer. IIF Program Materials [T]he program is designed to promote consistency. Under the IIF Program, LMSB may resolve issues that t are common to several different industries in a consistent fashion. As discussed below, a taxpayer or practitioner dealing with a tiered issue should be familiar with materials that the IRS has compiled in connection with the IIF Program. These materials, which may be found on the IRS website, include (1) general information about the IIF Program and the examination process and (2) guidance on specific, tiered issues. 9 Several sections of the Internal Revenue Manual ( IRM ) describe the IIF Program. IRM provides a general overview of the program and the process by which the IRS designates issues as tiered. 10 IRM describes the LMSB Rules of Engagement, which explain the roles and responsibilities of various IRS personnel involved in the IIF Program and clarifies lines of authority. 11 IRM describes procedures that should be followed by IRS personnel in implementing the IIF Program. 12 The IRS also has compiled guidance for each Tier I and Tier II issue on individual Web pages. 13 For CORPORATE BUSINESS TAXATION MONTHLY 23

4 Handling Tiered Issues example, the webpage for the Tier I research credit claim issue includes links to two Industry Director Directives, one Notice, a Mandatory Research Credit Claims IDR, and the Research Credit Claims Audit Technique Guide. Each Tier I and Tier II issue also has a Quick Reference Guide. The Quick Reference Guide typically contains a summary of the current status of the issue; lists the IOE, the members of the IMT and other relevant contacts; describes how the audit team should execute the IMT strategy; and provides links to and descriptions of guidance. 14 Evaluating the IIF Program Practitioner and Taxpayer Concerns Practitioners and taxpayers have expressed several concerns about the IIF Program. First, some have complained that adding another administrative layer has complicated and slowed audits. Second, practitioners and taxpayers have argued that, in LMSB s attempt to achieve consistency, the exam team s flexibility has been undercut. Third, some have complained that the actual decisionmakers have little or no direct contact with the taxpayer. Fourth, some have reported that certain transactions are being incorrectly labeled ed as tiered by an agent, and once so labeled, are subjected ed to IDRs and legal positions ion inappropriate to the facts. Fifth, some practitioners i and taxpayers have said that the IIF Program contributes to Appeals losing its ability to function as an independent ent decisionmaker. Concern 1: Audits Have Slowed Taxpayers and practitioners have complained that the IIF Program has caused audits of tiered issues to slow because there are more levels of review, agents cannot or will not make necessary judgments, and bona fide explanations of distinguishing facts that warrant different treatment are not receiving full consideration. Moreover, arguments regarding the issue frequently must be made to an agent, who must then act as a conduit to present the taxpayer s arguments to the IMT or IST, which delays resolution and leaves the taxpayer having to rely on the agent to be its advocate (see Concern 3, infra.). 24 Through the very practice of tiering issues in the IIF Program, the IRS is providing taxpayers and practitioners with a valuable list of issues seen as significant to the IRS. Concern 2: Exam Flexibility Has Been Undercut Some practitioners and taxpayers believe that the IIF Program creates a one size fits all approach to tiered issues, despite IRS assertions to the contrary. Practitioners and taxpayers have complained that the exam team often is unwilling or unable to deal with a tiered issue and acts only as an information gatherer for the IMT. As such, some taxpayers and practitioners say that they have been unable to obtain information or clarification on why the exam team has taken a certain action. Some individuals who have been through the audit of a tiered issue also complain that IMTs and/or ISTs seem unwilling to listen to counterarguments from taxpayers because they assume that the IRS s position must be correct because it was developed through the IIF process. Concern 3: Decisionmakers are Unreachable Taxpayers and practitioners also have been frustrated with their inability to communicate with the relevant decisionmakers on a particular issue. For example, some taxpayers have reported that exam teams are not willing to engage in a discussion about distinguishing facts, and that they are similarly unable to have substantive discussions with the IMT or other decisionmakers. LMSB, however, has stated that the exam team has more discretion than is being reported in these taxpayer anecdotes. Concern 4: Issues Are Labeled Incorrectly Some practitioners and taxpayers believe some of their audit issues have been labeled incorrectly as tiered issues because the issue has some similarity to a tiered issue. Once an issue is incorrectly labeled, these practitioners and taxpayers report, it is difficult to get the issue re-labeled correctly. Rather, the issue must be dealt with through the slower tiered issues process. Concern 5: Appeals Is Losing Independence Some practitioners and taxpayers have complained that the IIF Program has contributed to Appeals losing its ability to make independent decisions. Appeals generally is supposed to take a fresh look at an issue after the issue has gone through the examination stage.

5 Some fear, however, that Appeals may not take a fresh look at tiered issues because the IMT, which decides strategy with respect to an issue, includes an Appeals representative. As such, it is argued that Appeals has been compromised. The IRS, however, has countered that Appeals does take a fresh look at the issue after exam and that Appeals withdraws from IMT discussions if the IMT discusses specific cases. This response has been met with skepticism however, because with respect to an issue where the IRS s position is that it is common across industries, discussion of facts in the abstract is simply a surrogate for evaluating a series of supposedly identical cases. In addition, it is important that taxpayers continue to perceive Appeals as untainted by involvement with examinations. Even if Appeals successfully maintains its independence, the appearance of bias will shake taxpayers faith in the process. Dealing With Tiered Issues in Practice Although taxpayers and practitioners may have valid concerns about the IIF Program, understanding how the IIF Program works and taking a proactive approach in planning and controversy may improve one s chances of dealing successfully with a tiered issue and may help mitigate the perceived negative effects of the program. Planning Use the Tiered ed Issue List in Planning Through the very practice ce of tiering issues s in the IIF Program, the IRS is providing in taxpayers and practitioners with a valuable list of issues seen as significant to the IRS. As a result, taxpayers should evaluate a their current practices in light of whether an issue has been placed on the tiered issues list. If a taxpayer engages in a transaction or practice on the tiered issue list, the taxpayer should understand that the issue will be scrutinized by the IRS. Furthermore, although examiners will focus in the current audit cycle on transactions and practices that have already occurred, taxpayers should recognize that some tiered issues are not specific to discrete transactions and will continue to be evaluated by agents in future years. For example, a taxpayer making payments to foreign persons should examine its Code Sec withholding practices in light of the IRS s increased focus if the IRS will scrutinize the taxpayer s practices later, the taxpayer should scrutinize them now. Use Materials Compiled by the IRS As described above, the IRS has developed and/or compiled materials on tiered issues and how audits will proceed under the IIF Program. Taxpayers and practitioners should review these materials to (1) understand how their audit will proceed; (2) understand the IRS s view of the law on each relevant tiered issue; (3) consider their planning in light of the IRS s position; (4) develop and maintain adequate contemporaneous documentation. Although IRS guidance on tiered issues does not necessarily reflect the correct interpretation of the law and the materials do not have the force of law, taxpayers and practitioners should recognize that these publications reflect the IRS s current view. Taxpayers and practitioners should understand the risks of engaging in transactions or practices that conflict with the IRS s view of the law as stated in these materials. If taxpayers and practitioners disagree with the IRS s current view of the law as stated in these materials and, after weighing the risks, engage in a transaction or practice that conflicts with the IRS s view of the law, they should refine the arguments supporting their position in advance of a later examination of the issue. Many materials developed or compiled in connection with the IIF Program describe the documentation that an examiner will ask for in an audit, as well as the IDRs that the agent will issue to the taxpayer. Taxpayers should review these materials to ensure that they are developing, retaining and organizing the documentation that the IRS will expect. First, at the time of the transaction, the taxpayer should be sure to create and preserve the type of information the IRS will request. Second, by preparing, even well in advance of the audit, to provide documentation to an agent, the taxpayer can help encourage the audit to proceed at a reasonable pace. With all of the pressure agents face to remain current, having responses carefully prepared in advance for the IDRs one knows will be forthcoming will improve the atmosphere surrounding an audit, if not the substantive result. Taxpayers should thus review any pattern IDRs and ensure that they will be able to respond promptly and accurately. During the Audit Be Proactive Taxpayers should approach an audit of a tiered issue differently than an audit of a nontiered issue. Rather CORPORATE BUSINESS TAXATION MONTHLY 25

6 Handling Tiered Issues than simply waiting for and then responding to an agent s requests, the taxpayer should be proactive and present its case to the exam team as if it were presenting a case to Appeals. The taxpayer should be ready with documentation, responses to mandatory or optional IDRs, and well-developed factual and legal arguments. 15 The taxpayer may also wish to ask outside persons involved in the issue, such as consultants or technical specialists, to be available to speak to the exam team. Taxpayers also should be proactive about directing examiners to substantiation and should explain its relevance, rather than just providing the examiners with documents and leaving the examiners to discern the relevance of the material. Taxpayers should work to define the direction of the audit. If a taxpayer has an issue that is similar to a tiered issue, but not identical, the taxpayer should explain why its facts are distinguishable from the actual tiered issue to help the agent avoid mistakenly labeling the issue as tiered. A taxpayer has a much better chance of preventing a mislabeling of an issue from the outset than succeeding in having an issue recharacterized once the audit is underway. Even if the taxpayer agrees that its issue is a tiered issue, it still must be proactive to define its case from the beginning of the audit. For example, the taxpayer can review sample facts in IRS guidance and explain why its facts are distinguishable from the facts in the guidance. The taxpayer also should draft its IDR responses carefully to define the issue, as the initial IDR responses are critical in influencing the direction that the examiners will take. Do Not Argue the Law A taxpayer or practitioner i generally will not benefit from arguing the law with an agent. The IRS s legal position on a tiered issue is developed with input from many different parties, including the IOE and IMT, and an agent does not have the authority to change the IRS s position on that issue. If the taxpayer or practitioner has a novel argument or seriously believes that an aspect of the IRS position is extremely misguided, there may be some benefit to discussing the law with the IRS. This discussion, however, should take place with the IMT, not an agent. Even if a taxpayer or practitioner is able to elevate the discussion to the IMT, the taxpayer or practitioner should recognize that the IRS already has deliberated on the law and may not be open to reconsidering its view. The IRS generally prefers to resolve cases at the lowest possible level. Although LMSB has stated 26 that it encourages the IOE and IMT to be engaged in a dialogue with external stakeholders, it admits that its success on this point has varied. In general, if an issue is case-specific, the IRS encourages taxpayers to proceed according to the rules of engagement and the appropriate lines of authority. The IRS Issue Tiering Fact Sheet states that [t]axpayers should address questions pertaining to their specific cases through their examination team and management chain under LMSB s normal Rules of Engagement, but recognizes that [i]n some instances, it may be appropriate for taxpayers to discuss general but not case-specific questions regarding an issue with the Issue Owner Executive. Such communications should be fully transparent and with the goal of ensuring that any direction or guidance issued on the issue considers all relevant facts. If a taxpayer has general questions about an issue that are not case-specific, the IOE or IMT may be more willing to engage in discussion. Work With Others Taxpayers and practitioners should recognize that tiered issues tend to be common to many taxpayers across several industries. As a result, other taxpayers and practitioners may be helpful resources in dealing with a tiered issue. Taxpayers and practitioners with the same tiered issue can work together to learn about each other s facts, understand the IRS s approach, form coalitions and work to get the most favorable case before a court. If a particular tiered issue is new and the IMT is still formulating its strategy with respect to that issue, taxpayers with a common issue may benefit from accelerating the cases with the most favorable facts this may help influence pattern IDRs, augment any impetus to give exam teams flexibility on the issue and improve the taxpayers overall legal position. Consider the IRS s Docket Taxpayers and practitioners should consider the IRS s docket on their issues and form their strategy accordingly. They should look at cases that the IRS is litigating, evaluate the facts in those cases, and distinguish their own facts from those cases. Taxpayers and practitioners should also consider the strength of their case in relation to cases that may be further along in audit and/or controversy. For example, a taxpayer with very favorable facts should try to accelerate the pace of their audit. Because the IOE and IMT do not want to make the law with cases that have good facts, a taxpayer may achieve a favorable settlement if it can push its case to the front of the IRS docket.

7 Settlement The exam team is required to present proposed settlements of a tiered and listed issue to the Technical Advisor, Issue Specialist and/or Counsel before agreeing to any resolution with the taxpayer other than the taxpayer s full concession. The IOE also must agree to any settlement of a tiered and listed issue. If an issue is tiered but not listed, whether the settlement must be presented to the IMT may depend on several factors, including: (1) issue maturity (i.e., how well developed is the IRS position, whether other cases have been settled, etc.); (2) whether the settlement is consistent with any published guidance; and (3) whether the issue has been designated or is being considered for litigation. Taxpayers and practitioners should also consider alternatives to litigation. Fast Track may be available to resolve tiered issues. Although the taxpayer, exam team, IMT coordinator and the Fast Track coordinator must agree to use Fast Track, there may be several benefits to choosing to mediate rather than litigate. First, parties in Fast Track agree to seek a resolution within 120 days, which may conserve the taxpayer s resources. Second, the taxpayer may be able to achieve agreement with the relevant IRS decisionmakers and thus have a higher degree ee of certainty in the outcome. Taxpayers, however, should remember that Fast Track is a mediation io process, and thus must be approached with an expectation of compromise. If a taxpayer thinks Fast Track is a viable option, the taxpayer generally should try to get support from the exam team first. If the exam team agrees, it may be willing to contact the other constituencies, including the IMT coordinator and explain why your issue should be resolved in Fast Track. Once a taxpayer proceeds to Fast Track, the taxpayer should be prepared to address the views and concerns of all constituencies involved in the process. For example, the IRS may be more receptive to settlements that can be used in other cases. Case Study As discussed above, taxpayers and practitioners dealing with tiered issues should be familiar with The IRS could improve the program by clarifying the authority and role of examiners; facilitating dialogue between the IOE, IMT and external stakeholders; and generally responding to taxpayer and practitioner concerns. both (1) IRS materials describing procedural aspects of the IIF Program and (2) relevant substantive IRS guidance on tiered issues. This section provides a case study of how taxpayers and practitioners with the Tier I issue of research credit claims can use these materials. Although these materials do not necessarily describe the correct interpretation of the law, 16 they do describe the IRS s current approach and should be evaluated by taxpayers and practitioners as such as an aid in case preparation. The Research Credit Claims Quick Reference Guide summarizes the issue as follows: Formal and informal Research Claims are filed using high-level estimates, invalid assumptions, lack of nexus between qualified research expenses (QREs) and the business component without contemporaneous documentation to support the claim. Major accounting firms and professional boutique firms market research credit studies as a tax product, and in many instances are preparing these claims on a contingency fee basis. Thus, a taxpayer faces limited risk when claims are prepared under a contingency fee agreement. Audit teams expend enormous resources perfecting these claims and generally disallowing a large portion of the claim. 17 This description provides taxpayers and practitioners with insight as to how the IRS views the issue, and how individual ivid agents are likely to approach the issue. Agents are likely to be generally suspicious of research credit claims, especially if they appear to result from prepackaged products. They are likely to focus on whether the taxpayer can provide contemporary documentation and are likely to evaluate the taxpayer s estimates, assumptions and nexus. Taxpayers and practitioners can gain a better understanding of the audit process and lines of authority with respect to a particular tiered issue by reviewing internal (but public) IRS memoranda regarding that issue. For example, Industry Director Directive #2 on the research credit claims issue describes certain IRS procedures in examining a research credit claim. 18 According to the directive, a research credit claim not CORPORATE BUSINESS TAXATION MONTHLY 27

8 Handling Tiered Issues currently under examination is not subject to mandatory examination, but exam teams will perform a risk assessment to determine whether the claim should be examined, considering adjustment potential, future year impact, resources, and the abusiveness of the research credit claim. 19 If research credit claims are currently under examination, exam teams must issue the mandatory IDR unless the examination has not progressed beyond the mid-point of the examination, in which case the IMT recommends that the IDR be issued if substantial examination activity has not been performed on the claim. 20 The IRS has published a Research Credit Claims Audit Technique Guide (RCCATG), 21 which may assist taxpayers in understanding what examiners will focus on in an audit. For example, the RCCATG frequently states that examiners should be wary of estimates provided by the taxpayer. As a result, taxpayers and practitioners should begin organizing all relevant documentation to ensure they are able to respond promptly to documentation requests. The RCCATG also indicates that examiners will focus on the nexus between expenditures and qualified research activities, especially the accounting method or approach used by the taxpayer to demonstrate this nexus. A taxpayer should be prepared to respond to questions on nexus. As the Quick Reference Guide and Industry Director Directive #2 describe, a taxpayer under examination for a research credit claim generally will be issued a mandatory IDR. Because these IDRs are likely to be the first request est made of the taxpayer at the beginning of an examination, ation, a taxpayer can begin formulating responses in advance of an examination ion or even when a return with a research credit claim is filed. The initial IDRs are important because they may set the focus of the examination. The RCCATG instructs examiners that the responses to the mandatory IDR will identify the issues that you will need to focus on and will assist you in developing an audit plan. For example, the first question in the mandatory IDR concerns whether the taxpayer retained a third party to assist it in preparing the claim and, if so, whether the taxpayer paid a fee contingent on the amount of the research credit ultimately allowed under the claim. Examiners are likely to be skeptical of the taxpayer s claim if the answer to both of these question components is yes. Other questions highlight areas that examiners will focus on, including contemporaneous documentation, whether the taxpayer made a Code Sec. 280C(c)(3) election, whether the taxpayer aggregates its research expenditures with other members of a controlled group, and the methods used to calculate the claim. By knowing these areas of focus in advance, taxpayers and practitioners can plan to address these issues. A taxpayer should not rely on an examiner to substantiate its claims. In fact, the Quick Reference Guide states that a goal in auditing research credit claims is not to expend audit resources reconstructing taxpayer claims, but to audit only claims that can be properly substantiated. This IDR will enable the determination. If the claim is not adequately supported, a Notice of Claim Disallowance may be warranted. Taxpayers and practitioners should be ready to present documentation and substantiate its claim at the beginning of an audit to avoid quick disallowance. Conclusion Taxpayers and practitioners may be justified in their criticisms of the Industry Issue Focus Program. The IRS could improve the program by clarifying the authority and role of examiners; facilitating dialogue between the IOE, IMT and external stakeholders; and generally responding to taxpayer and practitioner concerns. Taxpayers and practitioners, however, also can assist in improving the functioning n of the IIF Program by understanding the process. Furthermore, taxpayers and practitioners should recognize that they can improve the likelihood of successfully resolving a tiered issue by taking a proactive approach to planning and controversy. 1 Although the program was introduced as the Industry Issue Focus Program, the IRS currently refers to the program as Issuing Tiering. See, e.g., IRS, Issuing Tiering LMSB, available at corporations/article/0,,id=200567,00.html. 2 Use of a name that includes abuse does suggest that the issue has been pre-judged. 28 ENDNOTES 3 For more information on Fixed, Determinable, Annual, Periodical (FDAP) income, see article/0,,id=96404,00.html. 4 The IRS currently states that LMSB will not demote issues from higherpriority to lower-priority tiers. IRS, Issue Tiering Fact Sheet LMSB, available at article/0,,id=200574,00.html. This appears to be a recent change in policy, as the IRS previously had demoted Backdated Stock Options from Tier I to Tier II in April Backdated Stock Options is now listed as a Tier I issue in the monitoring stage. 5 Id.

9 6 Id. 7 Other types of Code Sec. 118 Abuse (not involving universal service fund, bioenergy payments, and environmental remediation) are not yet in the monitoring phase. 8 IRS, Issue Tiering Process Frequently Asked Questions, available at www. irs.gov/businesses/corporations/ article/0,,id=204371,00.html. 9 A helpful starting point for information on the IIF Program is the main Issue Tiering page at the IRS website. IRS, Issuing Tiering LMSB, available at corporations/article/0,,id=200567,00.html. 10 IRS, Internal Revenue Manual Industry Focus and Control of LMSB Compliance Issues, available at part4/ch43s05.html. 11 IRS, Internal Revenue Manual Rules of Engagement, available at irm/part4/ch43s01.html. 12 IRS, Internal Revenue Manual Issue Management Process Guide, available at 13 See, e.g., IRS, LMSB Tier I Issue Research Credit Claims, available at article/0,,id=200599,00.html. Links to guidance for each tiered issue may be found on the main Issue Tiering page. IRS, Issuing Tiering LMSB, available at article/0,,id=200567,00.html. 14 See, e.g., IRS, Tier I Research Credit Claims, available at irs-utl/quickrefre.pdf. 15 Although, as further described in the text, a taxpayer generally will not benefit from arguing the law with an agent, a taxpayer should be prepared in advance with its legal arguments so that the taxpayer may present (a) facts in support of its legal position to the agent, and (b) its legal position to the IMT when appropriate. 16 See David L. Click, Zeal and Activity in the Arena of the Research Tax Credit, 121 TAX NOTES 1305 (Dec. 15, 2008), 2008 TNT (Dec. 16, 2008). Mr. Click argues that the IRS uses the IIF program to undermine taxpayer s ability to claim the Code Sec. 41 research credit by adopting an overall skeptical attitude to the research credit in its IIF materials, creating a higher standard of documentation through its IIF audit guidelines, and using IIF audit guidelines to avoid Administrative Procedures Act requirements, including the notice and comment period associated with the promulgation of regulations. 17 See, e.g., IRS, Tier I Research Credit Claims, available at quickrefre.pdf. 18 IRS, Industry Director Directive #2 on Research Credit Claims (Jan. 15, 2009), available at 19 Id. 20 Id. 21 IRS, Research Credit Claims Audit Techniques Guide, available at gov/businesses/article/0,,id=183208,00. html. This article is reprinted with the publisher s permission from the CORPORATE BUSINESS TAXA- TION MONTHLY, a monthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to CORPORATE BUSINESS TAXATION MONTHLY or other CCH Journals please call or visit www. CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH. CORPORATE BUSINESS TAXATION MONTHLY 29