SURVIVING AN IRS AUDIT Daniel J. Kusaila Partner Saslow Lufkin & Buggy, LLP 10 Tower Lane Avon, CT 06001 860/678.9200, ext. 2122 Fax 860/470.2197 dkusaila@slbcpa.com Charles J. ( Chaz ) Lavelle Partner and Chair, Federal Tax Team Bingham Greenebaum Doll, LLP 101 S. Fifth Street, Suite 3500 Louisville, KY 40202 502/587.3557 Fax 502/540.2155 clavelle@bgdlegal.com Tricia D. Villarreal Director, Global Risk Finance & Insurance Starwood Hotels & Resorts Worldwide, Inc. 15147 N. Scottsdale Road, Suite H-120 Scottsdale, AZ 85254 480/905.4718 Mobile 602/481.5588 patricia.villarreal@starw oodhotels.com
Discussion Topics IRS Organization Practice and Conduct before the IRS Life-Cycle of an IRS Audit Audit Selection Process Preparing for the Audit Conduct of an Audit Live Audit Example Handling Unagreed Issues Appeals and Litigation The Cost of Being Wrong 2
Life-Cycle Of An IRS Audit Selection for Audit Audit vs. Inspection Types of IRS Audits Conducting the Audit Information Document Requests (IDRs) Proposed Adjustments Disputes (Unagreed Issues) Litigation 3
Audit Selection Process: Who Gets Selected? Current IRS Captive Audit Projects : Projects: Sec. 501(c)(15) Tax Exempt Insurance Companies Foreign Insurance/Reinsurance Excise Taxes Other Hot Topics : Types of Risk Written Computer Selection and Matching DIF Scores (Discriminant Function System) Referrals/Informants Prior Audit History 4
Who Gets Selected? (cont d.) Collateral (Derivative) Audits: Parent Company (most common for Captives); Owners, Partners, Members; Officers/Directors; Affiliated Companies; Parties to the Same Transaction. 5
The Field Audit Process Initial Contact: The Heart Stopper First Meeting with the IRS: Initial Interview IRS Checklist Laying the Ground Rules: Scope of Audit Timing Mechanics 6
Representation Before The IRS Internal Personnel (CFO, Controller, etc.) Outside CPA Legal Representation Power of Attorney (Scope & Restrictions) 7
Professionalism Establishing Rapport with IRS Agent Understanding the Agent s Experience Understanding the Agent s Authority Being Respectful and Courteous Provide Good Working Conditions for Agent 8
How Far Back Can The IRS Audit? 3 Years General Statute of Limitations 6 Years If 25% Income Omission/Negligence Forever No Return Filed (or False/Fraudulent Return Filed) Extending the Statute of Limitations Extending All Issues vs. Selected Issues 9
Preparing For An IRS Audit The Best Defense is a Good Offense Anticipate the IRS Audit Lay a Good Foundation 10
Establishing A Good Foundation Engaging an Excellent Captive Manager Feasibility Study: Establishing Valid Non-Tax Business Purposes; Proper Structuring of the Captive; Providing Adequate Capital; and Consider a Tax Opinion or Private Letter Ruling. 11
Documenting The Birth Of The Captive Why Was the Captive Set Up? Why the Coverages? How Are Premiums Set? How/Why Was Domicile Selected? Initial Application and Business Plan Actuarial Studies Financial Projections Corporate Governance Documents 12
On-Going Captive Operations Updating the Business Plan Reviewing Structure, Organization, Pricing, Agreements, Capitalization, etc. Observing Corporate Formalities Best Practices Document Everything! 13
Conduct Of The Audit Location of the Audit Taxpayer s location CPA s offices Other Information Document Request (IDR) Written questions and responses Oral explanations? Interviews? 14
Westel Insurance Company - Background Wholly owned subsidiary of Starwood Hotels & Resorts Worldwide, Inc. Commenced operations on November 25, 1985 Pure captive Domiciled in Vermont Insures Starwood s owned and managed hotel: U.S. Workers compensation; U.S. General and Auto Liability; Employment Practices Liability; and Global Property 15
IRS Audit Process Purpose is to test whether or not Westel is an insurance company 1120-PC period under exam is 2007, 2008, and 2009 Two IRS Form 4564 Information Document Request (IDRs) were issued: November 4, 2011 February 29, 2012 Information due 30 days after issuance date 16
Sample Form 4564 17
November 4, 2011 IDR 1. Financial statements and filings with regulators 2. Insurance and reinsurance policies 3. Agreements relating to letters of credit or guarantees 4. Quarterly, semiannual or annual ceding statements 5. Computations of premiums charged for coverage 6. Tax legal opinions? If none, state the applicability of any tax safe harbor guidance 7. Names of any affiliated companies not part of the consolidated return 8. Statements of Actuarial Opinion, including supporting reports and work papers (reserve projections, etc) 9. Loan documents between Westel and any related entity 10. Explain 2007 Schedule M-2 (reason for increase) 18
IDR Response Process Collaborative effort between Starwood Risk Management, Tax, Accounting, and Captive Managers Documents were inventoried via spreadsheet Hard copies indexed and bound in 3 ring binders were submitted to agent 19
IDR Tracking Item # Documents Provided 2007 2008 2009 1 Audited Financial Statements X X X Vermont Captive Insurance Company Annual Report X X X 2 Insurance policies for coverage provided by Westel: General Liabilty X X X Workers' Compensation X X X Auto Physical Damage X X X Employment Practices Liability X X X Certificate of Facultative Reinsurance X X n/a 3 Parental Guarantee n/a X X Letters of Credit deductible agreement original LC issued reinsurance agreement original LC issued 4 Property Net Line Reinsurance Agreements X X X Annual Property Insurance premium ceeding statements X X X 5 Premiums Written Spreadsheet - ties to Financial Statements X X X Final Allocation Cost Summary - Split between Westel & Corporate X X X Hotel Insurance Allocations - Detail by Hotel X X X Premium Adjusments - Adds/Deletes X X X 6 None - need to state applicability of any tax safe harbor guidance being relied upon 7 Spreadsheet included that shows names of hotels owned by affiliated companies not part of the consolidated return for X X X which Westel provides general liabilty, workers' compensation, property, auto physical damage and EPL coverage 8 Statement of Actuarial Opinion X X X An Actuarial Analysis of the Loss and Loss Adjustment Expense Reserves X X X Potential Changes in Reserve Estimates after.... X X n/a Employment Practices Liability Reserves X X X Loss Reserve and Retention Level Analysis (GL/AL and WC) X X X Starwood/Westel Q4 Insurance Adjustments X X X Westel Reserve Analysis Year-End Rollforward X X X 9 Demand Promissory Note X X X 10 Tax will handle 20
February 29, 2012 IDR Conversations between agent and Starwood: Explain how premiums are accounted for with each type of entity o Is cash actually submitted? o Requested flow chart where premiums come from, how they flow through to the insurance company and how they are being reinsured Explain the billing and accounting for premiums for managed and affiliated hotels Data provided by Westel appears to be summarized in SAP and monthly entries are made on Westel s books. Explain Westel s accounting system Explain how retrospective premiums are reported for both statutory and tax accounting purposes Explain services provided by captive manager Explain how claims are processed and approved for payment 21
Other Sample IDR Please provide the information that is listed below regarding the captive insurance company s requirements: Please explain how your captive arrangement shifts risk; For the 2010-12 year, please provide a schedule of the lines of coverage written by captive, the coverage limits and whether the coverage is written to related parties (other member of consolidated group, affiliate, shareholder and/or their families) and/or general public; Please provide a schedule of all the premiums written (by line of coverage) for the 2010-12 tax year, listing the insured and the amount of premiums paid by each insured by line of coverage. In identifying each insured, explain if the insured is a related party (other member of consolidated group, affiliates, shareholder and/or their families) or the general public. If the insureds are third parties, please list the total written and identify the party insured as Third Parties ; 22
Other Sample IDR (cont d.) Please explain how your captive arrangement distributes risk; Please provide copies of all correspondence, power points, emails, handouts, etc., between individuals acting for the consolidated group and third parties relating to the creation and operation of this entity; Please provide a schedule reflecting the numbers and amounts of the captive s claims payments in each year since inception. Identify which, if any, claims payments were to unrelated entities or individuals. For claims payments to related entities of individuals, state whether any other insurer and reinsurer contributed to paying the insured s claims; Specify all amounts of funds the captive used to purchase the life insurance or real estate or to make loans to related entities of individuals. 23
Agreed Issues In an audit, one or more issues may be settled, even if other issues are not Form 870 is used to agree to the settled issues While in practice this ends the audit of agreed issues, technically the Taxpayer can file a claim for refund and the IRS can reopen (if it gets internal permission for the second audit) If all issues are settled, a no change letter is issued 24
Unagreed Issues Notice of Proposed Adjustment (NOPA) Response to NOPA Factual vs. Legal Differences Hazards of Litigation Agent can t use Technical Advice Request Advance Issue Resolution early referral of issue(s) to the IRS Appeals Office 25
Ending The IRS Audit Settlement and Negotiations Meetings with Examiner (and Supervisor) Agreed Upon Issues (Form 870) Unagreed Issues Fast Track mediation with IRS auditor, mediated by an Appeals Officer Appeal for Appeals Office consideration 26
Appealing Unagreed Issues IRS 30-Day Letter Protest - the response to the 30 Day Letter IRS Rebuttal the response to the Protest Ex Parte meeting Appeals and Examiner Meeting(s) with Appeals Officer(s) Control of the Statute of Limitations 27
Appeals Conference Appeals Office s mission is to settle cases Very informal 1 to 3 Appeals Officers No court reporters or other third parties Appeals Officer can consider Hazards of Litigation First conference and subsequent meetings Settlement time to settle 870-AD normally neither side is to reopen Closing Agreement Post Appeals Mediation 28
Going To Court 90-day Letter Statutory Notice of Deficiency Legal Representation Attorney-Client Privilege Attorney Work Product Cost of Litigation 29
Going To Court: Litigation Options TAX COURT DISTRICT COURT COURT OF FED. CLAIMS PAY FIRST NO YES YES JUDGE/JURY JUDGE OPTION * *Judge or Jury JUDGE PLACE OF TRIAL LOCAL** LOCAL LOCAL** **Judge Travels from DC **Judge Travels from DC % OF TAX CASES 100% 2% 50% GOVT. LAWYER IRS DOJ DOJ 30
The Cost Of Being Wrong Is it Insurance for Tax Purposes? Disallowance of Premium Deduction to Payor No Premium Income/Reserve Deduction for Captive? If it is Not a Premium, What is it? Capital Loan Deposit Indemnity Payment Other Income? Could it be something else? 31
The Cost Of Being Wrong (cont d.) Interest Third Quarter 2013 Overpayment Underpayment Deduct Individual 3% 3% No Corporate 2% 3% Yes Large Corporate.5%* 5%** Yes *Overpayment above $10,000 **Underpayment of $100,000 beginning 30 days after 30- day or 90-day letter 32
The Cost Of Being Wrong (cont d.) Penalties: 20% - Negligence/Substantial Understatement 40% - No Economic Substance (20% if disclose) - Undisclosed Foreign Financial Asset 75% - Fraud Reasonable Cause Act in Good Faith Relief - Not available for Economic Substance Penalties 33
The Cost Of Being Wrong (cont d.) Should you Pay or Deposit the Unagreed Assessment? Interest on Deficiency Uncertain Tax Position (UTP) Disclosures Audited Financial Statement Implications 34