IRS practices & procedures: A problem solving approach
Today s Presenters Panelist Bob Adams Partner IRS Practice and Procedure Washington National Tax bob.adams@mcgladrey.com Co Moderator Dean Fischbeck Senior Vice President Bank of America Federal Tax Audit and Controversy Executive dean.fischbeck@bankofamerica.com Panelist Patti Burquest Partner Tax Controversy Services Washington National Tax patti.burquest@mcgladrey.com Co Moderator Susanne Muller Director, Senior Tax Counsel Citigroup mullers@citi.com
Agenda Preparing for and managing an IRS examination New IRS process for IDRs Enforcement of delinquent IDR responses. Non performing loan issues and developments OREO property issues and developments Successfully resolving IRS examination issues Fast Track IRS Appeals Other ADR techniques Managing common IRS problems TIN mismatch issues and penalties for 1099s and 1098s Record retention IRS liens and levies against bank accounts
Case Study
Suburban Bank Suburban Bank is a community bank operating within a large metropolitan area. The bank began with only two branches in an area where the population is growing rapidly. It has expanded its presence in the area through mergers with other community banks and by opening up new branches. Suburban issues credit cards, mortgages, commercial and auto loans. It has a large deposit base of checking and savings accounts. Due to the economic downturn in the area, Suburban now holds an inventory of foreclosed properties and non performing loans. It also receives notices of garnishment on some of its account holders.
IRS examination issues
Problem: IRS opens examination Facts: Suburban receives a phone call from a local IRS agent who sets up an appointment to meet with the Tax Director of the bank. Is this the start of an IRS examination? Will the bank receive a written notice of examination? What happens before the meeting? What should the bank be prepared for?
New IDR process Information Document Requests (IDRs) are used by the IRS to develop information for the examination of issues. Old procedures significant IDRs with a due date (which may or may not have been agreed to). Often the due date for the response slips. The IRS may send reminders. In certain situations, it may issue a summons after repeated requests for the information informally. New procedures new agreement process backed by automatic enforcement process.
New IDR process Effective for all IDRs issued after June 30, 2013, including those related to currently open audits. Actions that must be performed in issuing IDRs Identify and state the issue that has led the examiner to request the information included in the ldr Discuss the ldr with the taxpayer in advance of issuing it Both parties must discuss and determine a reasonable timeframe for response This date cannot be reset Existing MOUs related to IDRs that do not comply are terminated All LB&I examiners and specialists should have completed training on this by now http://www.irs.gov/businesses/lbi Directive on Information Document Requests
New IDR enforcement process Effective for all IDRs issued on or after October 1, 2013, including those related to currently open audits. Enforcement of terms of IDRs has three steps Delinquency Notice Pre Summons Letter Summons IRS management personnel involved at each stage IDR enforcement process includes IRS Counsel support All LB&I examiners and specialists should have completed training on this by now LB&I directive when issued
New IDR enforcement process Delinquency Notice Delinquency Notice IRS Letter 5077 IDR expires, is incomplete or unresponsive, IDR is delinquent and enforcement process begins immediately Partial responses are delinquent regardless of the percent complete Case Manager, Team Coordinator (meaning the lead controlling agent for any case), any Specialist and Specialist Manager must discuss the unresponsiveness with taxpayer on the day after deadline, but within 10 days Delinquency notice must be given to taxpayer within 10 days of the originally agreed IDR deadline, no exceptions Signed by Team Manager for IRS Delinquency notice allows the taxpayer up to an additional 15 calendar days to respond to the IDR or the process moves on to the next step If IRS team or taxpayer wishes to extend this time it can only be done with Territory Manager approval and only in the most extreme or unusual circumstances IRS team discusses next steps with taxpayer: Pre Summons Letter then Summons Counsel involvement starts now
New IDR enforcement process Pre Summons Letter Pre Summons Letter IRS Letter 5078 Consequence of not responding to the Delinquency Notice is issuance of a Pre Summons Letter Prepared by audit team and Counsel Signed and issued by Territory Manager Discussed with and delivered to next level of taxpayer s management Makes taxpayer management aware IDR has not been answered Final notice to respond to the IDR before Summons is issued Taxpayer has 10 calendar days to respond No taxpayer response, audit team and counsel prepare and issue Summons Territory Manager must notify Director of Field Operations (DFO) that Summons will be issued and may need enforcement
New IDR enforcement process Summons Summons If taxpayer fails to respond to the IDR after the issuance of the Pre Summons Letter the audit team prepares and issues a Summons with counsel's involvement Counsel is adviser, does not steer or commandeer an audit IDRs are allowed to be more extensive than Summons Summons must meet Powell tests so are narrower than IDRs Counsel will work with audit team all along the way to be best prepared in case a Summons is needed These IDR enforcement procedures are designed to assure that IRS will follow though with the Summons process if necessary to complete examinations
Managing problem IDRs under the new process The fishing expedition IDR where it is clear that the IRS is not developing a particular issue, but looking for new issues that it can develop. The overbroad IDR asking for any and all documents relating to a particular issue. The unclear IDR where the response could take several paths, at least one of which would produce an examination adjustment. The late in the game IDR which is provided close to the last IDR date in the audit plan.
Problem: non performing loans Facts: Suburban has non performing loans on which it has stopped accruing income.
Tax treatment of nonperforming loans Issues to address: Accrual of interest Tax treatment of charged off receivable Collection on the receivable after non accrual or charge off
Problem: non performing loans Treas. Reg. 1.166 2(d)(1) (cont.) Conclusively presume debt is worthless/partially worthless for tax purposes if able to show debt was charged off in whole or part Either pursuant to specific orders or established policies of banking regulators Requires written confirmation as proof
Problem: non performing loans Treas. Reg. 1.166 2(d)(1) (cont.) Issues with proof Banks generally receive examination report at end of regulatory exam Includes list of ordered and agreed charge offs Confidential document IRS exam agents not permitted user IRS exam agents typically require separate confirmation letter documenting ordered charge offs unless regulator provides written permission for IRS exam agent to review pages from the report that show the charge offs were ordered by the regulatory examiner
Accrual of interest for tax purposes Have all events occurred to fix the right to the income? Can the amount of income be estimated with reasonable accuracy? Is there doubt as to collectibility? (Collectibility exception.) General rule for term loans: right to receive becomes fixed as it is earned under the loan. See Rev. Rul. 72 100; Rev. Rul. 74 607; Reg. 1.446 2(b).
IRS guidance on non performing loans Revenue Ruling 80 361 Facts: Taxpayer uses the accrual method of accounting and makes a loan to A in Year1. Initially, interest and principal are collectible. Late in Year 2, A suffers sudden and severe financial reverses, becomes insolvent, and defaults on the loan. The security is sufficient to satisfy only the principal amount of the loan. Holding: Taxpayer must accrue interest up to the time of A s insolvency. Interest related to the time after A s insolvency does not properly accrue, since the interest is uncollectible and no accrual of interest for tax purposes. To the extent that the accrued interest subsequently becomes uncollectible due to A s insolvency, then Taxpayer may deduct the accrued interest as a bad debt.
IRS guidance on non performing loans (cont.) Rev. Rul. 2007 32 Facts: Bank expects the borrower to make some, but not all, of the payments due under the loan. Bank stops accruing interest on the loan pursuant to federal banking rules. Bank has not written the loan off for regulatory purposes. Holdings: Bank must continue to accrue interest for tax purposes (despite federal banking rules forbidding the accrual). Late payment of interest is not sufficient by itself to demonstrate that bank has no reasonable expectation of payment on the accrued interest. Doubtful collectibility exception does not apply. Bank may claim a bad debt deduction for accrued amounts which subsequently become uncollectible (no reasonable expectation of payment.)
Doubtful collectibility exception Lender does not need to accrue interest if there is no reasonable expectation of payment A taxpayer, even though keeping his books on an accrual basis, should not be required to pay a tax on accrual income unless it is good and collectible, and, when it is of doubtful collectibility or it is reasonable certain it will not be collected, it would be an injustice to the taxpayer to insist upon taxation. Corn Exchange Bank v. United States, 37 F.2d 34 (2 nd Cir., 1930)
Collections Reg. 1.446 2(e) provides that payments on a loan are interest to the extent interest is accrued on the loan as of the date the payment is due. Restates existing law. Story v. Livingston, 38 U.S. 359 (1839) The correct rule as to interest is that the creditor shall calculate interest whenever a payment is made. To this extent the payment first to be applied, as if it exceeds the interest due, the balance is to be applied to diminish the principal.
Collections If borrower is insolvent, and the bank has foreclosed on the collateral (and bank will never get back the full amounts his principal), later collections are allocated to principal and not to accrued but unpaid interest, even in the case where lender and borrower agreed to an allocation of the payment between interest and principal. Newhouse v. Comm r, 59 T.C. 783 (1973); John Hancock Mutual Life Ins. Co., 10 B.T.A. 736 (1928).
Rev. Rul. 2007 32 Collections: Rev. Rul. 2007 32 Facts: Facts remain the same, but bank receives a payment on one of the loans the interest of which it wrote off as uncollectible. Holding: Even though for regulatory purposes, Bank applies the payment to principal, under Reg. 1.446 2(e), bank must characterize any payment (other than late charges) as a payment of interest for federal income tax purposes to the extent there is uncollected accrued interest outstanding. However, if Bank receives a payment that is less than the accumulated accrued unpaid interest legally due under the loan contract, for regulatory purposes, apply payment to principal rather than interest.
Collections: Rev. Rul. 2007 32 (cont.) Rev. Rul. 2007 32 Facts remain the same, but bank uses a conformity method of accounting as provided in Reg. 1.166 2(d), but does not accrue interest income for bank regulatory financial statements. (Important fact bank reasonably expects to receive some but not all of the payments, but has not so received them.) Holding: Bank must accrue interest for tax purposes but can charge off accrued interest as if it had been written off for regulatory purposes.
Recap IRS examination of nonperforming loans Primary question (factual) Is it collectible? IRS requires loan by loan review. Non performing loans directive #1 (2010) Rev. Rul. 2007 32 MSSP training guide Coordinated Issue Paper Other ideas?
Problem: Costs associated with OREO property Facts: during the past several years, Suburban has acquired approximately 30 properties through foreclosure. Suburban holds the property for future sale. It does not attempt to rent the properties. How should Suburban treat expenses associated with the OREO property?
Problem: capitalization of costs for on OREO property IRS Historic Position: OREO property is property described in 1221(a)(1) Property held primarily for sale to customers in the ordinary course of business or acquired for resale Treatment of expenses related to foreclosure property Section 263A applies to real or personal property described in 1221(a)(1) acquired for resale Query whether property is acquired for resale Rev. Rul. 74 159 holds that foreclosure property is property held for resale as described in 1221(a)(1) If 263A applies, the direct costs and allocable share of indirect costs of such property are capitalized Query whether the property fits into Reg. 1.263 A 1(b)(13)
Problem: capitalization of costs on OREO properties On audit, many IRS exam teams have been requiring banks to capitalize the direct and indirect costs of carrying foreclosure property For example: property taxes, general maintenance, utility expenses, etc. In response, many banks have either acquiesced to the issue on audit (on a method change or non method change basis), or voluntarily changed their method to capitalization
Problem: Capitalization of costs on OREO property FAA 20123201F (June 18, 2012) Field Attorney Advice issued by LB&I concluded that 263A requires capitalization of direct costs and an allocable share of indirect costs associated with a bank s foreclosure property (OREO) However, the FAA notes that properties held for the production of rental or investment income are not subject to 263A
Problem: capitalization of costs on OREO property GLAM2013 001 (Released March 1, 2013) Discusses the application of 263A to property acquired by a bank through foreclosure proceedings or by a deed in lieu of foreclosure. States that that the bank is not a traditional reseller of property The bank acquires the OREO in its capacity as a lender and not as a traditional reseller of property The bank is economically compelled to acquire the property to recover the funds that it originally loaned
Problem: capitalized costs associated with OREO property GLAM2013 001 (cont.) The GLAM reasons: When a bank originates loans, those loans are not treated as the acquisition of property for resale for purposes of 263A Acquisition of the property securing the loan should not convert the bank into a reseller Section 263A does not require capitalization of the direct or indirect costs to carry foreclosure property where the bank originated the loan upon which it foreclosed Facts of the GLAM are limited to situations where the bank originated the loan upon which it foreclosed The GLAM does not contain an effective date; however, the FAQs posted on the IRS website instructs agents who have issued Forms 5701 (notice of proposed adjustments) which proposes to capitalize OREO expenses should reconsider the position and revise or withdraw the Form 5701 to be consistent with the FAQs.
Problem: capitalization of costs associated with OREO property What does this mean for banks? Banks that currently deduct direct and indirect costs Banks currently under exam with a method of capitalizing the costs associated with OREO Banks not under exam with a method of capitalizing the costs associated with OREO
Problem: options for resolving IRS examination issues
Pre 30 day letter: Pre filing Agreement (PFA) Fast Track settlement Delegation orders Resolution Strategies Post 30 day letter IRS Appeals Litigation
Problem: taxpayer identification number (TIN) issues
Problem: Taxpayer identification number (TIN) issues Facts: Suburban s depositors and mortgage customers are provided with a Form W 9 when they open an account. In February, Suburban issues 1099s and 1098s to each depositor or mortgage customer and files a copy with the IRS. The IRS recently sent Suburban a Notice 972CG, informing it that more than 1000 1099s and 1098s contained incorrect or missing TINs. A penalty of $100,000 is proposed.
Discussion: supporting reasonable cause to obtain waiver of proposed penalty Suburban must establish that it acted in a responsible manner before and after the TIN reporting failure occurred. Initial solicitation letters to customers? Ensuring W 9s are complete and appear correct? History of compliance without TIN failures? Actions taken to ensure proper TINs? Annual solicitations to avoid penalties in future years? For missing TIN/name combination a second solicitation letter may be required Respond within 45 days of the date of the notice. What about electronic filing of 1099s/1098s?
Discussion: back up withholding Suburban receives Notice CP 2100 Send B notices to customers on list at the last known address in your records. Inform account holder that IRS has notified bank of incorrect TIN. Attach a copy of filled in W 9 (or substitute) Request return of corrected W 9 Provide return envelope Inform customer that you must begin back up withholding if you do not receive completed W 9 back from them Keep copy of this letter in your files If no response begin back up withholding
Discussion: alternative ways to obtain information (1099s) Annual solicitations by telephone Call each payee with a missing or incorrect name/tin combination Prepare telephone script for the callers and retain the script in your records showing each call made Call script should request to speak with an adult in the household or an officer of the business enterprise; should request customer s TIN and other information that is missing from the W 9 (or other form) or is incorrect; inform payee of $100 penalty if TIN is not provided Complete solicitations by December 31 (first solicitation) or January 31 for accounts opened the preceding December Electronic solicitations Email or fax Requirements in Publication 1586 to ensure security and accuracy
What if penalties are not abated? If you receive a CP 15 or CP 215 fully or partially denying the request for a waiver of penalties, this can be appealed to IRS Appeals.
Problem: record retention issues
Problem: record retention issues Facts: Suburban has been growing by opening new branches and by acquiring smaller community banks in its geographic area. Suburban s systems and products replace those of the target bank s within 24 hours of the acquisition. Can Suburban turn off the target bank s systems? How should it prepare for a potential audit? More warehouse space? Digitized records? IRS guidance
General IRS guidance on record retention, IRC section 6001 General tax guidelines for record retention Sound record retention policy, cornerstone for successful management of IRS exams Maintain records the proper amount of time and in the right format IRC section 6001, records must be available at all times for inspection by the IRS Burden of proof is on taxpayer to determine length of time to keep records Issue becomes more complex with a corporate merger, where conflicting record systems, obsolete technologies raise new questions on how to interpret the law
General IRS guidance on record retention, IRC section 6001 Section 6001, records must be maintained so long as they may be material in administration of tax law General rule, keep any record that supports an item of income or deduction until the statute of limitations expires (generally three years from the date the return is filed) But may be necessary to keep longer Keep records of basis in assets (e.g., buildings, land, fixtures) almost indefinitely, substantiate capital gain or loss on the asset s final disposition Net operating losses and other carryback items can often extend the time frame that records are kept for the carryback years Employee wage and salary information provided to the Social Security Administration, other federal agencies and to state tax administrations must also be kept for many years
General IRS guidance on record retention, Revenue Procedures IRS has issued detailed guidance through revenue procedures relating to machine sensible records, electronic storage of imaged documents, and microfiche records Rev. Proc. 98 25, 1998 1 C.B. 689 Rev. Proc. 97 22, 1997 1 C.B. 652 Rev. Proc. 81 46, 1981 2 C.B. 621
Machine sensible records Rev. Proc. 98 25, 1998 1 C.B. 689 Machine sensible records and EDI transactions are records for 6001 and must be maintained in a format capable of being processed (i.e., accessed, retrieved and printed) during an examination. Flat (sequential) files may meet this requirement. Must include transactional detail supporting a clear audit trail between the source document and the electronic record. (Source documents also must be maintained.) If requirements are met, can discontinue old computer systems.
External storage media and scanned images Rev. Proc. 97 22, 1997 1 C.B. 652 Guidelines for taxpayers whose hard copy original records are scanned into an electronic storage system, or whose electronic records are transferred to an external storage medium, such as laser or optical disks Scanned or transferred image must reliably transfer, store, preserve and reproduce the original record, and must have a high degree of legibility when reproduced Legibility and readability is required for both paper reproductions and for records displayed on a video display terminal The electronic storage system must have an indexing system that allows Retrieval of the records and Ability to reproduce the record in hard copy form upon the request of the IRS A procedural manual which explains the use of the electronic storage system must be made available to the IRS during an audit, as well as resources needed to access the documents (e.g., software, trained personnel)
Microfilm records Rev. Proc. 81 46, 1981 2 C.B. 621 Microfilm records, which include microfiche, magnetic tape and other micrographic systems, not commonly used for today s storage needs, but many older generation records still reside on the medium In compliance with Section 6001 if they are exact duplicates of the original ledgers or books (e.g., journal, cash books, voucher registers), and are readable and legible Taxpayer to develop a set of operating procedures for the microfilm records, including indices that can be used by the IRS to immediately retrieve documents A workable microfilm reader and printer must be available for the use of the IRS
Put recordkeeping in perspective Records retention is essential for compliance with the tax law Records management can be expensive (in terms of warehouse space, systems maintenance and operational personnel) Taxpayers should not feel compelled to retain records longer than is reasonable and necessary to comply with the law A prudent corporate policy is to regularly review recordkeeping budgets and practices against IRS guidelines A corporate records destruction policy should be created and maintained, according to schedules in the policy Overall, records management may have complex tax, accounting and budgetary implications
Other considerations Tax return bridge workpapers DFO memo, February 23, 2012 Requires CAS obtain electronic version of bridge workpapers Taxpayer records for which IRS auditors cannot generally compel production Privileged documents IRS Announcement 2010 76: http://www.irs.gov/pub/irs drop/a 10 76.pdf http://www.aicpa.org/publications/taxadviser/2013/april/pages/clinicstory 08.aspx IRM 4.10.20.3 Auditors workpapers Tax accrual workpapers Tax reconciliation workpapers
Problem: bank liens and levies
Problem: managing liens and levies on customer accounts Facts: Suburban has recently received IRS notices of federal tax lien on several customer s accounts. Can the IRS levy on the customer s account? How should Suburban handle this process?
Lien vs. levy Lien: a claim by the IRS used as security for a tax debt of the account holder. Levy: a legal seizure of property to satisfy a tax debt.
Steps in the levy process Bank customer with unpaid tax debt will receive: Notice and Demand for Payment is first mailed to a taxpayer who has neglected or refused to pay tax, generally on the date the IRS assesses the tax Notice of Federal Tax Lien is filed in public record where the customer has property. The notice can be provided to the bank. Final Notice of Intent to Levy and Notice of Your Right to a Hearing (this is a levy notice) is sent to the taxpayer at least 30 days before the levy. This notice can be sent to the customer via certified or registered mail or delivered to the customer in person. CDP Hearing: the customer can request a hearing where it can present evidence that the lien was filed in error or that the presence of a lien and potential levy could cause economic hardship. (IRS Appeals officer handles the CDP hearing where the issue is settled or the Lien upheld.) Levy served on bank
Bank levies Which accounts can be levied? The levy attaches to funds in a bank account for which the customer/debtor has an unrestricted right to withdrawn funds (signature authority) even if multiple persons have signature authority for that bank account. Reg. 301.6332 1(c)(4). Bank must wait 21 days after levy is served before sending payment. But, on next business day, it must make the payment using the customer s funds. During the 21 day period the levy may be released or reduced If no release during 21 days, bank must make payment without additional notice. Levy can only reach the amount on deposit when the levy is served Additional levies required to reach subsequent deposits Customer/debtor may request that the bank extend the 21 day hold period to determine ownership of the account. IRS may provide notice to the other account signatories/owners so that they can challenge the potentially wrongful levy.
Bank levy examples Facts: bank levy for $10,000 A. Customer/debtor has $5,000 in the bank Bank sends $5,000 plus interest earned during the holding period. B. Customer/debtor has $25,000 in the bank Bank sends $10,000 only. No interest. C. Customer/debtor has $9,999 in the bank Bank sends $10,000 if at least $1 of interest is earned on the account during the holding period During the 21 day holding period, the bank is to treat the IRS as the depositor up to the amount of the levy. Thus, cannot defeat the payment of interest to IRS. If bank charges a levy fee, cannot reduce the levy proceeds to collect the fee
Exemptions from levy More bank levy procedures Even though customer/debtor s income may have some exemptions from levy, any amount deposited into the customer s account is treated as not exempt IRS can release (full or partial) amounts from levy to prevent hardship to the customer/depositor Mortgage escrow accounts Interest and taxes escrows cannot be levied unless there is an excess surplus, which can be levied If the property is sold, the levy can also reach excess escrow amounts
Questions
Today s Presenters Panelist Bob Adams Partner IRS Practice and Procedure Washington National Tax bob.adams@mcgladrey.com Co Moderator Dean Fischbeck Senior Vice President Bank of America Federal Tax Audit and Controversy Executive dean.fischbeck@bankofamerica.com Panelist Patti Burquest Partner Tax Controversy Services Washington National Tax patti.burquest@mcgladrey.com Co Moderator Susanne Muller Director, Senior Tax Counsel Citigroup mullers@citi.com