An insider’s guide to IRS examination of financial products and transactions
In my prior role, I was involved in numerous examinations of financial products and transactions as a Large Business and International (LB&I) special trial attorney for the IRS. if you’re not on the inside at the IRS or have never had a client selected for an examination, you may not know its structure or procedures. But you should.
Knowing how the IRS views and examines financial products and transactions can help you implement best practices to help your clients avoid investigation. Knowing the investigators who are responsible for a transaction you may be planning or judging, and how they approach an audit, will help inform the steps you take during the planning and implementation phases of a transaction. Equally important, this understanding can help you guide your client should an investigation occur.
How is the IRS organized?
There are four operating divisions of the Internal Revenue Service. The first two are less relevant to examinations of financial transactions.
Wage and Investment (W&I) helps taxpayers understand and comply with all applicable tax laws and protects the public interest by applying the tax laws with integrity and fairness to all. W&I is concerned with the standard W-2 taxpayer and other filing related services.
Tax Exempt and Government Entities (TEGE) handles employee plans, has purview over exempt organizations under section 501, and oversees tax issues for government entities.
Small Business/Self-Employed Division (SB/SE) is responsible for collections, examinations, and operations support for small businesses (with or without employees), taxpayers with rental properties, individuals investing in businesses such as partnerships and S corps, and corporations, S corporations, and partnerships with assets of $10 million or less.
Large Business & International (LB&I) is for the largest of taxpayers and those with international operations. LB&I handles tax administration activities for domestic and foreign businesses with a United States tax reporting requirement and assets equal to or exceeding $10 million. LB&I is responsible for the global high wealth and international individual compliance programs, which focus on complicated and high dollar transactions, including those involving financial products. You will likely encounter an LB&I Revenue Agent as part of an examination of a financial instrument or transaction.
Like the military, the IRS conducts campaigns.
In 2017, LB&I changed its methods for identifying and selecting issues for examination. According to the LB&I press release accompanying the initial rollout of campaigns:
“LB&I is moving toward issue-based examinations and a compliance campaign process in which the organization decides which compliance issues that present risk require a response in the form of one or multiple treatment streams to achieve compliance objectives. This approach makes use of IRS knowledge and deploys the right resources to address those issues.”
LB&I’s stated goal is to improve return selection, identify issues representing a risk of noncompliance, and make the greatest use of limited resources. It is focused on examining issues presenting a risk to compliance.
For practitioners, knowing whether a client’s potential transaction falls within the ambit of a campaign is an important consideration in planning the transaction. You can expect heightened scrutiny if it does, though absence of a related campaign does not mean the issue cannot be examined. LB&I continues to address, in addition to campaigns, noncompliance related to unreported income, undisclosed assets, or any other tax avoidance scheme.
Campaigns are identified through LB&I extensive data analysis, suggestions from IRS compliance employees and feedback from the tax community. Current campaigns related to financial products include:
- Financial Services Entities Engaged in a U.S. Trade or Business: This campaign addresses whether foreign investors were subject to U.S. tax on effectively connected income from lending transactions engaged in through a U.S. trade or business. In general, foreign investors who only trade stocks and securities for their own account are not engaged in a U.S. trade or business under the safe harbor rule set forth in IRC section 864(b)(2). The safe harbor rule, however, is not available to dealers in stocks or securities, or to entities engaged in a lending business, or to foreign investors in partnerships engaged in such activities. The treatment stream for this campaign is issue-based examinations.
- Forms 1042/1042-S Compliance: Taxpayers who make payments of certain U.S.-source income to foreign persons must comply with the related withholding, deposit, and reporting requirements. This campaign addresses withholding agents who make such payments, but do not meet all their compliance duties. The Internal Revenue Service will address noncompliance and errors through a variety of treatment streams, including examination.
- Individual Foreign Tax Credit Phase II: Individuals who meet certain requirements may qualify for the foreign tax credit. This campaign addresses taxpayers who have claimed the credit but do not meet the requirements. The IRS will address noncompliance through a variety of treatment streams, including examination.
- Offshore Service Providers: The focus of this campaign is to address U.S. taxpayers who engaged offshore service providers that facilitated the creation of foreign entities and tiered structures to conceal the beneficial ownership of foreign financial accounts and assets, generally, for the purpose of tax avoidance or evasion. The treatment stream for this campaign will be issue-based examinations.
- Virtual Currency: IRS Notice 2014-21 states that virtual currency is property for federal tax purposes and provides information on the U.S. federal tax implications of convertible virtual currency transactions. The Virtual Currency Compliance campaign will address noncompliance related to the use of virtual currency through multiple treatment streams including outreach and examinations. The compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in Notice 2014-21.
All LB&I active campaigns are listed at https://www.irs.gov/businesses/corporations/lbi-active-campaigns.
What’s the lifecycle of an examination?
Examinations follow a pattern, with seven stages.
- The first step in the examination process is the selection of the return for audit. This could be via campaign as discussed, or traditional means such as DIF score analysis, mismatching due to information reporting, whistleblowers, or because of the type of taxpayer.
- Once selected, the IRS will “risk” the return. Risk analysis is the process of comparing the potential benefits to be derived from examining a return or issue to the resources required to perform the examination. Factors considered in determining whether to audit an issue include potential for fraud, materiality, corollary effect of the adjustment, compliance impact, the type of adjustment and the hours required to audit. Thus, if the transaction is small and/or there is little concern with compliance, the chances of the issue being selected for examination are low. This could be useful in assessing risks for clients who may ask what the probability is of them being audited for a particular transaction.
It is often during the risk analysis that specialists are brought in. The initial agent assigned to the examination is usually a generalist, who may need assistance with specific issues. The Financial Products Specialty is one example. If there are financial products issues, the LB&I agent will make a referral to the Financial Products Specialty. Referrals are also commonly made to International Examiners and valuation specialists.
- Once the exam team is formed, there is an Opening Conference with the taxpayer and its representatives. This is when the IRS explains the examination process, advises the taxpayer of its rights, and identifies the issues they intend to examine. The Internal Revenue Manual (IRM) describes the Opening Conference as the first formal meeting with authorized employees or corporate officers of the taxpayer. The main purpose of the meeting is for the examination team and taxpayer to have an interactive dialogue about their respective roles in the LB&I Examination Process. The examination team should ensure the taxpayer understands how the examination process will proceed from beginning to end. Additionally, the meeting’s purpose is to summarize agreements on coordination and accommodations, and to discuss the general scope and depth of the examination. Thus, the Opening Conference is a great opportunity to probe the issues the IRS intends to examine.
- After the Opening Conference, the IRS will begin to develop the issues for examination. Information gathering at this stage usually is done via Information Document Requests (IDR), third-party contacts, summonses, and/or treaty requests. If the IRS needs information from third parties, it will either send third-party contact letters or issue a summons. For many financial transactions, you can expect the IRS to contact and request information from the counterparty. Financial institutions generally will not produce information and documents without a summons. There is generally no need to challenge routine requests for bank statements and transaction-related documents.
- Once information gathering is complete, the IRS will either drop the issue with a no change or propose an adjustment. If the IRS proposes an adjustment, the taxpayer will receive a Notice of Proposed Adjustment (NOPA).
- If the taxpayer disagrees with the proposed adjustment, it can protest the adjustment and seek resolution in Appeals.
- If Appeals is unsuccessful in settling a case, the taxpayer can elect to go to Tax Court or pay the tax and sue for a refund in District Court or the Court of Claims.
How does the IRS view financial products?
Within the Enterprise Activity Practice Area (one of eight Practice Areas within LB&I) is the Financial Products Specialty, responsible for examinations of financial transactions. Typically, if a taxpayer is picked for audit and there is a non-routine financial transaction, the revenue agent (a generalist) will make a referral to the Financial Products Specialty for assistance.
The Financial Products Specialty, the group within LB&I responsible for examinations of financial transactions, has specific objectives. The program “seeks to identify, develop and resolve financial products tax issues that are: (a) national in scope; (b) significant in dollars; (c) Important to tax administration; and (d) Important for uniform and consistent treatment.”
Some key wording gives insight into what the IRS is looking for. The IRM explains that
- derivative securities markets have revolutionized how capital is raised and risk is managed
- financial products are primarily marketed by investment bankers and securities firms
- inter-bank lending and borrowing, foreign exchange trading and security sales occur in global markets, 24 hours per day
- financial arrangements include re-packaging new products or hedging with existing products
- transactions often arbitrage different tax laws that exist between the U.S. and foreign markets and occur in U.S. and foreign subsidiaries and/or branches
- financial products often involve the financing of business or the direct products or services rendered by a business.
From these sentences, we can distill what the IRS is looking for—arbitrage transactions that take advantage of the laws of different jurisdictions and transactions that manage risk; financial product tax issues that involve character, amount, timing, source, and debt/equity determinations; and yes, the old debt vs. equity question is within the Financial Products Specialty.
The IRM also includes questions to be considered at the outset of an examination. These are standard questions one would consider in trying to understand the transaction.
- What is the financial product?
- Where is it traded? On an exchange? Traded at all?
- Who is the taxpayer?
- Why was the transaction completed?
You can be expected to produce any contracts associated with the transaction, to identify where the product is traded, if at all, and the parties involved. Of note is the question why was the transaction completed—to make money, or hedge another transaction? There needs to be a legitimate reason. If not, you can expect the IRS to dig even deeper into the taxpayers’ affairs to see if there are other tax motivated transactions.
Annually, the IRS publishes a priority guidance plan identifying issues that Chief Counsel is prioritizing and may issue guidance on during the current year. It’s a good list to review at the outset of each year to see if there are any issues that may impact a client. This serves as a useful tool for planning and client management. The IRS’s 2021-2022 Priority Guidance Plan for Financial Institutions and Products lists the following hot topics:
- Final regulations relating to the definition of registered form under §§149(a) and 163(f). Proposed regulations were published on September 19, 2017.
- Guidance under §166 on the conclusive presumption of worthlessness for bad debts. Notice 2013-35, which requested comments on the existing rules, was published on June 10, 2013.
- Regulations under §249 relating to the amount of a repurchase premium attributable to the cost of borrowing.
- Guidance under §§446, 1275, and 6050H to address the treatment and reporting of capitalized interest on modified home mortgages.
- Guidance addressing issues relating to mark-to-market accounting under §475.
- Guidance regarding application of the cure provisions under §851(i) for regulated investment companies (RICs) and §856(c)(7) and (g)(5) for real estate investment trusts (REITs).
- Guidance clarifying the definition of income in §856(c)(3) for purposes of the REIT qualification tests.
- Guidance under §860G(e) for modifications of certain mortgage loans held by a real estate mortgage investment conduit.
- Regulations under §1001 on the modification of debt instruments, including issues relating to disregarded entities.
- Guidance under §1001 on the elimination of interbank offered rates. Proposed regulations were published on October 9, 2019.
- Guidance on the constant yield election under §1276(b).
- Guidance on the treatment of fees relating to debt instruments and other securities.
How can you affect IRS regulation?
Every year, the IRS solicits suggestions for inclusion in the priority guidance plan. This past April, the IRS requested topics for inclusion in the 2022/23 plan. If you believe clarification in a specific area would serve your clients better than ambiguity, I encourage you to submit. And I would highly recommend making comments to any proposed or final regulations. Taxpayers are increasingly prevailing in procedural challenges to regulations, including challenges premised on Treasury’s failure to consider important comments. What you say now in response to a proposed regulation could be useful to you and your clients in the future.
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