Designing Tax And Business Solutions: How to Develop Structures that Deliver Results and Won’t Collapse Under IRS Scrutiny

The following excerpt from Modern Tax Litigation: How to Gain Tactical Advantage from the Initial Transaction Through Case Resolution, by Steven Ledgerwood, will appear in the book, Tax Litigation Best Practices, to be released in 2006 as part of Aspatore Publishing’s “Inside the Minds” series. It is used with permission of the publisher.

In any tax matter, the most desirable outcome is to achieve your preferred treatment and avoid a government challenge. Ideally, the taxpayer should begin developing a tax litigation strategy as the transaction is being planned and implemented.

The following are suggestions for creating and maintaining strong positions, which will make your transaction a less inviting target for the IRS. Fortunately, many of the best pre-audit tactics will also provide a strong foundation for favorably resolving those conflicts that can’t be avoided.

1. Developing a Coherent Narrative. Complex transactions always involve a combination of tax and non-tax considerations that must be integrated into a structure or series of events. By thinking strategically at the planning stage, you’ll often be able to make relatively minor adjustments that will create a far stronger tax position.

If you’re structuring a transaction that raises difficult tax issues, it’s very helpful to think strategically about the case you’d like to present and develop a coherent narrative. By “coherent narrative,” I’m referring to a general conceptual framework that unifies the elements of the transaction and provides a rationale for the participants’ behavior. The narrative, however, need not be—and in the majority of cases probably should not be—a separate written document.

Of course, you must first understand the client’s fundamental non-tax objectives and identify tax risks associated with accomplishing those objectives. Then, ask questions similar to the following:

• What are the elements of the transaction that may concern the IRS or a court?
• Are those elements necessary to achieve my tax and non-tax objectives?
• Are there elements of “the deal” that can be modified slightly to strengthen the tax position?
• What are the ambiguities that could give rise to a dispute with the IRS?
• How can I emphasize facts that will support my preferred interpretation of ambiguous circumstances?
• What can be done to enhance the overall presentation of this case?

There are, of course, many other questions that might help you develop a coherent and defensible tax position. The key is to think strategically about the case you’d like to present and work back to the fundamental elements of the deal, making adjustments as you can.

2. Documenting the Transaction. Once you have developed a coherent narrative, it should be reflected in the transaction documents and other key evidence. At times, creating a strong tax position may require more thorough documentation than would otherwise be required. Please take care, however, to exercise caution and good judgment with this suggestion. You want to make it easy to establish the merits of your case, but you don’t want your formal documents to “prove too much,” particularly when the taxpayer is taking a legitimate but “aggressive” position.

For example, it can be helpful to state the parties’ intention to consistently treat the transaction in a particular way for tax purposes: “The parties intend the transactions contemplated by this agreement to constitute a Section 368 reorganization for federal income tax purposes….” And at times, it may be helpful to include “recitals” of demonstrable facts that demonstrate non-tax motivations. On the other hand, extensive conclusory, self-serving recitals may do nothing more than telegraph your weakness and imply a guilty conscience.

Always keep in mind that it can be very difficult to maintain privilege over written documents because of the tendency for taxpayers to waive the privilege by providing copies to persons outside the privileged relationship.

3. Preserving Key Evidence. A corollary to properly documenting the transaction is taking steps to preserve key evidence that is not reflected in the transaction documents.

For example, if the “tax ownership” of an asset is ambiguous, the taxpayer may be required to show that it bore certain risks related to the asset for its tax treatment to be respected. In that situation, take care to preserve evidence reflecting management’s understanding of the risk and their actions consistent with presence of the risk (e.g., letters showing adequate disclosure to third parties, inquiring about or purchasing insurance to cover the risk, etc.).

4. Avoiding Friendly Fire and Self-Inflicted Wounds. This probably should go without saying, but I’m sometimes amazed at the things people say or write when they really should know better. What I’m talking about are inaccurate and unnecessary characterizations that can be incredibly harmful in the context of tax litigation. This type of “friendly fire” can easily happen when someone involved in a transaction doesn’t understand or doesn’t want to communicate the subtleties of a complicated structure.

Let’s assume, for example, that “Seller” owns an asset that generates tax credits the Seller cannot use, and “Buyer” desires to acquire the asset and utilize the tax credits. Seller and Buyer enter into a complex sale-leaseback or similar arrangement under which the “benefits and burdens” of owning the asset are divided in some fashion between Seller and Buyer. Although tax ownership may be somewhat ambiguous after the transaction, the parties conclude that Buyer legitimately has enough of the economic characteristics of ownership to be treated as the owner for income tax purposes.

In ambiguous situations like this, evidence of intent and purpose can easily tip the scales in favor of one characterization or another. So, the last thing you want your assistant vice president of real estate to create is a one-page presentation to senior management, entitled “How to Buy Tax Benefits Without Really Owning the Property.” I’m exaggerating a bit, but in the chaos of business, people make these kinds of mistakes. Need I say more?

5. Maintaining Privileged Communications. This suggestion also seems obvious, but in practice it’s harder than it sounds. As part of the planning process, counsel should advise the client of relevant issues, tax risks, and ways to mitigate them. The client should take care about making statements that may compromise its position and should attempt to preserve privilege for certain written and oral communication.

6. Reducing Audit and Penalty Risks. It is never too early to begin considering ways to reduce the taxpayer’s audit and penalty risks. Effective tactics to reduce audit and penalty risks include: (i) avoiding any unnecessary elements that require special disclosure or invite additional scrutiny; (ii) properly and consistently characterizing a transaction; (iii) taking favorable positions on the original return and avoiding amended returns; and (iv) consistently treating the transaction for financial reporting and other non-tax purposes, if possible.

The preceding excerpt from Modern Tax Litigation: How to Gain Tactical Advantage from the Initial Transaction Through Case Resolution, by Steven Ledgerwood, will appear in Tax Litigation Best Practices, to be released in 2006 as part of Aspatore Publishing’s “Inside the Minds” series. It is used with permission of the publisher.

A downloadable version of Modern Tax Litigation, by Steven Ledgerwood, will be available soon at www.stevenledgerwood.com.