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.

It is, therefore, more important than ever to know how to effectively assemble an excellent team of professionals. But, how do you sort through the complex tangle of tax, business and wealth advisors, many of whom offer advice as a means of selling other products and services? Here are some suggestions:

Distinguish Yourself by Understanding the Process. Whether your situation is simple or complex, there are three distinct elements in the process of creating successful project outcomes: (i) design; (ii) implementation; and (iii) maintenance.

All three are critical, but clients and professionals often focus primarily on implementation activities, such as drafting legal documents and setting up accounts. Consequently, the elements of design and maintenance are frequently neglected, or completely overlooked, with serious consequences.

In several well publicized cases, for example, the IRS has successfully challenged the efficacy of family limited partnerships, based in part on errors in maintaining the legal structure and faulty accounting procedures. Common failures include the payment of personal expenses from partnership funds and the distribution of partnership funds in an informal manner.

The element of design is also frequently neglected or overlooked. This can easily happen when clients simply instruct their attorney or CPA to take some action, such as drafting an agreement to purchase real estate. The costly error, however, may only be apparent years later, when the client desires to sell the business and retain the real estate, both of which are held in an S corporation (generally, you can’t extract appreciated property from an S corporation without triggering tax on the gain).

Know What You Don’t Know. Whether you are coordinating a project for yourself, your company, or a client, it’s critical to be fully aware of what you are doing and to engage additional expertise as needed. You’re not expected to know everything, and there’s no shame in seeking expert help when it’s warranted by the complexity of your circumstances or magnitude of your project. In fact, recognizing the need for additional expertise is an excellent way to create additional value and enhance client relationships.

So, how do you know what you don’t know? You can start by asking the following two questions regularly:

(i) “What third parties might, now or in the future, be interested in or affected by this event [transaction, plan, structure, etc.]?”

(ii) “What can be done to reduce the associated cost or risk?”

If you can answer the first question, but can’t answer or resolve all issues raised by the second question, you’ll need to find a specialist. If you can’t answer the first question, you’ll need to get someone with broader knowledge. Remember, there are times when the most valuable answer you can give is: “I don’t know.”

Identify Your Needs. For simple matters, one person may be able to design, implement and maintain (or conclude) a project, without multiple experts or the need to coordinate them. More complex circumstances, however, may require several experts and multiple levels of coordination.

Regardless of the level of complexity, make sure that someone is clearly responsible for coordinating the project and for each of the three critical elements—design, implementation, and maintenance. You don’t necessarily need to engage a separate professional for each position—you may, for example, remain responsible for overall coordination of the project, or your lawyer may be responsible for implementing and maintaining a legal structure—but someone must be responsible for each role.

Carefully Select Your Team. For each key position you will not handle personally, choose an excellent professional who is well-suited for the need (i.e., design, implementation, maintenance, or coordination) and for the overall team. Keep in mind that skills and technical competence are necessary, but alone are not sufficient.

In order to increase the probability of a successful outcome, select professionals who will work well with the team and who will be highly motivated to think independently, take responsibility, and be responsive. All other things being equal, my general suggestion is to hire an individual or the smallest firm which has, or can effectively assemble, the required skills.

A large law firm, for example, may be the best choice to draft documents requiring very specialized expertise or to negotiate and quickly draft the blizzard of interrelated legal documents required to implement a major transaction, such as selling a large ongoing business. On the other hand, an individual or smaller firm may be more responsive on regular legal matters and may have less pressure to direct work to other lawyers in the same firm. Generalizations are difficult, but you get the idea.

Seek Objective Advice. Financial and legal professionals typically offer a combination of advice, services, and/or financial products, and it’s sometimes difficult to know what you’re buying. “You get what you pay for” is hardly original, but generally sums it up.

Some of the largest investment and insurance companies offer “free” planning services of a general nature, in an effort to generate investment management fees or sales commissions on financial products. Similarly, some partners at the largest professional firms are compensated handsomely for generating hourly work performed by other professionals in the firm.

There is nothing wrong with making a profit by providing services or selling a financial product. With that said, if you’re seeking objective advice, you have a right to know how your advisor is compensated and whether the arrangement is fully aligned with achieving your objectives as quickly and simply as possible.