Daily Tax Report
Tuesday, October 10, 2017
Tax Audits: A Ban on Outside Lawyers in IRS Audits Is Past Due, Lawyers Say
By Alison Bennett
The possibility of a Treasury Department proposal to keep private-sector counsel out of tax examinations is getting mixed reviews.
The idea, announced in an Oct. 4 report, calls attention to one of the most closely watched issues in the tax-law community: Should the Internal Revenue Service be allowed to get help from outside law firms?
The ban would eliminate a practice the IRS employed in a complicated Microsoft Corp. audit, when the agency hired a team of lawyers to augment its own resources. Microsoft sued the IRS over it, and while the company didn’t win, the agency was strongly discouraged from hiring outside firms again.
Some attorneys praised the ban. Others called it unnecessary.
On the “good news” side, “I think Treasury and the IRS will be doing the right thing by abandoning this experiment in its entirety,” said Thomas V. Linguanti, a partner at Morgan, Lewis & Bockius LLP.
‘Nail in the Coffin’
But the ban might not even be needed, said Stuart Bassin, who runs Bassin Law Firm PLLC, a boutique tax controversy practice. “This is one more nail in the coffin of an idea that never should have been born and is long since dead,”he told Bloomberg BNA.
In the Treasury report, the department said it is considering an amendment to existing IRS regulations that would only apply going forward. The provision was one of eight items related to tax regulations issued in 2016 that Treasury identified for withdrawal or amendment.
The ban Treasury is considering would generally preclude the IRS from hiring attorneys for audits. Private-sector lawyers wouldn’t be allowed to question witnesses on behalf of the IRS. Nor could they play a “behind-the-scenes”role, such as offering the IRS advice on legal strategies or reviewing records obtained through a summons. The only outsiders permitted would be subject matter experts, under narrow circumstances.
Bad Idea?
Whether the ban is needed now or not, practitioners said the furor over the Microsoft case highlights one thing, in their view: Outside attorneys on audits are a bad idea.
Bassin, who was a Tax Division litigator at the Department of Justice for 20 years, said the uproar ensured that the experiment would be a “one-time thing,” and the agency isn’t likely to try it again.
Linguanti, who specializes in tax controversy and tax litigation at Morgan Lewis, pointed out that not only did the IRS end up in court, but the Senate Finance Committee subsequently approved a measure that would have banned the agency from using private contractors for any reason.
Linguanti said he understands the IRS is short on resources, but “the credibility of the entire tax system was put at serious risk” by this ‘farming’ out of legal representation to private lawyers.”
Microsoft Controversy
In the 2015 case, Microsoft sued the IRS in federal court after the agency brought in top-flight litigation firm Quinn Emanuel Urquhart & Sullivan, based in Los Angeles. The IRS was seeking help in a complex audit of some of the technology giant’s offshore deals.
Microsoft argued that the IRS improperly delegated a governmental function to outside lawyers, while the government contended the deal was a legal use of outside help for a complex investigation.
The court ultimately said the agency had the legal authority to enlist outside help, but criticized the IRS for doing it, saying it was “by no means established by prior practice.”The judge also cautioned that Congress might scrutinize the IRS for hiring private attorneys (United States v. Microsoft Corp., W.D. Wash., No. 2:15-cv-00102, order11/20/15).
John Hildy, a partner in Mayer Brown LLP’s tax controversy practice, called Treasury’s work on a ban “a welcome development.”
Hildy said some companies worry about information going too many places. “The arguments that taxpayers have advanced surround a control of the process,” he said. “Their concerns get back to issues surrounding confidentiality.”
With trade secrets and other commercially confidential data in the balance, Hildy said, “the aim is to keep the number of people who have access to your information as limited as possible.”
The IRS and Quinn Emanuel couldn’t be reached for comment by press time.
After a lengthy battle by Department of Justice attorneys to defend the legitimacy of Treasury regulations that permit the IRS to hire outside lawyers to interview summoned witnesses and examine summoned documents, Treasury has acknowledged that it may have gone too far.
Regulations under section 7602 that facilitated the IRS’s engagement of Quinn Emanuel Urquhart & Sullivan LLP in a transfer pricing audit of Microsoft Corp. became the focus of a high-profile summons enforcement case against the company and now stand to be rolled back, according to an October 2 Treasury report. During litigation in United States v. Microsoft(No. 2:15-cv-00102) and United States v. Mundie (No. 2:15-cv-00103), the government maintained that section 7602 is an empowering statute granting the agency authority to have contractors fully participate in summons interviews.
That position was enshrined in temporary regulation 301.7602-1T(b)(3), issued in proposed (REG-121542-14) and temporary (T.D. 9669) form in June 2014, less than a month after the IRS executed its $2 million contract with Quinn Emanuel to aid in the Microsoft audit. The regulation clarifies the statute and puts everyone on notice about what the IRS is trying to do in complicated audits, said James Weaver, senior litigation counsel for the DOJ Tax Division during a November 2015 hearing.
Microsoft countered that the regulation was invalid and that enforcement of summonses issued during the audit would constitute an abuse of the court’s process, in part because of the agency’s engagement of Quinn Emanuel to perform functions reserved for the Treasury secretary and specified delegates.
While troubled by the level of involvement of the private firm, which Microsoft argued was involved in dozens of cases adverse to the company, Judge Ricardo Martinez of the U.S. District Court for the Western District of Washington granted enforcement of the summonses on November 20, 2015. He didn’t rule on the validity of the regulations, however, finding the issue moot because Microsoft failed to prove that the IRS lacked authority under section 7602 to delegate the questioning of witnesses to contractors like Quinn Emanuel attorneys.
“This case may lead to further scrutiny by Congress,” Martinez wrote, adding that the idea that the IRS can farm out legal assistance to a private firm is not established by prior practice.
Final regulations (T.D. 9778) were released in July 2016, largely unchanged from their proposed form. The only change to the temporary regulations was the replacement of the word “examine” with “review” concerning what contractors can do with books, papers, and other data received by the IRS under a summons. The change was meant to clarify that contractors are not permitted by the regulations to direct examinations of a taxpayer’s return, according to the preamble.
Microsoft was particularly concerned about the prospect of private attorneys conducting interviews for the IRS. Patricia Eakes of Calfo, Eakes & Ostrovsky PLLC, arguing for the company in court, acknowledged that third-party contractors can examine books, papers, records, and other data, and even suggest questions for the IRS to ask. But she drew the line at asking the questions of summoned individuals under oath. The IRS unilaterally handed off power given to it by Congress with ramifications “significant to every taxpayer in America,” she said.
Treasury Report
Echoing Eakes’s arguments, the October 2 report acknowledges that IRS investigators wield significant power to question witnesses under oath and review books and records, “with potentially serious consequences for the taxpayer.” By enlisting outside attorneys to perform investigative functions usually performed by IRS employees, the government risks losing control of its own investigation, the report states.
The report is a response to Executive Order 13789, which calls for a reduction in tax regulatory burdens. Among announcements concerning several other regulations, the report states that the “Treasury and the IRS are looking into proposing a prospectively effective amendment” to the 7602 regulations, narrowing their scope by prohibiting the IRS from enlisting outside attorneys to participate in an examination, including a summons interview.
In addition to foreclosing the possibility that outside attorneys could question witnesses on behalf of the IRS, the amendment would prevent those attorneys from even reviewing summoned records or consulting on IRS legal strategy. Outside subject matter experts — economists, engineers, or foreign attorneys, for example — would still be allowed to participate in summons proceedings under the proposal, including by posing questions to witnesses and reviewing summoned materials.
While the current regulations require the IRS to retain authority over important decisions, “the risk of a private attorney taking practical control may simply be too great,” the report states.
While an interim report suggested that Treasury doesn’t think any of the eight regulations tapped for reform exceed the IRS’s statutory authority, Patrick J. Smith of Ivins, Phillips & Barker Chtd. said the October 2 report seems to reflect considerable sympathy for the position that the 7602 regulations may have. The report also reflects the view that even if the use of outside attorneys was statutorily authorized, it’s not a good idea on policy grounds, Smith said.
Smith said he doubts the changes will have any material effect on the conduct of most examinations. “I think it is quite likely that the Microsoft examination was the only examination where the IRS ever made use of outside attorneys,” he said. Microsoft has also asserted that the Quinn Emanuel contract was the first time the IRS engaged private civil litigators in a U.S. income tax audit.
It may seem puzzling that Treasury would voluntarily limit its own options. But the strategy of hiring a litigation firm for the Microsoft audit garnered significant criticism and ultimately failed, said Stuart Bassin of the Bassin Law Firm PLLC. It would be easy for Treasury to revoke a regulation supporting the strategy, he said, noting that the Treasury announcement doesn’t prevent the IRS from hiring a firm to handle a complex trial.
The justifications cited in Treasury’s report for the proposed amendment include that the core functions of questioning witnesses and conducting investigations are “well within the expertise and ability” of IRS attorneys and examination agents, and that power over important decisions should be exercised by government employees committed to the public interest.
Steve Johnson, a professor at Florida State University and former senior attorney with the IRS Chief Counsel’s Office, said one of the complaints he hears most from tax lawyers is that they have to spend more and more of their time educating IRS agents on tax law.
“But the answer to that is not to spend money hiring outside law firms,” Johnson said. The answer is to pay good revenue agents more and give them caseloads that allow them to focus on where the dollars are, he added.
Johnson said the regulations may have been a slap in the face to IRS employees. There could also be concern about the appearance of impropriety and the IRS forming special relationships with some law firms, he said. “The IRS has enough public and political image problems,” Johnson said, citing the agency’s award of an identity protection services contract to hacked credit agency Equifax.
Lost the War
Although the IRS won the summons fight, it may have lost something bigger, according to Bassin. The summons enforcement case was a sideshow to the main event, which was the transfer pricing audit of Microsoft and potential later litigation, Bassin said. The IRS hired Quinn Emanuel because it wanted to make Microsoft the litigating vehicle for transfer pricing issues, he said, adding that the IRS “expended scarce resources to hire Quinn Emanuel in hopes of improving its chances in that case.”
For years before the temporary regulation was issued, “the IRS’s record in 482 litigation was — let me be generous — mixed,” Johnson said.
During testimony at an August 2015 hearing, Eli Hoory, senior adviser (transfer pricing operations), IRS Large Business and International Division, said the IRS wanted to increase its efforts in this case and take a different approach than it had in the past. Quinn Emanuel was hired because the IRS thought advice from a commercial litigator with experience evaluating large, complex cases would help it determine the correct adjustment and support its numbers, the government argued.
At a November 2015 hearing, Eakes criticized the IRS’s use of trial lawyers as outside counsel rather than tax lawyers, given the agency’s claim that it was just trying to get to the right numbers in what Weaver described as “one of the largest and most complicated audits ever undertaken by the IRS.” The summonses at issue are about getting an advantage in preparing the case for the Tax Court, Eakes said.
Philip Beck of Bartlit Beck Herman Palenchar & Scott LLP, counsel for Microsoft at the time of the August 2015 hearing, suggested that Quinn Emanuel was retained to help the IRS avoid the mistakes that led to an unfavorable outcome for the agency in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), non acq. AOD 2010-05.
During the time the summons enforcement case against Microsoft was delaying its audit, the IRS litigated and lost several transfer pricing cases in Tax Court, “thus, the overall IRS strategy of making Microsoft the test case has failed,” Bassin said. Given the IRS’s overall strategy, the Quinn Emanuel venture must be viewed as a failure, he said.
Microsoft declined to comment on Treasury’s proposal.
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