Utah Bar Journal

While this article discusses how the IRS is using Appeals to expand its ADR alternatives, it should be noted that there are many other types of ADR processes available for taxpayers, depending on the circumstances. For example, there are Advance Pricing Agreements for transfer pricing matters, Pre-filing Agreements for certain discrete issues (though not transfer pricing), and even a special process for valuing artwork before filing a return. However, since at least 1927, Appeals have been the IRS’s main administrative option for resolving tax disputes outside of court, and it has the broadest reach in terms of subject matters that can be addressed as compared to other ADR initiatives. Therefore, under the current IRS organization, it seems logical to use Appeals for other ADR functions such as mediation and arbitration.

Typically, when taxpayers are faced with an audit of a tax return, assuming the audit leads to a proposed adjustment, they will be issued a “30-day letter” by the examiner, which provides the basis for the adjustment, and advises them that they have thirty days within which to file a request for Appeals consideration. If the taxpayers fail to file a request for appeals assistance (commonly referred to as a “protest”), then the IRS will issue a “90-day letter” which advises the taxpayers that they have ninety days within which to file a petition with the U.S. Tax Court, or else face assessment and collection procedures. Generally, the 30-day letter is the taxpayers’ ticket to re-consideration of Exam’s proposed adjustment by Appeals before proceeding into litigation.

PRE-APPEALS ADR
Alternatively, instead of waiting for the proposed adjustment to go to a 30-day letter, a taxpayer may involve Appeals as a mediator at the end of an IRS examination (after the IRS has fully developed the disputed issue). This is accomplished either through the Fast Track Mediation (“FTM”) Procedure, or through the Fast Track Settlement (“FTS”) Procedure.

Fast Track Mediation
In July 2000, the IRS implemented a pilot FTM program with the Small Business/Self-Employed (“SB/SE”) Division. The program provided that the SB/SE Exam team and the taxpayer could mediate disputed issues with an Appeals Officer acting as a “neutral party.” The case remained under the jurisdiction of Exam during the mediation. The pilot program’s goal was to promote issue resolution between the Exam team and the taxpayer within thirty to forty days of the initial joint discussion. Due to the success of the pilot program, the IRS issued revenue procedure 2003-41, see Rev. Proc. 2003-41; 2003-1 C.B. 1047, to formally establish the FTM Procedure.

FTM is generally available for all SB/SE non-docketed cases and certain collection source work (e.g., offer in compromise and collection due process issues), but it is only initiated after an issue is fully developed by the SB/SE Exam team. FTM is optional, either side may terminate the process, and it does not replace other existing dispute resolution processes. For example, if mediation with the Exam team and the Appeals Officer (mediator) is unsuccessful, the taxpayer may still request a meeting with the Exam team manager, or go through the normal Appeals process after the issuance of the 30-day letter. The mediator is generally not able to consider the hazards of litigation in his or her recommendations or to use delegated settlement authority. The purpose of the FTM Procedure is to help the Exam team and taxpayer reach their own agreement. The taxpayer does not have the option of using a non-IRS employee or outside person in order to conduct the mediation.

This latter point can be a problem for many taxpayers, even if only a perceived problem. Under usual Appeals processes, there is a prohibition on ex parte communications between the Appeals Officer and other IRS employees “to the extent that such communications appear[s] to compromise the independence of the appeals officers.” See Rev. Proc. 2000-43, 2000-2 C.B. 404 (addressing limitations on ex parte communications). That prohibition does not apply to the FTM Procedure because the mediator is not acting in his or her role as an Appeals Officer. Section 8.26.3.5 of the Internal Revenue Manual (“IRM”) provides that if a FTM case is unagreed with the SB/SE exam team, it will be assigned to a different Appeals Officer (for normal administrative reconsideration). See Internal Revenue Manual 8.26.3.5 (October 24, 2007), available at http://www.irs.gov/irm_08-026-003.html#d0e203. There is, however, no prohibition on communications between the Appeals mediator and the later assigned Appeals Officer. See id. 8.26.3.9. Thus, in a 2007 American Bar Association survey, more practitioners said, “Appeals lacked independence in fast track mediation” than had actually tried the program; clearly indicating at least a problem of perception. See American Bar Association, Survey Report on Independence of IRS Appeals (August 11, 2007), available at http://www.abanet.org/tax/irs/survey/appealssurvey07.pdf. Nonetheless, for taxpayers with certain types of cases such as where the law is fairly clear, but there is a factual dispute, or a misunderstanding about how the facts should be interpreted, the FTM Procedure may help bring the taxpayer and IRS personnel to a relatively quick settlement.

Fast Track Settlement
In a different tack from FTM, the IRS established the FTS Procedure in revenue procedure 2003-40, see Rev. Proc. 2003-40; 2003-1 C.B. 1044, for Large and Mid-size Business (“LMSB”) Division taxpayers to have an opportunity to mediate their disputes at the examination level with an Appeals Officer acting as a neutral party. The goal of the FTS Procedure is to resolve the case through a mediated settlement within 120 days, see Internal Revenue Manual 8.26.1.4 (October 13, 2008), available at http://www.irs.gov/irm/part8/irm_08-026-001.html#d0e138. During the pilot program phase, by May 31, 2003, the IRS and 104 LMSB taxpayers had successfully settled their disputes through the FTS Procedure in an average time of sixty-nine days.

While the FTS Procedure still involves mediation between the taxpayer and the LMSB Exam team, the process provides that the Appeals mediator has settlement authority under Delegation Order 97 found in section 1.2.47.6 of the IRM, Delegation of Authorities for the Appeals Process, and he or she can consider the hazards of litigation in proposing a settlement. See id. 1.2.47.6 (August 18, 1997), available at http://www.irs.gov/irm/part1/irm_01-002-047.html#d0e361. If a FTS case is settled due to consideration of the hazards of litigation, Appeals exercises its delegated authority to enter into a closing agreement with the taxpayer, see id. 8.26.1.3.2 (October 23, 2007), available at http://www.irs.gov/irm/part8/irm_08-026-001.html#d0e57. An Appeals closing agreement in such a case is necessary because LMSB does not have authority to enter into a settlement based on the hazards of litigation. Revenue procedure 2003-40 provides that if the taxpayer accepts the Appeals FTS Officers’ proposed settlement, but the LMSB team manager rejects it, the issue is elevated within the IRS, and the LMSB Territory Manager must review it. If the Territory Manager does not accept the settlement on behalf of LMSB, the case is closed out of the FTS Procedure as unagreed. Thus, arguably the Appeals mediator will not be able to reach a FTS with a taxpayer without agreement from Exam, either at the audit level or with management.

Similar to the FTM Procedure, the taxpayer does not lose any administrative rights to pursue resolution of the case if the FTS Procedure is unsuccessful, such as continuing in the normal Appeals process. However, like FTM, the rule against ex parte communications does not apply, and revenue procedure 2003-40, section 7.02 explicitly states: “With respect to FTS cases that are returned for traditional Appeals consideration, ex parte restrictions will not be imposed on intra-Appeals communications.” Rev. Proc. 2003-40. Thus the Appeals FTS Officer may presumably discuss the FTS case with any later assigned Appeals Officer, and therefore, if unsuccessful with FTS, a taxpayer may find there is a diminished level of Appeals independence (a concern that Exam would be able to influence indirectly the later assigned Appeals Officer through the FTS Officer).

Procedurally, FTS should be initiated when the issue in dispute has been fully developed, a Notice of Proposed Adjustment (Form 5701) has been issued, and the taxpayer has provided a response. If a 30-day letter has been provided to the taxpayer, the case is then generally ineligible for FTS, see Internal Revenue Manual 8.26.1.7 (October 13, 2008), available at http://www.irs.gov/irm/part8/irm_08-026-001.html#d0e400. The expectation is that all relevant issues and claims were raised, all pertinent information was disclosed, and the case is ready for resolution in the process.

The FTS Procedure has seen some success as an ADR process, not as a way for taxpayers to avoid an adjustment, but more to be able to reach an agreement with the Exam team on an expedited basis. For example, for Merck & Co., Inc., it was part of the process used to resolve $2.3 billion in federal tax adjustments and resolve all issues in dispute for years 1993-2001, see IRS Info. Rul. 2007-35. Similarly, Marriott issued a press release in June 2007 describing its agreement with the IRS using the FTS Procedure to resolve proposed adjustments for 2000-2002 for $220 million (Marriott had received a notice of adjustment in March 2007). An IRS Appeals official in June 2007 noted that the FTS cases were concluding in an average of 79 days, while the average complex audit cases were taking 600 days or more to move through the traditional Appeals process.

The LMSB FTS model has proven to be sufficiently effective that the IRS formally broadened the availability of the FTS Procedure to SB/SE taxpayers in Ann. 2006-61, see 2006-2 C.B. 390, applicable for a test period of two years, and extended again in Ann. 2008-110, see 2008-48 I.R.B. 1224, for another two years (applicable for applications received through November 30, 2010). Not to be left out, the Tax Exempt and Government Entities (“TE/GE”) Division was also granted formal access to FTS in Ann. 2008-105, see 2008-48 I.R.B. 1219. For both SB/SE and TE/GE, the IRS’s goal with FTS is to complete the cases accepted into the procedure within 60 days (or about half of the goal time for LMSB taxpayers).

POST-APPEALS ADR
Despite its effectiveness, some taxpayers do not conclude the Appeals process with an agreed settlement of their tax dispute. Such an occurrence does not necessarily mean that the only option is litigation or an adjustment by Appeals. Taxpayers may still have available post-Appeals mediation or arbitration.

Post-Appeals Mediation
Late this year, the IRS issued revenue procedure 2009-44, see 2009-40 I.R.B. 462, which provided an updated post-Appeals mediation program (replacing revenue procedure 2002-44). The general idea is that where a taxpayer cannot reach agreement with the Appeals Officer assigned to the case, but where there are meritorious arguments in the taxpayers’ favor that they feel is not being adequately considered, the taxpayer can request another Appeals Officer to come in and mediate a resolution. Not surprisingly, the post-Appeals mediation program is enjoying little success, though not without effort.

Former Tax Court Judge Carolyn Miller Parr wrote in late 2009, see Carolyn Miller Parr, Why Postappeal Mediation Isn’t Working and How To Fix It, Tax Notes Today, Sept. 16, 2009, available at http://www.com/taxcom/features.nsf/Articles/1170408SC68E8F788525763300002C150?Open Document 2009 Tax Notes Today 175-8, Sept. 14, 2009, about her experiences as a mediator in this program, and commented that “[T]he fundamental reason IRS mediation is not working is the deep lack of trust flowing both ways.” This should surprise no one. The participants are the taxpayer and Appeals, with an Appeals mediator, but Appeals is able to bring in virtually any other IRS resources that the officer thinks may be relevant to the proceedings, and to communicate ex parte with such other participants as necessary. Since the post-Appeals mediation process provides for an Appeals Officer to do the mediation, even if the taxpayer brings in a co-mediator (at the taxpayer’s own cost, but subject to approval by the IRS), there is understandably an apprehension that the taxpayer is not going to receive a fresh look at the facts, and both co-mediators can easily end up being perceived as advocates for their respective employers.

There are also unequal incentives to settle (the desire to settle is typically a key requirement for mediation to work). One of the primary concerns of the taxpayer is of course the cost, not only with the tax adjustment it faces, but also costs related to pursuing litigation. Some tax disputes can lead to bankruptcy. On the IRS side, however, the government employees involved get a paycheck either way, and where they feel they have made their last and best offer, then the hope of reaching a mediated settlement is likely not to be realistic.

Post-Appeals Arbitration
Arbitration of tax disputes can sound inviting where circumstances have dragged on for an extended period of time, and where the taxpayer believes its position has serious merit (and is not simply an attempt to reach a better deal). Revenue procedure 2006-44, formally established the procedure, see Rev. Proc. 2006-44 2006-2 C.B. 800, following several years of a pilot program begun in 2000, see Announcement 2000-4; 2000-1 C.B. 317. It is specifically designed to resolve only factual issues relevant to the dispute. However, if the parties to post-Appeals mediation described above are unable to reach an agreement, and if the factual issues are the determinant point, then the taxpayer may seek to bring the unsuccessful mediation into arbitration.

The arbitration contemplated by the IRS procedure is significantly different in its process from what is involved in usual commercial arbitration, or for that matter, what is accepted by the IRS in its treaties with Canada, Germany, Belgium, and Switzerland. The latter generally involves a scenario whereby the arbitrator must choose between the best positions offered by each side (“baseball” arbitration). Commercial arbitration tends to be governed by many rules of practice designed to ensure independence, see generally, American Arbitration Association, available at http://www.adr.org. Unfortunately for taxpayers, the scenario for IRS post-Appeals arbitration provides a significantly different context.
Under IRS procedures, Appeals does not have to agree to arbitrate. There is no formal method to appeal the denial of a request to arbitrate. An Appeals Officer unrelated to the dispute may be selected, or if the IRS and taxpayer agree, an outside arbitrator may be selected (with a sharing of the costs). Appeals may bring in IRS Chief Counsel attorneys to participate, and there is no taxpayer assurance of independence as there would be in the commercial or treaty context.

Thus, the post-Appeals arbitration procedure has generally been a resounding failure in terms of taxpayer support. For example, the post-Appeals arbitration process was announced in 2000, but through mid-2007, only fourteen taxpayers had requested it, and of those cases, only one had been resolved, see Stephen Joyce, Officials Urge Taxpayers to Use Alternative Dispute Resolution Tools, 105 Daily Tax Report G-3 (June 1, 2007).

This is not to say that post-Appeals arbitrations or mediations are not useful processes for taxpayers. For example, a factual misunderstanding where the details are objectively favorable to the taxpayer, but misunderstood by the Appeals Officer, could be addressed by post-Appeals arbitration. However, there may be a better way.

An Alternative to IRS ADR
John Klotsche, an attorney in Washington, DC, suggested in a series of three articles this year, published in Tax Notes Today in March, July, and September 2009, that the present IRS ADR processes, such as post-Appeals mediation and arbitration, are antiquated, too confrontational, and do not effectively advance the IRS’s goal of promoting a high level of tax compliance. He proposed three changes to the present system: moving forward the timing of the ADR process, requiring mandatory mediation, and assuring the mediator is independent. These are sensible suggestions that would go a long way to improving IRS ADR processes.

Requiring mediation at the end of the audit or the beginning of Appeals would help avoid the entrenched positions that can result after years of negotiating with Exam and then later with Appeals. If both sides knew mediation was required, perhaps they would be more flexible and realistic in evaluating their positions from the outset. In addition, mediation is mandatory in many state and federal courts, see, e.g., Utah’s Mandatory Divorce Mediation Program, and could be effective for the IRS and taxpayers as well. Mediation is, by its nature, non-binding on the parties, but it presents an opportunity to identify and discuss with a trained mediator and the other side the primary issues, the strengths and weaknesses of each side’s position, and to seek jointly a settlement.

Finally, to resolve the perceived lack of independence in the current ADR processes, Klotsche proposes the IRS form an “ADR Center,” which would be separate from Appeals. The use of Appeals officers for mediation and arbitration, even if well intentioned, cannot ever be entirely independent because the officers are employees of one of the parties to the dispute. “Independence” means a truly neutral third-party mediator or arbitrator with no ties to the IRS or the taxpayer. In the commercial world, ADR is practiced this way.

Klotsche envisions the ADR Center as an independent, mutually exclusive alternative to Appeals, but not an elimination of traditional Appeals. Therefore, a taxpayer could choose one or the other, but would not be allowed “two bites of the apple,” by going to Appeals after reaching an impasse at the ADR Center. While the structure, staffing, function, and coordinating rules of such an ADR Center would certainly be subject to public debate and are presently difficult to anticipate, it presents a novel idea for resolving several problematic issues with the present IRS ADR processes.

Still, despite some challenges with the present ADR processes, the commitment of the IRS to making available more alternative venues for resolving tax disputes is promising for those taxpayers who end up with adjustments that are not resolved with Exam. Taxpayers may seek mediation before going through the traditional Appeals processes, or if Appeals cannot reach a settlement with a taxpayer, then it may be possible (under the right set of facts) to go through a post-Appeals ADR process before having to face litigation.