Planning Considerations

Chapter 1

Chapter 1 Sections

Click the links below to read specific sections related to Chapter 1.

Insight Summary

Transaction Planning Considerations

Tax Return Disclosures

Pre-Filing Agreements

I. Insight Summary

Effective transaction planning is not just about closing the deal, but it is also about preparing for the possibility of IRS scrutiny. Taxpayers cannot always predict which elements of a complex transaction will draw the IRS’s attention. That is why proactive tax controversy risk management must be embedded in the transaction planning process.

Companies should continually monitor IRS campaigns and the broader enforcement environment, to identify sensitive return positions and understand which industries, structures, and transaction types are under heightened scrutiny. Strong preparation places taxpayers in the best position if exam issues arise. That means making appropriate disclosures, preserving contemporaneous documentation, protecting privileged communications, and aligning internal stakeholders.

A proactive approach in conjunction with a disciplined transaction record provides the best insurance against audit risk and provides strategic advantages in defending return positions during examination. The sections that follow outline practical steps that every company should consider when planning significant corporate transactions.

II. Transaction Planning Considerations

IRS Campaigns and Anti-Abuse Doctrines

- Active Campaigns: The IRS Large Business & International (“LB&I”) division has numerous active campaigns targeting corporate transactions. For example, the capitalization of facilitative costs in Section 355 spin-offs; the proper tax treatment of success-based transaction fees; transfer pricing and captive insurance; the new corporate alternative minimum tax under the Inflation Reduction Act; and excess partnership distributions. Separately, the IRS regularly targets topics like foreign tax credits, intangible asset transfers, and “Dirty Dozen” tax schemes.
  - Transaction planners should review the IRS published campaigns to identify any potential areas of risk and adjust their transaction strategy accordingly.
- Economic Substance and Other Anti-Abuse Doctrines: The IRS is aggressively invoking judicial and statutory anti-abuse rules to challenge corporate transactions. The economic substance doctrine is a long-established anti-abuse provision that allows the IRS to disregard transactions for lacking economic substance or profit motivation, apart from U.S. tax benefits. In 2010, the economic substance doctrine was codified under Section 7701(o), and a penalty regime was imposed. Section 6662(b)(6) imposes a penalty of 20% of any underpayment attributable to the disallowance of claimed tax benefits under the codified economic substance doctrine. The penalty is increased to 40% if an economic substance transaction is not adequately disclosed on the tax return under Section 6662(i).
  
  There is no reasonable cause defense or exception to the economic substance penalty, meaning the penalties are “strict liability” penalties that apply without regard to whether the taxpayer had a professional advisor’s tax opinion or any other “reasonable cause” for believing the transaction at issue had economic substance.
  
  Other anti-abuse doctrines such as the business purpose test, step-transaction doctrine, sham transaction doctrine, and the substance-over-form principles are no longer being reserved solely for aggressive tax shelters but are now being asserted more broadly in routine transactional contexts.
  - Transaction planners should assume the transaction could be evaluated under one or more anti-abuse standards and assess each step of the transaction accordingly. The proper defense is to anticipate this level of IRS scrutiny by documenting business purpose, understanding the economic effects of the transactions beyond tax, and preserving contemporaneous records to support the substance of the transaction.

Assembling the Internal Team

Key Players: Companies should assemble small cross-functional deal teams drawn from senior in-house tax, finance, legal, and operational professionals who will manage the transaction. These individuals should have a full appreciation and understanding of the deal structure and facts, in addition to any potential tax issues as they will be the primary respondents in the event of an IRS audit or they may be witnesses in an eventual litigation.
Coordination and Confidentiality: Detailed transaction information should be restricted to this core group to maintain confidentiality. The company should communicate key aspects of the transaction to this group and maintain open lines of communication. This core deal team should function as an audit response team.

Engaging External Advisors

Companies should identify and retain outside experts based on the complexity of the transaction. The following advisors are typically common:
- Legal counsel are often necessary for legal structuring, providing opinions on complex issues, and helping to maintain privilege and confidentiality.
- Accounting firms are often necessary for due diligence, modeling, and assistance with tax provision or accounting methods.
- Valuation experts often provide purchase price allocations and intangible valuations
Companies should bring in external advisors at appropriate milestones of the transaction.
- Legal counsel are often necessary for legal structuring, providing opinions on complex issues, and helping to maintain privilege and confidentiality.
- Accounting firms are often necessary for due diligence, modeling, and assistance with tax provision or accounting methods.
- Valuation experts often provide purchase price allocations and intangible valuations
- Companies should bring in external advisors at appropriate milestones of the transaction.

Seeking Formal Tax Opinions or Tax Advice

When planning significant transactions, companies must carefully assess whether informal tax advice is sufficient, or whether a formal written tax opinion is warranted. General tax advice can guide structuring and planning decisions, however only a formal opinion can provide the level of protection needed in higher risk situations, including penalty protection, support for financial reserves, and audit credibility.
Companies need to determine who would provide the tax opinion:
- Law Firms – covered by the attorney-client privilege.
- Accounting Firms – advice may be protected under the tax practitioner privilege (Section 7525), with limitations.
- Law firms with accounting firms under a Kovel relationship – privilege extended to accountants working at the direction of legal counsel.
Formal tax opinions are based on representations and assumptions from the company. Companies must be able to prove these facts with supporting records.

Maintaining “Audit Ready” Files

“Audit Ready” Files
- Maintaining good transaction document hygiene is one of the most effective defenses in an audit. Documents created during the planning and implementation stage will likely be discoverable in audit or litigation. Therefore, companies should maintain a clear and consistent file maintenance system for organizing all transaction materials. Being able to pull an “audit-ready” file could shorten the audit and make defense and litigation significantly less costly.
Deal Time Capsule
- Companies should create a “deal time capsule” (exempt from ordinary retention policies) that is saved to a central location. This should include the following:
  - Executive summary including the technical and factual background of the transaction
  - All final executed documents, closing sets, opinions, and valuations
  - Interviews with the business regarding purpose and particulars of the transaction
  - List of all key players: business clients, lawyers, accountants, other advisors
  - Cost/benefit analyses and valuation back-up
  - Transaction-related collateral information, including memos, presentations, press releases, minutes, and other factual materials
  - Legal or tax advice on the transaction
A well-organized file system demonstrates transparency and provides credibility with exam teams. This ensures the company is prepared to respond effectively and efficiently during an examination.

Communication Hygiene

Good document hygiene means good communication practices. Clear and disciplined communication practices regarding a transaction protect privilege and minimizes potential audit risk.
- Control drafts and emails. Be sure to be clear in marking comments and saving as draft or final. Delete drafts in accordance with retention policies.
- Limit distribution. Share privileged or sensitive information only on a need-to-know basis. Do not over copy. Start a new email chain.
- Label and secure privileged materials. Mark privileged or tax advice communications clearly, and store appropriately from other project files.
- Follow document retention policies. Adhere to the established corporate policies for document retention.

Managing Internal Stakeholders

Published Information about Transactions
- Stakeholders like the C-suite and the General Counsel’s office may not understand the complexity of the audit process or tax controversy. It can be frustrating for those individuals outside of tax to watch the slow audit process. It is important to coordinate with all internal groups that have a stake in the transaction and provide high level overviews of the process, set expectations, and provide periodic updates.
- IRS increasingly looks to public sources outside of the tax return or narrative responses drafted by the tax team for information about transactions. It is crucial to ensure disclosures, statements, and external communications about the transaction are reviewed by tax counsel before being made public to avoid inconsistent characterization.

Internal Documentation and Contemporaneous Substantiation

With the possibility of audit, companies should be thinking ahead to how the transaction is characterized even in the internal documentation. The characterization of the transaction, and its motivations, should be consistent to the extent possible.
The company should keep contemporaneous workpapers, board materials, corporate documentation, and internal notes related to the transaction. These items should preserve facts and analysis and note the business purpose of the transaction.

Privilege Considerations

Privilege considerations are critical in transaction planning because they protect sensitive legal and tax analyses from disclosure, preserve the integrity of the audit defense, and ensure that communications with advisors remain confidential in the event of an examination or litigation.

Attorney-Client Privilege

The attorney-client privilege stipulates that confidential communications, between the company and its attorneys, that seek or provide legal advice are protected. The privilege belongs to the client, so only the client can waive it.
- Communication. It is important to keep in mind that the attorney-client privilege does not protect from disclosure the facts underlying a communication. The privilege covers only legal advice, including tax legal advice, not business or pure financial guidance. The types of communications that may be covered by the attorney-client privilege include oral communications, as well as “a variety of written formats including memoranda, letters, emails, facsimiles, summaries and handwritten notes.”
- Confidentiality. The client must have the expectation of confidentiality.
- Legal Advice Sought or Given. To be privileged, the communication must be with a lawyer for the purpose of giving or receiving legal advice.
- Communication with outside or in-house counsel regarding business decisions (not related to legal issues) are not privileged.
- In-house lawyers often wear two hats; they are both legal and business advisors.
- Attorney-client privilege covers only communications in furtherance of legal advice
- Generally, legal advice must be the primary purpose of the communication in order to be covered
- It is a good idea to be explicit regarding the legal nature of your inquiry
- Be clear that you understand you are reaching out to the in-house lawyer in their capacity as counsel
- In-house Clients
  - Under U.S. law, a communication between corporate employees and in-house counsel is privileged so long as:
  - the communication is made to secure legal advice for the corporation, at the direction of a corporate superior
  - the subject matter of the communication is within the scope of the employee’s duties, and
  - the communication is not disseminated beyond those who need to know its contents.

Tax Practitioner Privilege (Section 7525)

Under Section 7525, the federal tax practitioner privilege extends attorney-client protection to federally authorized tax practitioners when giving tax advice (not tax compliance or tax return preparation).
The term “federally authorized tax practitioner” includes attorneys, certified public accountants, enrolled agents, and enrolled actuaries.
This privilege is limited as it only applies in certain civil cases, not in a criminal tax matter.
The privilege does not apply to tax compliance or tax return preparation, or to the promotion of the direct or indirect participation of the corporation in any tax shelter.
The privilege can be waived in the same manner as the attorney-client privilege.

Kovel Arrangement

When a company involves non-attorney experts at the direction of legal counsel, the attorney-client privilege can extend to their communications under the Kovel doctrine. United States v. Kovel, 296 F.2d 918, 921-922 (2d Cir. 1961). The non-attorney expert must be necessary for the attorney’s advice.

Work-Product Doctrine

The work-product doctrine protects documents and tangible things from discovery if they are prepared in anticipation of litigation by a party. Federal Rules of Civil Procedure Rule 26(b)(3). This privilege exists to prevent “exploitation of a party’s efforts in preparing for litigation.” Admiral Ins. Co. v. U.S. Dist. Court for Dist. of Arizona, 881 F.2d 1486, 1494 (9th Cir. 1989).
- The work-product doctrine applies to documents created (1) in anticipation of litigation (2) by the party or the party’s representative.

III. Tax Return Disclosures

Disclosures on tax returns are also a critical part of transaction planning. Return disclosures help to demonstrate transparency, show positions are supported by authority, establish credibility with IRS exam, and safeguard against penalties. Thoughtfully drafted disclosures explain the facts and legal basis of a tax position, which reduces risk of the IRS assuming the company has hidden or misstated certain information.

Adequacy of Disclosures
- To be effective, disclosures must be complete, accurate, and supported by contemporaneous documentation. Adequacy matters for penalty protection purposes, consistency with financial statement reserves, and credibility with auditors and the IRS.
  
  An item is treated as properly reported if the facts are adequately disclosed on the return and the position has a reasonable basis. Disclosures are generally made on the tax return itself, or through Form 8275 or Form 8275-R.
  
  Adequate disclosure is especially important to avoid accuracy-related penalties and the strict liability penalties associated with the economic substance doctrine. If the IRS recharacterizes a transaction as lacking economic substance, an adequate disclosure can protect the taxpayer from a 40 percent penalty.
Uncertain Tax Positions
- Corporations with $10 million or more in assets that issue audited financial statements are required to file Schedule UTP with their federal returns when they have uncertain tax positions. These positions arise when a reserve is recorded in financial statements or where no reserve is booked because the company expects litigation and believes it will prevail.
  
  These filings often draw auditor and IRS attention, so companies should be prepared with clear, well-documented support for each position. The support should be inclusive of legal opinions, valuations, board minutes, and other contemporaneous records. The transparent and accurate disclosure of uncertain tax positions is essential, as it not only satisfies reporting obligations but also strengthens a company’s ability to defend the position during examination.

IV. Pre-Filing Agreements

- - The IRS Pre-Filing Agreement program gives large corporate taxpayers the opportunity to resolve specific tax issues with the IRS before filing their return. By addressing issues in advance, companies gain certainty in how the transaction will be treated and reduce the likelihood of disputes during a later audit. This proactive approach can also shorten the examination process and conserve resources on both sides.
    
    The program works best for issues where the law can be applied to established facts, such as valuation matters, accounting methods, or treatment of particular transactions. If accepted, the taxpayer and the IRS enter into a binding agreement that governs how the issue must be reported. The agreement can potentially cover multiple future tax years. Participation in the program requires a detailed submission, payment of a user fee, and full disclosure of all relevant facts. For companies engaged in significant transactions, the Pre-Filing Agreement program can provide certainty and reduce audit risk.

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