A systematic approach to tax controversy management

The past ten years have brought two significant changes in the nature of the federal tax controversies. Historically, virtually all federal tax controversies were settled. Most are still settled today. Today, however, many taxpayers find settlement virtually impossible short of total surrender. The second change is the increased factual focus of tax controversies. A critical element, if not the critical element, for a large number of disputes is what are the facts. Section 482 pricing cases and tax inventory accounting cases are two examples of when this occurs.

This article describes a risk assessment a roach that can assist tax managers and other members of company management in dealing with this new environment in an effective and cost efficient manner. Reliable, detailed information concerning the uncertainties of a tax dispute is essential to good decision-making. When employed by individuals experienced with its use and with the resolution of tax controversies, the assessment yields reliable and useful information about the range of potential outcomes, the likelihood of each outcome, and the present dollar value of each. Armed with that information, and taking other relevant factors into account -- such as whether the dispute involves a one time or repeating issue and the cost to litigate -- company management can make informed decisions. They can shape the company's strategy more effectively and work toward a resolution that is in the company's best interest. In short, they can make smart "fight" or "settle" decisions.

The Nature of the Assessment Process

The necessary information concerning dispute uncertainties for routine, small-dollar controversies can usually be obtained through a top level or back of the envelope type of assessment. Little, if any, factual or legal research is required. Larger, complex cases require a more careful analysis. Relevant facts and legal precedents must be researched. Pertinent documents must be reviewed, and individuals with relevant information must be interviewed. Critical to this analysis is an organized and systematic methodology that ensures that all of the relevant factual and legal issues are considered. The analysis is of little or no value if important issues are overlooked or given inadequate attention.

The curricula of business schools offer tools that are of great assistance in avoiding those problems. The two most important are 'influence diagrams' and "decision trees." These tools can be used to help focus and guide the process. The identification of the issues that can have a significant effect on the outcome is an important step in the assessment process. The creation of influence diagrams helps assure that the key issues and their primary relationships are identified. The illustrative influence diagram in Figure 1 on the following page does just that. It is for a hypothetical inventory tax accounting controversy.

The diagram identifies the issues, their relationships, and alternative courses of action. Influence diagrams and the analytical work that goes into their creation are normally the product of a collaborative effort. Collectively, the members of the team need knowledge of the relevant facts and law, must be skilled in the application of this technique, and need tax litigation experience. For disputes requiring this type of detailed analysis, the work group should include legal counsel. Indeed, for the analysis and its fruits to obtain the protection of the attorney-client privilege, the analysis must be conducted in confidence under counsel's direction for the purpose of providing company management with legal advice. In some circumstances, attorney work product may also apply.

Underlying most of the principal issues are one or more sub-issues. The resolution of those sub-issues and the principal issues, as well as their interaction, must be integrated. That integration and the identification of the chains of sub-issues is frequently difficult. This difficulty is increased by the fact that the consequences of alternative resolutions of each of the issues must be extended through multiple steps to the ultimate outcomes. Decision trees provide the means to organize and accomplish those tasks. They link the uncertainties and trace the alternative scenarios. Figure 2 is a simplified decision tree for the portion of the hypothetical inventory accounting dispute that hinges on the accuracy of the taxpayer's method.

A full decision tree for the entire dispute would have many more branches and would identify the alternative, ultimate outcomes. It would present the probability of each and their present dollar values.

As reflected in the illustrative decision tree, an important step is the assignment of probabilities to the resolution of each issue. These probabilities are expressed as percentages. For example, an 80-percent probability has been assigned to the issue whether full expert testimony will be admitted into evidence if the missing accounting data are located. The decision tree also shows a 34-percent cumulative probability that the court will find the company's method accurate if the missing data are found and if the full expert testimony is admitted. That percentage is the product of multiplying the probabilities assigned to each of the three issues in the chain (.6 x .8 x .7).

While that part of the process is mechanical, the assignment of probabilities to the individual issues is not. It is an exercise of judgment that is dependent on in-depth knowledge of the relevant facts and law. For example, the 80-percent probability that the full expert testimony will be admitted into evidence is based on knowledge of the factual and legal issues and of the Federal Rules of Evidence. That kind of knowledge, as well judgment and experience, are at the core of the assessment process.

In addition to the influence diagrams and decision trees, other charts are frequently prepared as a part of the assessment process. One of the most useful is a bar chart that displays the probability and present dollar value of each of the alternative, ultimate outcomes.

Use of the Assessment Results

Armed with the information produced by a litigation risk assessment and the underlying factual and legal foundation, management can make an informed fight or settle decision. It can formulate an effective settlement strategy.

The data can also be used to create other information that is helpful in evaluating the dispute and how to proceed most effectively. For example, when litigation is the necessary course, companies will face the question of how much time and money to expend on the development of particular factual issues. Sensitivity analyses can be performed. Here, for example, such an analysis is useful in determining whether an additional $100,000 on expert witness support for the company's position is warranted. Without the testimony there is a six-percent probability of prevailing on the accuracy issue. With expert testimony, there is a 51-percent probability (34 percent plus 17 percent).

Timing of the Assessment

The same factors that guide whether the top-of-the-envelope or a more systematic, detailed assessment is required also determine when the evaluation should be performed. For a one-time issue arising from a routine company action and involving a relatively small amount of taxes, a top-level review as part of the preparation for settlement discussions at the district level should be adequate.

A complex, large dollar issue may warrant a full litigation risk assessment prior to those settlement discussions. A realistic view of the issue is needed from the beginning in order to make the best fight or settle decision. If one or more of the factors listed below are present, an early full litigation risk assessment should be performed:

* Complex and uncertain legal or factual issues;

* A large amount in dispute; or

* Anticipated difficulty in reaching a settlement.

Further, if litigation is the ultimate course, a litigation risk assessment done at the outset should be updated as the case develops. Such updates are important for effective case management and for consideration whether settlement should be revisited.

In some instance, it may be prudent to perform a litigation risk assessment as part of the tax planning process. Taxes can have a major impact on the number of dollars that reach the bottom line of financial statements. Many tax-planning questions involve the application of ambiguous rules with the alternative interpretations having significant tax consequences. When that is the case, a litigation risk assessment or at least a top-level evaluation may be appropriate. The tax manager and other members of management would know the chances of sustaining the proposed position in the likely event the Internal Revenue Service challenges it. Company management can then determine whether the degree of risk posed by the position is prudent in light of the potential tax benefits.

Conclusion

A primary task of most tax mangers is the resolution of tax controversies. In order to discharge that responsibility in an effective and cost effective manner, the tax manager must have reliable information about the uncertainties of the dispute that he is trying to resolve. The risk assessment approach outlined above provides just that. It gives the tax manager and other members of management access to the reliable information they need to make smart decisions.

CRAIG D. MILLER is a principal in The Miller Group in Washington, D.C., and Savannah, Georgia. He is a former member of the Washington, D.C., law firm of Miller & Chevalier. Mr. Miller expresses his appreciation to Alexander Zakupowsky, Jr., and Frederick H. Robinson of Miller & Chevalier for their editorial assistance.

COPYRIGHT 1997 Tax Executives Institute, Inc.
COPYRIGHT 2004 Gale Group