On September 16, 2008, the IRS identified ten Tier III issues under its “Industry Issue Focus” (“IIF”) program. The IRS established the IIF program in March of 2007 to improve consistency in issue resolution across industry lines, allow the IRS to focus on high risk areas, increase coverage of non-compliant taxpayers by maximizing limited resources, and provide greater oversight on and accountability for important issues.
In the IIF program, the IRS Large and Mid-Size Business Division (“LMSB”) identifies compliance issues through field examinations and prioritizes the issues into one of three categories (i.e., Tier I, Tier II, and Tier III) based on how prevalent they are across industry lines and the level of compliance risk they present. The IRS anticipated that Tier III issues would likely contain issues affecting fewer taxpayers than issues in Tiers I and II. Tier I and II issues address listed transactions and other issues of high potential non-compliance or significant non-compliance risk, with varying levels of discretion available to field examination agents. For additional information on the IIF program, please see our March 14, 2007 news item.
The ten Tier III issues identified by the IRS span each of the LMSB five industry focus groups. The ten issues include:
- Launch Fees Paid to Cable Operators (Communication, Technology, and Media Industries). The IRS is examining whether cable television operators who receive cash incentives (launch fees) in connection with the execution of long-term affiliation agreements may defer the launch fees and take them into income over the agreement period.
- Amortization of Intangibles (Communication, Technology, and Media Industries). The IRS is examining whether broadcasters and cable channel providers accrue liabilities for license fees for the rights to broadcast sporting events upon the execution of the broadcast rights contracts and amortize the fees over the term of the contract when they should, according to the IRS, accrued the liability as the games are played.
- Real Estate Mortgage Investment Conduits (“REMIC”) (Financial Services Industry). The IRS is examining REMIC sponsors’ potential understatement of reportable gain on the retention and the sale of regular interests. The IRS is reviewing the sponsors’ economic models and assumptions used to value the residual interests in order to determine if the fair market value and basis allocations are appropriate for the retained regular interests.
- Premium Deficiency Reserves (Financial Services Industry). This issue concerns a reserve required by health, life and property casualty companies to book additional liabilities and expenses associated with any contract that will produce a loss during the subsequent year.
- Uniform Capitalization for Automobile Dealerships (Heavy Manufacturing and Transportation Industries). The IRS is examining whether retailers (including motor vehicle retailers) are properly applying the limitations imposed in 2007 on a variation of the simplified retail method allowed by the Uniform Capitalization (UNICAP) rules under Section 263A to calculate capitalized costs. The IRS is concerned with how it should apply a 2007 technical advice, inconsistent treatment by examiners, and its belief that the industry is “virtually completely non-compliant” with the 2007 technical advice.
- Service Loyalty Programs (Heavy Manufacturing and Transportation Industries). The IRS is concerned about the appropriate tax treatment of loyalty programs such as frequent flyer programs in the air transportation industry and frequent stay programs in the hospitality industry, specifically whether revenues received as payment for these points are subject to deferral under either a 1971 or 2004 revenue procedure.
- Delay Rental Payments (Natural Resources and Construction Industries). The IRS is examining whether delay rental payments are subject to capitalization under Section 263A as costs of producing property.
- Environmental Remediation Costs Under Section 198 (Natural Resources and Construction Industries). The IRS is examining whether taxpayers are complying with the requirements of Section 198 and related guidance, as well as the relationship between capitalization requirements of environmental remediation costs and the expensing of those costs.
- Cost Segregation Studies (Retail Food, Pharmaceuticals, and Healthcare Industries). The IRS is examining whether assets are Section 1250 property (generally subject to depreciation over 39 years) or Section 1245 property (generally subject to depreciation over 5-7 years).
- Vendor Allowances (Retail, Food, Pharmaceuticals, and Healthcare Industries). The IRS is examining whether vendor allowances are properly characterized as gross income, trade or other discounts reducing the invoice price of merchandise, or the reimbursement of an expense, as may be appropriate. Vendor allowances include, but are not limited to, asset-based allowances, merchandise-based allowances, sales-based allowances, post acquisition-based allowances and can also include upfront payments.
Although many of these issues address accounting issues, the IRS has indicated that it is not specifically targeting accounting issues. However, due to the recent prevalence of accounting issues in examinations and the IRS’ historic difficulty of handling accounting issues, the focus on these issues is not surprising.
The identification of an issue as a Tier III issue does not necessarily mean that audits on these issues are automatic. Instead, the IRS sees these issues as issues in need of national coordination, development, and potential guidance. Even so, taxpayers, and their advisors, with these issues should prepare themselves for potential examination by the IRS.
McGuireWoods LLP routinely handles tax controversies and litigation against the Internal Revenue Service and has broad experience representing clients in LMSB audits. If you have any questions, please do not hesitate to contact us at your convenience.