A systematic approach to tax controversy management

Tax Executive, The, May-June, 1997 by Craig D. Miller

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).