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A Dangerous IRS Precedent

Microsoft sign in front of an office building in Redmond, Washington
photo by Robert Scoble

Normally, an Internal Revenue Service audit is more or less a collaboration between the examining agent and the taxpayer, or the taxpayer’s representative.

The IRS asks for information it needs to determine what it thinks is the correct tax. The taxpayer, who is responsible for keeping records to support his or her tax position, provides that information voluntarily. The Service then reaches its conclusion, and the parties either agree or take their disagreement through the appeals process.

A summons is different. In a summons, the IRS legally demands documents or testimony from a taxpayer, backed by the power of the courts. The taxpayer has very limited grounds on which to decline to provide anything requested by the IRS in this instance. These grounds typically include Fifth Amendment protections, which only apply when there is the prospect of a criminal case, or attorney-client privilege, which generally does not extend to information related to the calculation of tax.

Hold on to that distinction; we will come back to it.

It is not uncommon for the IRS to consult experts in the process of determining the correct tax. In some instances, particularly valuation disputes, experts are given detailed information about particular taxpayers’ situations. Nobody objects to this practice, because the technical experts provide the IRS with the skills necessary to do its job - that is, to determine the correct tax.

Hiring private litigators to participate directly in an audit process is a very different matter. And that difference is why Microsoft is so dedicated to fighting back against the move.

In 2014, the IRS hired a private law firm to assist in the examination process for Microsoft. The firm, Quinn Emanuel, was a litigation firm with no particular specialty in tax law, according to Politico. The decision to hire litigators arrived almost concurrently with a regulation change, adopted by the Treasury Department, to allow private contractors to participate in the examination process. The change raised a variety of concerns, for outside observers as well as for Microsoft. Microsoft pushed back against the decision by filing a Freedom of Information Act complaint, seeking to learn more about the terms of the contract between Quinn Emanuel and the IRS.

In the meantime, the IRS hit Microsoft with a variety of summonses, including for testimony from former CEO Steve Ballmer. Microsoft attempted to argue that the summonses were improper because of Quinn Emanuel’s heavy involvement. The company also pointed out that the firm’s client list included major Microsoft competitors like Samsung. But in November, U.S. District Judge Ricardo Martinez of Seattle ruled that Microsoft must comply with the IRS’ summonses, despite expressing concerns about the Quinn Emanuel’s involvement in the audit process.

As Keith Fogg observed at Forbes, summonses were once a tool the IRS used only sparingly, mainly as a last resort. That has begun to change. The temporary regulation that allows private contractors to participate in examinations also extends to summons interviews, including questioning the individual compelled to provide testimony. This rule makes the problems with the IRS hiring a private law firm all the more acute.

The IRS hiring private litigators is qualitatively different from its hiring technical experts or economists, for a few reasons. First, litigators do not see their job as being to determine exactly what their clients deserve. Instead, their job is to try to see that their clients receive the most they reasonably can get. Bringing litigators into the audit process is not an exercise in determining the correct tax; it is an effort to obtain the biggest tax payment or settlement the government can extract.

Second, while an IRS examining agent’s job is to elicit all the information possible, whether favorable or unfavorable to the taxpayer, a litigator will structure an interview in order to try to elicit only information that favors the client (in this case, the government). Introducing litigation attorneys to the examination process, and perhaps especially involving them in summonses, destroys the fact-finding nature of the process and renders the entire exercise suspect.

Not that any observers will expend a lot of sympathy on a taxpayer like Microsoft, which can obviously hire as much legal talent as it wants to defend its interests. But the precedent of turning a tax examination process into what amounts to a pretrial discovery proceeding for the IRS’ benefit should appall the great majority of taxpayers.

Moreover, suppose the government loses a case to a talented attorney and later decides to bring a similar case against another taxpayer. Simply by hiring the victorious attorney’s firm, even in an unrelated matter, the IRS can create an ethical conflict that will prevent the attorney or her firm from representing other taxpayers against the Service.

On top of all this, the letter of the law does not support the Treasury’s position, announced in its temporary regulation issued in 2014, that it is entitled to bring in private attorneys and allow them to directly interview taxpayers under summons.

As with so much else that has happened in the IRS under this administration, these proceedings are part of a political agenda. In this case, the goal is to crack down on multinational corporations that the administration believes are unfairly shifting profits overseas. Pursuit of that goal now comes at the expense of the procedural protections that all taxpayers are entitled to expect when the government calculates how much they are legally obligated to pay.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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