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June 15, 2015
Negotiating a Closing Agreement With a Department of Revenue
by Peter L. Faber

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Settlements of tax audits are typically reflected in closing agreements between the department of revenue and the taxpayer. Negotiating these agreements can be an important part of any settlement.

It is important that an audit be resolved by an agreement that binds the DOR, as well as the taxpayer. State auditors will sometimes give a taxpayer a form to sign that is not signed by the department. Taxpayers should insist that the terms of any settlement be endorsed by, and be binding on, both the DOR and the taxpayer. Whether the agreement is referred to as a "closing agreement" or by some other name is unimportant; what's important is that there should be a written agreement that binds the department to its terms.

The DOR may have standard closing agreements, and the practitioner should determine the extent, if any, to which the printed form can and should be changed. DOR auditors may insist that the printed forms be used without change, but taxpayers should resist this. The printed forms are slanted toward the DOR and typically do not contain provisions that the taxpayer will want to have included. If DOR representatives are reluctant to change the printed form, one possibility is to add an appendix that elaborates on -- and even contradicts -- the provisions of the form.

DOR forms often provide that the agreement settles only tax liabilities asserted and in dispute in the audit. This language allows the DOR to come in later, re-audit, and raise other issues not raised in the initial audit. Taxpayers should insist that any payments of deficiencies be in complete settlement of its entire liability for the type of tax in dispute, subject only to exceptions specified in the agreement.

I generally like to do the first draft of any agreement, whether with a DOR in a tax audit settlement or with a private party in a business transaction. The first draft sets the framework for further negotiations and shifts the psychological, if not legal, burden to the other party to justify changes to the initial draft. Although offering to prepare the first draft relieves the DOR auditors of the burden of preparing it, the department will sometimes insist that its printed form agreement be used as the starting point.

A revenue department's first draft will often indicate that any deficiencies must be paid by a specified date. Taxpayers should check with their administrative people to make sure that the designated date is reasonable. Large corporations often have procedures for processing tax payments, which can be cumbersome and time-consuming. Although revenue departments are often willing to grant extensions of time when the taxpayer's representative can show that the processing and arrangement for payment are unexpectedly delayed, one cannot rely on this flexibility, and it is best to provide for a reasonable cushion in the first place.

The agreement should make clear that the amount indicated for payment includes tax and interest and that, if this is part of the agreement, no penalties will be imposed.

The agreement should indicate whether it is effective regarding similar issues in future years. Part of the settlement may be an agreement as to how some items will be treated in the future. If so, that should be explicitly stated. On the other hand, if the intent is that the agreement will not govern future treatment of settled items, that, too, should be explicitly stated. I like to include language, when appropriate, that the agreement does not represent the position of either party as to the correct tax treatment of any item. I have had many cases in which the amount of an agreed-on deficiency was based on specific concessions by the parties on specific issues, but that was simply a way of getting to an agreed-on dollar amount, and the parties that conceded issues still felt that their positions on those issues were correct. I have had cases in which that was not made clear and, when the taxpayer in future years departed from the agreed treatment of some items, the auditors expressed the view that the taxpayer was reneging on a deal. When the taxpayer pointed out that the agreement specifically said that the settlement was not to apply to future years and did not necessarily reflect the opinions of the parties as to the proper tax treatment of any item, the auditors backed down, but they were still somewhat resentful. The best approach is to pin down precisely the effect, if any, of the agreement on future years.

The DOR may want to provide that it can reopen the audit years if it discovers tax avoidance transactions. While the auditors are thinking about abusive tax shelters, their suggested language is often broad and can apply to routine business transactions when tax considerations have been taken into account. One government draft closing agreement that crossed my desk would have allowed the department to reopen the audit for any "scheme, product, or transaction structured with the intent of evading or avoiding federal or state taxes." This language could literally have applied to the most routine business transactions when taxes were taken into account in structuring the transactions, such as a decision to sell a business in a tax-free reorganization as permitted by Internal Revenue Code section 368 rather than in a taxable sale. Taxpayers should try to limit any such provisions to objectively determinable tax shelters such as "listed transactions" within the meaning of the Internal Revenue Code or comparable state statutory provisions. While the desire of state tax officials to be able to challenge abusive transactions is understandable, the typical closing agreement occurs only after an audit has gone on for some time and the taxpayer's books have been carefully checked, so there is no reason why any significant transaction should not have come to light. The DOR should not be allowed to reopen an audit or address routine business transactions just because they were structured with tax considerations in mind.

Taxpayers should insist that the agreement allow their liability to be recomputed to reflect net operating loss and capital loss carryovers and carrybacks. Revenue departments will normally insist on allowing liabilities to be redetermined to reflect IRS audits that result in increases in taxable income, and taxpayers have no ground for objecting to that. On the other hand, it is also fair that reductions in taxable income resulting from federal tax audits should give rise to refunds. Although IRS audits do not usually result in reductions in taxable income, it can happen in some instances, for example, when the agency audit results in moving income or deductions from one tax year to another.

Closing agreements will often contain confidentiality provisions. In the past, it was principally taxpayers that wanted the DOR to be prohibited from disclosing the terms of the settlement to the media or otherwise. This has become a particular concern in whistleblower and qui tam proceedings in which the government case has been taken over by the state attorney general's office. State revenue departments are often prohibited by statute from disclosing confidential taxpayer information, including the results of audits, and my experience has been that they have been conscientious in adhering to those restrictions. On the other hand, the statutes typically do not apply to attorneys general, and attorneys general are often eager to publicize their victories over taxpayers and others for political purposes. (A cynic might say that the letters "AG" refer to "aspiring governor.") Taxpayers generally will not want the resolutions of their audits to be announced by the attorney general at a news conference.

Taxpayers are not the only ones seeking confidentiality. Revenue departments often have the same concerns. They do not want taxpayers to be allowed to discuss settlements with their colleagues in other companies. State DORs, like taxpayers, often settle cases on a compromise basis, and settlement agreements frequently do not reflect the DOR's views regarding the substantive issues that have been raised in the audit. Like a taxpayer, a DOR may concede an issue in an audit in exchange for a taxpayer concession on another issue, despite feeling that its position on the conceded issue was correct. A revenue department may agree to a percentage settlement regarding an issue, again as part of an overall negotiated settlement involving many issues or because of a concern about hazards of litigation regarding that particular issue. Revenue departments, like taxpayers, need to make deals, and negotiating deals involves compromises. Understandably, departments do not regard such settlements as having precedential value, and they do not want other taxpayers having the same or similar issues to argue, in unrelated audits, for comparable treatment.

The taxpayer's objectives will be achieved if the DOR is prohibited from disclosing the existence or terms of the settlement, except under tax information sharing agreements with other jurisdictions. It is not enough to allow the DOR to disclose the agreement to jurisdictions with which it has such agreements. Any permitted disclosure must be pursuant to such an agreement.

The parties should be allowed to disclose the existence and terms of the settlement if compelled to do so by legal process. If a taxpayer or a revenue department is required to disclose the agreement in a lawsuit with a private party or a government agency, that disclosure should not be a violation of the agreement.

Also, a taxpayer should be allowed to disclose the existence of the agreement and its contents to its professional advisers and to its employees, outside auditors, and government regulators. I have seen draft closing agreements prepared by DORs that would not have allowed the taxpayer to disclose the agreement to its outside lawyers for the purpose of seeking their advice as to the agreement's meaning and enforceability. Taxpayers should insist that the confidentiality language not be too narrow, and revenue departments have generally been reasonable in adjusting their form language in that respect.

Negotiating and drafting a closing agreement with a DOR should be approached in the same way that any other important contract is approached. An agreement may be interpreted in later years by people not involved in its negotiation and drafting. Arguments as to what was really intended may fall on deaf ears. The language should be precise and its implications should be carefully considered. No one is perfect, and we cannot anticipate every situation that might occur in the future, but parties to a closing agreement (and I include government representatives as well as taxpayer representatives) should do their best to anticipate how the agreement might be applied in the future.

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