In a guest article, three experts look at the US tax authority's audit program that wealthy individuuals and family offices must be aware of.

Editor’s Note: Here, three partners of McDermott Will & Emery outline why the IRS’s Global High Wealth Industry program marks a new kind of audit that wealthy individuals and family offices need to be aware of.

In its ongoing Global High Wealth Industry (GHW) program aimed at audits of high net worth individuals and family offices, the Internal Revenue Service recently announced that its attorneys experienced in examining large corporate taxpayers with international issues will be front and center during GHW audits.

This means that GHW taxpayers are now facing increased scrutiny, not just from revenue agents directed to engage in detailed information gathering, but also from government lawyers who could be involved in later litigation. Taxpayers potentially subject to a GHW audit are well advised to be prepared to defend against an intrusive examination covering multiple tax years for related entities that also includes an IRS mandate to examine estate, gift and generation skipping transfer tax issues.

The recent news comes after the Transactional Records Access Clearinghouse (TRAC) at Syracuse University issued a blistering report in 2012 criticizing the scope and efficacy of the program. Despite the trumpeting of the program by the IRS, TRAC reported that for fiscal year 2011 and the first five months of fiscal year 2012 the IRS had only completed 36 GHW audits, and twelve of these resulted in “no change,” meaning no additional taxes were found to be owed. The IRS responded quickly, defending the GHW program by noting the natural learning curve since the program’s inception in late 2009 and warning the public that there were more than 100 enterprise cases under audit involving review of more than 500 returns, with many more cases in the pipeline. Thus, all signs point to an increased focus on raising revenue through GHW audits. This focus raises many questions for individuals and family offices potentially subject to a GHW audit.

Because GHW audits taxpayers with tax returns showing over $1 million in income, many successful individuals and family offices are potentially subject to such an audit. These returns often feature particular complexities such as diverse types of assets, many levels of income flowing from partnerships, S corporations or trusts, and increasingly have cross-border tax issues. Before the creation of GHW, the IRS perceived that its standard audit function was often ill-equipped to deal with such complexities.

The goal

The goal of GHW is therefore to create a team of experienced auditors that work in tandem with other IRS specialists (such as counsel, appraisers, international/financial products specialists, economists, etc.) to better evaluate the relevant returns. The program has over 100 revenue agents and multiple exam teams. Over time, the IRS believes that coordination and concentration of these different functions as one team will improve the IRS’s expertise and sensitivity to the greatest audit risks.  

GHW audits differ from traditional audits of individuals in several respects. Significantly, GHW is part of the IRS’s Large Business & International (LB&I) Division, rather than the Small Business & Self Employed Division. LB&I typically audits business entities with over $10 million in assets and LB&I agents and attorneys have more expertise in audit compliance and international issues.

Thus, placement of GHW within the LB&I function shows that the IRS expects the level of intensity of such audits to be commensurate to a large corporate audit, necessitating an LB&I approach. Often, cross-border issues may be involved, and indeed the IRS is increasingly cooperating with tax authorities in peer countries in pursuing these GHW audits. This enterprise approach typical of the LB&I audit could be overwhelming to many high net worth individuals and family offices who lack a tax director or senior financial officer used to dealing with federal and state audit issues.

Another difference involves the scope of the audit. Unlike the Small Business & Self Employed Division that typically looks at one year’s tax return in isolation, GHW audits often cover multiple tax years. GHW audits also often branch out into examinations of related entities like partnerships and S corporations. Where these entities are so-called TEFRA entities (generally, partnerships with ten or more partners), this can add an even greater level of complexity if the IRS opens a unified proceeding against all the other partners or shareholders, which for closely-held businesses may include other family members. Many GHW audits will likely implicate these complex TEFRA rules in some manner. Moreover, the mandate of these audits is broadened to include transfer tax issues of estate, gift and generation skipping taxes in addition to the income tax issues attendant with LB&I audits. 

Overwhelming

Individuals targeted by GHW will not find the enhanced audit program pleasant and could easily be overwhelmed. At the start of the audit, the IRS will send a notice of the examination and request the individual to sign a detailed audit plan covering topics such as audit expectations and response time frames. Negotiating of the audit plan is critical. An initial conference will be scheduled to discuss the audit plan and it is recommended that the taxpayer be represented by seasoned tax professionals or counsel.

Topics covered at this initial meeting may include the identification of IRS personnel involved in the audit, the individuals authorised to act on behalf of the individual, the audit schedule, response times to information and document requests, agreements on whether the statute of limitations will be extended, and certain due dates or time periods for IRS actions. This opening conference is a crucial opportunity for the taxpayer and his or her representative to explain the tax picture (including organizational charts) and thereby guide the scope of the audit. This is also an opportunity to set IRS expectations regarding realistic time-frames for responding to IDRs which comes from the IRS LB&I experience dealing with tax directors for the taxpayer. 

An agent will typically try to enter into an “understanding” that IDRs must be responded to within ten or 15 days (longer, if international issues are involved). The initial IDR is massive, requesting detailed responses and documents related to almost every business and investment activity of the individual and any related entities. Some GHW standard IDRs have identified 47 different items, including explanations of all sources of income and all assets owned, and ownership interests in partnerships or corporations (with supporting organizational documents).  Given the IRS’s recent increased use of its summons power when information is not provided on time, the ability to negotiate longer response time frames up front can be an important factor in determining the progression of the audit.

The IRS normally will follow up with even more detailed questions after reviewing the initial information provided. At the end of the GHW audit, the IRS will issue a summary report with an explanation of all the proposed adjustments. The GHW audit team will then hold a closing conference with the taxpayers and his or her representative. If these adjustments cannot be resolved through the closing conference process, the taxpayer retains its typical appeal rights and judicial remedies. 

Taxpayers facing a GHW audit need to be prepared for an intrusive examination covering multiple tax years and several entities. The massive amount of information requested, coupled with the IRS’s increased use of its attorneys during the planning and execution of GHW audits, should not be taken lightly. Individuals potentially subject to a GHW audit, or already under audit, should consult their tax advisors to determine the best course of action. This may include a pre-audit analysis of the relevant tax returns that will be subject to review or starting to gather relevant business and investment information and formulating a long-term strategy to minimize the impact of the audit on business activities and preserving the strongest defense to any assertion of additional taxes and penalties. The time of the kinder, gentler IRS audit when there was a fiscal budget surplus is over.

Andrew Roberson and Rogers Jones are partners in the US & International Tax practice group, and Domingo Such is a partner in the Private Client practice group, at McDermott Will & Emery.  Brad McCormack also contributed to this article.