Texas State Bar Tax Section Comments on Proposal to Require Reporting of Uncertain Tax Positions

On behalf of the Section of Taxation of the State Bar of Texas, I am pleased to submit the enclosed comments concerning the Internal Revenue Service (the "Service") proposal concerning reporting of uncertain tax positions.

THE COMMENTS ENCLOSED WITH THIS LETTER ARE BEING PRESENTED ONLY ON BEHALF OF THE SECTION OF TAXATION OF THE STATE BAR OF TEXAS. THE COMMENTS SHOULD NOT BE CONSTRUED AS REPRESENTING THE POSITION OF THE BOARD OF DIRECTORS, THE EXECUTIVE COMMITTEE OR THE GENERAL MEMBERSHIP OF THE STATE BAR OF TEXAS. THE SECTION OF TAXATION, WHICH HAS SUBMITTED THESE COMMENTS, IS A VOLUNTARY SECTION OF MEMBERS COMPOSED OF LAWYERS PRACTICING IN A SPECIFIED AREA OF LAW.

THE COMMENTS ARE SUBMITTED AS A RESULT OF THE APPROVAL OF THE COMMITTEE ON GOVERNMENT SUBMISSIONS OF THE SECTION OF TAXATION AND PURSUANT TO THE PROCEDURES ADOPTED BY THE COUNCIL OF THE SECTION OF TAXATION, WHICH IS THE GOVERNING BODY OF THAT SECTION. NO APPROVAL OR DISAPPROVAL OF THE GENERAL MEMBERSHIP OF THIS SECTION HAS BEEN OBTAINED AND THE COMMENTS REPRESENT THE VIEWS OF THE MEMBERS OF THE SECTION OF TAXATION WHO PREPARED THEM.

We commend the Service for the time and thought that has been put into preparing the proposal, and we appreciate being extended the opportunity to participate in this process.

Although many of the people who participated in preparing, reviewing and approving these comments have clients who will be affected by the federal tax law principles addressed by these comments and frequently advise clients on the application of such principles, none of the participants (or the firms or organizations to which such participants belong) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the subject matter of these comments.

Contact Persons:

I. EXECUTIVE SUMMARY.

The following comments are submitted in response to a request for comments made by the Service in Announcements 2010-9 and 2010-17, issued on January 26, 2010 and March 5, 2010, respectively, regarding a proposal to require certain taxpayers disclose uncertain tax positions. The Service requested comments by June 1, 2010. On April 19, 2010, the Service issued the draft schedule and instructions with Announcement 2010-30.

The following is a summary of our comments.

• Given the foreseeable pressures on Service personnel to use the reported information to propose adjustments, it will be critical to properly train Service personnel, align incentives, and monitor the program to avoid improper and excessive adjustments on audit. In addition, significant additional resources will be required to resolve the treatment of positions during audits, at Appeals and potentially in court.

• Given the potential for significant disruption resulting from implementation of the disclosure requirement, the Service should consider a long transition or pilot period during which Schedule UTP would be required only from a small group of taxpayers.

• The scope of tax positions subject to disclosure should be clarified, consistent with public pronouncements by Commissioner Shulman and LMSB Commissioner Maloy, in instructions for the schedule and any regulations to be issued.

• The Service should eliminate the requirement to report tax positions for which no reserve is recorded because of the Service's general administrative practices, and investigate alternative methods of gathering information about such tax positions.

• The Service should eliminate the requirement to provide a "concise general statement of the reasons for determining that the position is an uncertain tax position," as too likely to require the disclosure of opinion work product. The Service should also formalize a commitment that the government will not take the position that disclosures on Schedule UTP constitute a broad subject matter waiver of any privileges to which the taxpayer is entitled.

• The Service should modify its policy of restraint to renounce requests for tax accrual workpapers if the taxpayer filed Schedule UTP for the years at issue.

• The Service should establish clear guidelines regarding the substantial evidence, obtained only through methods other than reviewing the tax accrual workpapers, required to assert a penalty for failure to disclose an uncertain tax position.

• Given the inherent imprecision involved, taxpayers should not be subject to penalties merely from errors concerning the determination of the maximum tax adjustment.

• Penalties should not be draconian and should contain broad exceptions for good faith and reasonable cause. Penalties should only apply in instances of intentional disregard of the requirements.

• The Service should provide by regulation that a complete and accurate disclosure of a tax position on Schedule UTP constitutes adequate disclosure for purpose of various penalties and extensions of the statute of limitations.

• We concur that it is appropriate to rank transfer pricing and valuation issues separately instead of listing a maximum tax adjustment.

• We generally agree that the calculation of the maximum tax adjustment should relate solely to the tax period in which the position is taken and recommend that net operating losses, excess credits and similar secondary computational adjustments should not be taken into account in determining the maximum tax adjustment.

• We recommend that the definition of a "tax position taken in a return" be modified to require reporting, for certain defined categories of tax positions that have effects in multiple years, only for the year in which the tax position arose.

• With respect to the related entity rules, it is appropriate for reserves of all relevant related entities to be included in Schedule UTP. With respect to the members of a consolidated group, generally only one disclosure schedule should be filed for the consolidated group, and all uncertain positions should be included. However, if both a parent company and a subsidiary prepare GAAP financials and the parent files a consolidated return that includes the subsidiary, we recommend that uncertain tax positions be reported on Schedule UTP for the consolidated return only if the parent company's financial statements include a reserve for the position.

• The monetary thresholds for taxpayers subject to the disclosure requirements should be permanently increased, to include fewer taxpayers.

• The Service should confirm that amendment of information concerning a previously reported uncertain tax position (for example, to revise the maximum tax adjustment) is not required.

• The Service should confirm that pass-through entities, not currently required to file Schedule UTP, will not be subject to penalties for failure to disclose if the Service later concludes the entity should have filed Form 1120 instead of Forms 1065 or 1120 S.

• If the Service later requires pass-through entities to file Schedule UTP, they should report only items that potentially affect their own tax liability, rather than the tax liabilities of their owners.

• The Service should clarify requirements for entities owning an interest in a pass-through entity to report pass-through items on Schedule UTP.

• Uncertain tax positions of disregarded entities should be included on the Schedule UTP filed by the owner of the disregarded entity.

• For tax-exempt entities, there should be no requirement to file Schedule UTP since uncertain tax positions are already disclosed on Schedule D-Part X of the Form 990.

On January 26, 2010, the Service issued Announcement 2010-9 concerning a proposal to require certain taxpayers to file a new schedule with their tax returns, reporting any "uncertain tax positions." The Announcement provided general guidance concerning the intent of the new program and solicited comments, including responses to eight specific questions. On March 5, 2010, the Service issued Announcement 2010-17, extending the deadline for comments and requesting comments on three supplemental questions. Drafts of the new Schedule UTP and instructions were released with Announcement 2010-30 on April 19, 2010.

The proposal, as set forth in Announcement 2010-9 and clarified in the new schedule and instructions, would require business taxpayers with more than $10 million in total assets to report a concise description of each uncertain tax position in sufficient detail so that the Service can determine the nature of the issue, along with a concise general statement of the reasons for determining that the position is an uncertain position and the maximum amount of potential federal tax liability attributable to the uncertain tax position.

Uncertain tax positions are described as positions for which a tax reserve must be established under generally accepted accounting principles ("GAAP"). For purposes of the proposed disclosure, GAAP includes Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109 ("FIN 48")¹ or other accounting standards, such as International Financial Reporting Standards ("IFRS") or a foreign country's GAAP subject to which the taxpayer issues financial statements. Uncertain tax positions also include other positions for which the taxpayer or a related entity has not recorded a tax reserve because (i) the taxpayer expects to litigate the position and prevail, or (ii) the taxpayer has determined that the Service has a general administrative practice not to challenge the position.

III. COMMENTS.

We commend the Service for the time and thought that has been put into preparing the proposal. We also appreciate the opportunity to comment on the proposal and hope that our comments prove to be helpful.

A. GENERAL COMMENTS

In addition to our responses to the specific questions posed by the Announcements, we offer the following general comments and observations.

Practical Effect

Tax positions are uncertain for a number of reasons. As Commissioner Shulman recognized in recent comments to the Tax Executives Institute Midyear Conference, these reasons may include ambiguity in the law and a lack of public guidance on issues. An uncertain tax position may, and often will, simply reflect the taxpayer's honest effort to apply the tax law correctly rather than an aggressive interpretation of the law in the face of contrary guidance or case law. Often, the correct resolution of an uncertain tax position will be no adjustment of the taxpayer's return position. It is clear from public pronouncements that Service management understands this and does not intend that Exam automatically propose adjustments for all disclosed uncertain tax positions. However, we have serious concerns about the practical effects of the proposed disclosure requirement.

Under FIN 48, the taxpayer generally must establish a reserve in its financial statements for part or all of the tax benefit from a return position unless it is more likely than not that the Service would fully concede the issue prior to litigation.² Based on our experience, although Appeals normally will not demand concessions based on "nuisance" value, it is unlikely that the Service will fully concede the issue unless it assesses the probability that the taxpayer would prevail in litigation as at least 80%. This is consistent with our understanding of the "strong should" degree of confidence at which accounting firms typically do not require a reserve for financial reporting purposes.

Service personnel will know, simply from the fact that a position was listed on Schedule UTP, that the taxpayer determined it probably would have to concede at least a partial adjustment if the Service challenges the position. These will appear to be easy sources of additional tax collections, based on the taxpayers' own assessments. Also, Congress, the Executive Branch, the media, and the general public may not have the same understanding as the Service that an uncertain tax position is often completely proper, and could react negatively if uncertain tax positions are not always disallowed. As a result, the Service will need to provide extensive training and align incentives to ensure that Service personnel use the information as intended and withstand the foreseeable pressure to automatically propose adjustments for virtually all reported positions.

It will also be necessary to quickly and efficiently identify and resolve common issues. Exam will have enough published guidance and other authority to resolve many of the uncertain tax positions but other positions may be uncertain because of the lack of such authority. A thoughtful review and evaluation of the latter will require extensive coordination at National Office. As with other issues identified by Exam, such coordination will help avoid wasteful duplication of effort and promote consistency. Depending on the volume of disclosures, however, the amount of time and effort required may well increase significantly.

In summary, we believe that for this disclosure process to be effective and meet the Commissioner's stated goals of certainty, consistency and efficiency, the following components of the implementation will be critical:

• Establish and conduct comprehensive training for Exam and Appeals personnel concerning the proper handling of uncertain tax positions during an audit or appeal.

• Properly align incentives.

• Carefully monitor performance to ensure training and incentives are working as intended.

• Allocate additional resources within National Office to provide timely guidance as necessary for the proper and consistent resolution of uncertain tax positions.

• Anticipate that additional resources will be needed by Appeals to properly handle a larger number of audit adjustments relating to disclosed uncertain tax positions.

Scope of Tax Positions Subject to Disclosure

We believe it is important to clarify the scope of tax positions subject to disclosure, particularly with respect to questions of materiality and level of aggregation. The Service has addressed these to some extent in public announcements. For example, Chief Counsel Wilkins, in a presentation to the District of Columbia Bar Tax Section, stated that the Service intended that "the schedule key[] off what the company's accounting practice is," that is, that the proposed disclosures generally would be consistent with and based on the work done for the financial reserves. He noted further that the Service would not impose any penalty for failure to report a position that the company did not reserve (other than the positions for which the taxpayer does not record a reserve because of intent to litigate or the Service's general administrative practices). Similarly, in his speech to the New York State Bar Association, Commissioner Shulman expressed his opinion that the new requirement would not impose a significant compliance burden because "[t]he work is already being done."

The draft instructions clarify that, other than with respect to the exceptions for intent to litigate and general administrative practices, only items for which a reserve is recorded need be reported and that the unit of account for the new schedule should be the same as for financial reporting. We believe that, on balance, this is an appropriate standard, although there are some associated disadvantages. For example, there may be some reduction in consistency, as identical and comparably sized transactions might be reported by a smaller taxpayer but omitted by a larger taxpayer simply as a result of the materiality limitation, and different taxpayers may aggregate differently. There are also, however, several advantages to this standard. It provides clarity, minimizes the increase to the taxpayer's compliance burden, reduces the number of positions disclosed to a more manageable number for the Service's review, and alleviates the potential unfairness of a penalty imposed because of differences of opinion concerning materiality or how to aggregate items.

The proposal in Announcement 2010-9 would require reporting of tax positions for which a company does not record a tax reserve because of intent to litigate or the Service's general administrative practices. The FIN 48 standards for level of aggregation ("unit of account") and materiality do not come into play explicitly for such positions, and in fact, taxpayers may not go through a FIN 48 analysis for such positions.

The draft instructions state that the category for administrative practice includes "a tax position for which a reserve would have been recorded in the audited financial statement but for a determination that, based upon past administrative practices and precedents of the IRS in dealing with the tax position of the taxpayer or similar taxpayers, the IRS has a practice of not challenging the tax position during an examination." We believe that the "but for" standard is appropriate and incorporates the same materiality and unit of account standards as uncertain tax positions for which a reserve is recorded. We recommend that this definition and standard be incorporated in regulations.

The draft instructions state that the category for intent to litigate includes "a tax position for which a reserve was not recorded in the audited financial statement after the taxpayer or a related party determines that, if the IRS had full knowledge of the tax position it is unlikely a settlement could be reached. For this purpose, a settlement is unlikely if the probability of settlement is less than 50%." We believe that this standard is broader than appropriate, as it could be interpreted to include tax positions for which no reserve would be necessary even absent the intent to litigate. We recommend that this definition and standard, for the instructions and regulations, follow a similar "but for" standard as used for the administrative practice category. For example, it might be defined as "a tax position for which a reserve would have been recorded in the audited financial statement but for the taxpayer's determination that it will litigate, and prevail, rather than settle the issue with the IRS."

We believe the above are appropriate standards and recommend they be incorporated in regulations as well as the instructions for Schedule UTP.

Finally, as discussed further below, we believe the Service should not require reporting on Schedule UTP for those tax positions for which the taxpayer does not record a tax reserve solely because of the Service's general administrative practices. Instead, the Service should consider alternative methods to identify and evaluate such positions.

Privilege and Waiver

We recognize and appreciate what appears to be intended to be a de facto compromise in requesting sensitive information from taxpayers. However, we believe some modifications of the proposal would increase taxpayer comfort with the disclosure without significantly impeding the Service's purposes in requesting the information.

We do not share the Service's apparent conclusion that the information sought is not protected by various privileges. In particular, we believe that the proposed disclosures will undoubtedly compromise the work-product privilege in many circumstances.

The Supreme Court first articulated the work-product doctrine in Hickman v. Taylor,³ and the Advisory Committee incorporated it into the Federal Rules of Civil Procedure in 1970.⁴ It generally protects from discovery "documents and tangible things that are prepared in anticipation of litigation or for trial by or for another party or its representative."⁵ Although that protection may be overcome on a showing of substantial need, courts are directed to "protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of a party's attorney or other representative."⁶ In Upjohn Company v. United States⁷ the Supreme Court recognized that the protection is much stronger with respect to such opinion work-product⁸ and some courts have held that the protection is nearly absolute.⁹

Schedule UTP primarily focuses on factual information about tax positions, rather than opinion work product often contained in tax accrual workpapers, such as the analysis of possible arguments and an overall assessment of the relative strength of the position and the hazards of litigation. However, there are aspects of the information required to be disclosed that clearly constitute opinion work product.

First, the inclusion of a tax position on Schedule UTP does not disclose the taxpayer's exact risk assessment, but it does demonstrate that the taxpayer assesses the risk as high enough that the Service probably would not fully concede the issue. This is a limited disclosure but it is still opinion work product. Second, and more important, the proposal requests "a concise general statement of the reasons for determining that the position is an uncertain position." Similarly, the draft instructions include, as part of the concise description in Part III of the schedule, "the reasons for determining the position is uncertain." It is difficult to interpret this as asking for anything other than the taxpayer's assessment of the relative weaknesses of that position, since that assessment drives the decision to record a reserve for an uncertain tax position. All three examples given in the draft instructions are consistent with this interpretation. Therefore, the schedule and instructions appear to request the taxpayer's "conclusions, opinions, or legal theories," that is, opinion work product.

Taxpayers have legitimate concerns about the disclosure of information that is protected by work-product or other privileges, as well as the possibility that the Service could later argue that the disclosures constitute broad subject matter waivers of any privilege. The possibility of waiver is particularly troublesome as the waiver, if it is such, is effectively required. This could essentially eliminate the privilege altogether for any such uncertain tax positions. In the context of requests for tax accrual workpapers, taxpayer concerns over privilege and waiver often lead to costly and time-consuming litigation to resolve the dispute. Although the proposed disclosures are less intrusive than a request for tax accrual workpapers, they are also being directed at a much larger population of taxpayers. As the proposal is structured, there is a significant possibility of dramatic increases in the resources needed to litigate privilege disputes.

A substantial increase in such litigation over privileges or waiver is not in the interest of either the Service or taxpayers. Both taxpayers and the Service would expend significant time and expense and, even if the Service ultimately prevailed, the actual disclosures by those taxpayers who choose to litigate could be significantly delayed. Consequently, we recommend the following modifications to the proposal. We believe that these constitute a reasonable compromise and would alleviate most taxpayers' concerns to the point that litigation likely would be unnecessary.

First, we recommend that, in appropriate regulations, the Service confirm that the government will not take the position that Schedule UTP disclosures constitute a broad subject matter waiver of any privileges to which the taxpayer is entitled and that the disclosure requirements do not alter the otherwise applicable law relating to such privileges. We assume this is the Service's intent but believe the commitment should be formalized.

Second, we recommend that the Service modify its policy of restraint to declare that it will not request tax accrual workpapers from any taxpayer who has disclosed its uncertain tax positions on Schedule UTP. In various public statements, Service personnel have stated that the Service would not, as a result of the new program, request additional tax accrual workpapers otherwise restricted by its policy of restraint. We agree that the policy of restraint should not be loosened as a result of the new program but believe the Service should go further and explicitly modify the policy of restraint to rule out such workpaper requests if the taxpayer has filed Schedule UTP.¹⁰ Although the Service may need additional facts about some of the uncertain tax positions, those can easily be obtained through normal channels in the course of the audit once the position has been identified. The only other information in the tax accrual workpapers would be the taxpayer's analysis and risk assessment. Under ordinary circumstances, we see no legitimate purpose for the Service to have that information.

Third, we recommend that the Service eliminate from the information to be disclosed the "concise general statement of the reasons for determining that the position is an uncertain tax position" or "reasons for determining the position is uncertain." If the reasons why the return position is uncertain are factual in nature and unknown to the Service, such a request may be appropriate, but the information likely can be obtained as easily through normal channels during the audit rather than on the proposed schedule. If the reasons are legal in nature, they likely fall within the realm of opinion work product. In addition, our experience is that the Service has no difficulty, once it has the relevant facts, identifying the arguments that could be used to challenge a tax position. Even in an audit, the Service does not normally ask the taxpayer to provide a statement of why the tax position is uncertain or incorrect. Schedule UTP requests an explanation of the reasons for the taxpayer's return position, and that information should be sufficient. Accordingly, we believe a statement of why the taxpayer's position is uncertain is of minimal value to the Service, while requesting such information raises significant privilege concerns for the taxpayer. Therefore, the Service should not request a "statement of the reasons for determining that the position is an uncertain tax position" or the "reasons for determining the position is uncertain."

Transfer Pricing

As recognized in the instructions to Schedule UTP, transfer pricing issues are unique in terms of the maximum tax adjustment. We agree that it is appropriate to rank transfer pricing and valuation issues separately instead of listing a maximum tax adjustment.

We recommend that the Service consider specifying in the instructions that taxpayers should note in the "Concise Description" or elsewhere whether the issue is being considered or has been considered by the Advance Pricing Program or the United States Competent Authority. This would help avoid situations where Exam may review transfer pricing issues that are more properly addressed by other Service functions, and/or would not ultimately benefit the United States tax base.

In this regard, we recommend that the Service issue internal guidance regarding the use of Schedule UTP in these situations, in order to properly focus Exam's attention upon productive issues.

Penalties

Announcement 2010-9 states that the Service is evaluating additional options for penalties or sanctions when a taxpayer fails to make adequate disclosure of its uncertain tax positions, including legislation imposing penalties specific to the new disclosure regime and associated form. We believe that the existing penalty regimes, if extended to the new disclosure requirements, are sufficient.

For example, the accuracy-related penalty of Section¹¹ 6662 et seq. and other applicable penalties are sufficient to incentivize taxpayers to comply with their tax obligations. In this regard, we note that the disclosure of uncertain tax positions is not primarily intended to increase tax compliance (although that may be a significant benefit), but to reduce the fact-finding and analytical burden on the Service's Examination function and to prioritize and speed up the examination of uncertain tax issues.

However, the Service appears to be primarily concerned that there is no incentive for taxpayers to fully comply with or even file the new uncertain tax position disclosure schedule. We agree that existing penalties likely would not apply to the omission of specific tax positions from, or errors concerning the amount of a maximum tax adjustment reported on, Schedule UTP.¹² Therefore, the Service may consider a new penalty regime necessary to ensure disclosure of uncertain tax positions. We are generally concerned, however, about the proliferation and duplication of penalties under the Code.

Whether under an existing penalty provision or a new penalty regime, we recommend that the Service establish clear guidelines concerning the investigation and assertion of potential penalties for tax positions not reported on Schedule UTP. We recommend that the Service confirm that any penalty for failure to report a specific tax position on Schedule UTP will apply only if: (a) the financial statement reserves include the position; or (b) in the case of a position for which no reserve was established because of the taxpayer's intent to litigate if necessary, the position was considered during the reserve analysis and expressly excluded because of the intent of litigate. Applying penalties for a position not included in the reserves and not even considered during the reserve analysis would introduce complicated questions of whether the tax position met the requirements for disclosure on Schedule UTP.

As discussed below, we recommend the elimination of the category of tax positions for which no reserve is reported because of the Service's general administrative practice not to challenge the position on examination. If that category is not eliminated, it should be treated for penalty purposes similarly to the category of intent to litigate. That is, a penalty should apply only if the tax position was considered during the reserve analysis and expressly excluded because of the general administrative practice.

Because the obligation to report a tax position on Schedule UTP derives from its inclusion in the financial statement reserves, penalties for failure to report a tax position on Schedule UTP also raise significant concerns over taxpayer privileges and the Service's policy of restraint with respect to tax accrual workpapers. We recommend that the Service carefully consider these concerns in designing its guidelines for the investigation and assertion of such penalties. For example, the Service should develop methods of identifying whether a tax position was improperly omitted from Schedule UTP that do not involve reviewing the tax accrual workpapers.¹³ We also recommend that the Service modify the policy of restraint to specifically renounce requests for tax accrual workpapers to determine whether to apply a penalty for failure to disclose a tax position on Schedule UTP.

In addition, the Service should establish clear standards regarding: (a) the substantial evidence required to assert a penalty for failure to disclose; and (b) acceptable methods for taxpayers to defend against such penalties without being required to produce tax accrual workpapers. Clearly, a significant tax adjustment related to a tax position not reported on Schedule UTP, by itself, is not sufficient basis to assert the penalty. Just as uncertain tax positions will often be correct, a disallowed tax position is not necessarily "uncertain" within the definitions in the draft instructions.

We further recommend that, given the inherent imprecision involved, taxpayers should not be subject to penalties merely from an error concerning the determination of the maximum tax adjustment, except perhaps in cases of fraudulent intent, intentional misrepresentation, or similar cases.

In the event that a separate penalty regime is established, we recommend that material penalties should only be imposed in the case of intentional disregard. Limiting any new penalty regime to intentional disregard would benefit both the Service and taxpayers. For taxpayers, imposition of a reasonable penalty regime would prevent inequitable imposition of penalties, in recognition of the difficulty and uncertainty associated with evaluating whether and to what extent, tax positions are uncertain. For the Service, imposition of a reasonable penalty regime would greatly enhance the efficacy of the new reporting requirement. A more draconian penalty regime would encourage taxpayers to protectively list more tax positions and inflate the maximum tax adjustments, preventing the Service from easily evaluating the most important uncertain tax positions.

To the extent that the penalty regime is not confined to intentional disregard of the requirements for Schedule UTP, we recommend that the penalty regime contain broad good faith or reasonable cause exceptions, for the same policy reasons outlined above.

Finally, we recommend that any penalty, for all cases other than intentional disregard or other similar situations, be either an enhancement of accuracy-related or other penalties with respect to an adjustment or a small flat fee penalty. Large penalties such as those imposed under Sections 6707 or 6707A, applicable only in circumstances that the Service considers potentially abusive, are inappropriate for a disclosure requirement applied routinely and broadly to so many taxpayers, except in the most egregious circumstances. Further, the history of strict liability penalties shows that exceptions for reasonable cause and good faith should apply.

To the extent that the penalty is percentage-based or is an "enhancement" to or related to an accuracy-related or other penalty with respect to an adjustment, such penalty should be applied solely to the issue that was not disclosed on Schedule UTP. While this should be an obvious requirement for any new penalty regime with respect to the schedule, it is critical to ensure that non-disclosure does not result in the imposition of disproportionate penalties.

B. QUESTIONS FROM ANNOUNCEMENT 2010-9

Based on the draft instructions, the Service appears to have rejected, at least for now, the idea of using dollar or percentage ranges rather than specific dollar amounts. As a general matter, we concur and believe that, at least initially, appropriate dollar ranges would not be a useful way to measure the magnitude of reported tax positions. If the range is used to adjust for risk assessment without disclosing the exact assessment, we believe it would be an improper, even though limited, invasion of the taxpayer's thought processes and opinion work product. It would be better not to introduce risk assessment at all. If the range is used in recognition of the inherent imprecision in measurement, it provides little if any benefit to the Service. If penalties are not imposed for erroneous but good-faith calculations of the maximum tax adjustment, as recommended above, reporting by ranges also provides little if any benefit to taxpayers. Finally, we believe that the Service's definition of appropriate ranges at this time may be premature. After it gains more experience with actual filings on Schedule UTP, the Service may be better able to define ranges that would be appropriate and useful for its evaluation.

While we understand that the Service is concerned that the new schedule achieve its stated purpose -- (prioritizing issues and increasing examination efficiency) -- ending the calculation of a maximum tax adjustment to the effect in multiple years will significantly increase the administrative burden on taxpayers while resulting in little to no increase in the utility of the schedule for prioritizing issues. Specifically, it is often significantly more difficult to calculate the impact of a particular adjustment on a multiple year basis, thus increasing the compliance burden upon taxpayers.

For the Service, an accurate comparison of the uncertain tax positions on an annual basis would appear to better achieve the objective of the schedule to prioritize examination issues. Calculating the maximum tax adjustment on a multiple year basis would result in smaller multiple year issues being prioritized over larger single year issues. While this could be beneficial with respect to some issues, it could lead to focusing on issues that are (i) beyond the scope of the current examination and/or (ii) more routine and non-controversial issues (such as timing differences) over more uncertain issues. In addition, a brief analysis by Exam of the type of issue should allow the Service to gauge the effect upon multiple tax years.

We do, however, recommend some clarification or modification of the tax periods for which a tax position should be reported, based on the definition of a "tax position taken in a tax return." It is important to note the distinction between multiple-year adjustments or issues, which are properly reported in multiple years because the adjustment in each year is determined primarily by facts applicable to that year, and single-year adjustments or issues that have effects in multiple years. For example, certain credits, net operating losses (NOLs), depreciation, and various other standard tax items are determined primarily with respect to a single year, with purely computational effects on the taxation of other years. We recommend that tax positions be reported on Schedule UTP for the tax period in which they arose, and a maximum tax adjustment be calculated solely with respect to such year. The draft instructions define a "tax position taken in a tax return" as a position "that would result in an adjustment to a line item on that tax return." In the case of single-year adjustments or issues that have effects in multiple years, we believe that would inappropriately require reporting such tax positions in multiple years. There are two specific categories of such adjustments or issues that we believe warrant reporting only in a single year.

First, we see no value to the Service of reporting in multiple years certain tax positions that, if not sustained, would result in adjustments that completely offset over time (temporary differences). For example, a position with respect to the classic deduction versus capitalization issue could affect multiple years, but we recommend that the maximum tax adjustment be calculated only for the return year in which the position first arises. In the case of disallowance of immediate deduction in favor of capitalization, the maximum tax adjustment would be calculated solely for the year in which the deduction is denied. It would take into account the loss of the deduction and any applicable depreciation or amortization relative to the capitalization of the expense for that year only. If the tax position were not sustained, there would be adjustments in other years, but a maximum tax adjustment in those other years would be negative, reflecting that the tax liability would decrease rather than increase. Reporting the issue in the year in which it arose, combined with an indication on Schedule UTP that the tax position concerns a temporary difference, should be enough information for the Service to determine whether to examine the position.

Second, in most circumstances a secondary effect that merely shifts the increased tax liability from one year to another, because losses or credits are carried back or forward, should not be taken into account in calculating the maximum tax adjustment, because it will multiply the taxpayer's reporting requirements without providing significant benefit to the Service. For example, consider a situation with a $100 NOL carryforward that cannot be used in 2011 because 2011 has insufficient taxable income. The NOL therefore is carried forward and used in 2012. If $500 of deductions taken in 2011 are later disallowed, increasing taxable income, the NOL may now be used in 2011 and therefore is not available in 2012. The cumulative effect of the disallowance may approximate 35% of the $500 disallowed deductions. Although the disallowance of the deduction will shift an NOL or credit from 2011 to 2012, taking that shift into account when calculating the maximum tax adjustment merely changes the year in which the cumulative effect is realized and requires the taxpayer to report the uncertain tax position in both years. In addition, the exact determination of such secondary effects may depend on the interplay of multiple items and cannot easily be determined with respect to one particular uncertain tax position. We believe that ignoring that shift in the computation would minimize the taxpayer's compliance burden, by simplifying the calculation and requiring that the position be reported only once, in 2011. It also would focus the Service on the year in which it is most appropriate to examine the position -- 2011, rather than 2012. This seems adequate for the Service's purposes in requesting the information.¹⁴

We believe that reporting these two types of tax positions in multiple years would be inappropriate, as taxpayers' compliance burden would far outweigh any minimal benefit to the Service. However, reporting in multiple years would appear to be required by the definition in the draft instructions of "tax position taken in a tax return" as a position that would result in an adjustment to a line item on the return if the position is disallowed. We recommend that this definition be modified to limit the reporting of such positions to the year in which they arise.

In the case where both a parent company and subsidiaries prepare GAAP financials and the parent files a consolidated return that includes the subsidiaries, we recommend that uncertain tax positions be reported on Schedule UTP for the consolidated return only if the parent company financial statements include a reserve for the position. The examination and review of financial statements for all of the subsidiaries will not substantially increase the disclosed items, and to the extent additional items are listed, they are likely immaterial to the consolidated return. Therefore, this recommendation does not impact the Service's objectives with respect to the uncertain tax positions schedule. However, requiring parent companies to review subsidiary financials in detail will impose an undue compliance burden upon them. Essentially, the substantial costs outweigh the immaterial benefits.

As defined, these positions would not warrant disclosure because of the very high probability that no adjustment would be made. We understand that the Service may be uncomfortable relying on the definition in FIN 48 without knowing more about what types of tax positions might fall within this category. However, FIN 48 is applied based on a presumption that the tax position will be examined by the Service with full knowledge of all relevant information, the exception is limited to general administrative practices that are "widely understood," and the taxpayer's application of FIN 48 is subject to review by independent auditors. We therefore believe that there are few abuses of this provision and that requiring their disclosure would increase the compliance burden to taxpayers -- who may normally conduct an abbreviated and informal FIN 48 analysis, if any, for such positions -- without materially improving the Service's ability to enforce the tax law.

We recommend that, instead of requiring disclosure of these positions, the Service investigate alternative methods of determining whether such positions warrant review and investigation during examinations. For example, the Service could request such information, informally as a pilot project, from a small number of taxpayers such as those involved in the Compliance Assurance Program (CAP). The Service could use data it obtains from such a pilot project to evaluate whether the benefits of requiring disclosure of such positions would warrant the additional compliance burden on taxpayers and time and effort for the Service to review.

We believe that there should be a transition period of a year or longer, in which only certain taxpayers should be subject to reporting. This group could include CAP taxpayers or another small group of taxpayers where Service examination personnel have significant knowledge of the taxpayer. Alternatively, a transition period in which the schedule is prepared by only those taxpayers with assets of greater than $50 million or revenues greater than $500 million is appropriate.

In addition, we recommend that the Service consider permanently increasing the thresholds for taxpayers subject to reporting. The administrative convenience to the Service likely does not outweigh the significant compliance burden on taxpayers below a certain threshold.

Finally, we recommend that the Service require Schedule UTP only from those taxpayers who are required to routinely file GAAP financial statements with the Securities and Exchange Commission or another governmental agency. This would exempt those taxpayers who do not regularly prepare GAAP financial statements but may need to do so occasionally for a limited purpose, such as obtaining a loan. Taxpayers who are not required to file GAAP financial statements every year are less likely to have developed systems or procedures that would facilitate preparation of Schedule UTP. The reporting requirements would likely impose a significant compliance burden on the taxpayers while providing minimal, if any, benefits to the Service.

We do not believe that adding complexity by including tax positions taken in past returns on the current year's schedule is necessary given the relatively small number of such positions. While we do not believe that the added complexity is justified, if the Service requires taxpayer to identify positions not previously reported, the schedule should designate that the item existed, but was not disclosed, in a prior year.

In summary, we believe that the current Part II of Schedule UTP and related instructions thereto take the correct approach and generally should not be modified. However, we recommend some clarifications.

We recommend that the Service confirm that there is no duty to amend, either in Part I or Part II, information about a previously reported tax position, for example, to change the amount of the maximum tax adjustment. Once a tax position is reported, whether in Part I or Part II, the Service is on notice about the item. Taxpayers should not be required to revise or amend information provided in good faith. If inaccurate or incomplete information is reported intentionally or in bad faith, a penalty regime can address such problems, as discussed elsewhere herein.

We also recommend that the Service explicitly limit the prior tax years which have to be reported on Part II of Schedule UTP to years for which statutes of limitation for adjustments are open, and in no event more than the six prior years. While a limitation to open years is implicit in the scope of the schedule (as it relates to financial statement reserves), we believe that such a clarification is appropriate. We believe an overall limit of the six prior years, even if the statutes of limitation are still open, is also appropriate. An uncertain tax position will be reported no later than the first tax return filed at least 60 days after the decision to establish a reserve. Very rarely, if ever, will a taxpayer first identify and decide to establish a reserve for an uncertain tax position more than six years after filing the tax return on which it took the tax position.

Calculating maximum tax adjustments with respect to every uncertain tax position is both imprecise and imposes a significant compliance burden. We believe that a ranking or grouping of issues may be equally useful to examination team, while reducing the compliance burden on taxpayers. In addition, as calculations of maximum tax adjustments are often inaccurate and/or misleading (as they do not take into account correlative issues), eliminating this requirement would not significantly reduce the efficacy of the schedule.

While the schedule notes that taxpayers are responsible for a "concise description" of uncertain tax positions, the examples in the instructions indicate that the description is intended to summarize the entire issue. Taxpayers are therefore left with the choice between briefly summarizing an issue, but not providing context, or providing so much information that the schedule becomes a significant compliance burden.

We recommend that the description of the item be limited to one line and be in the nature of a title or heading. A brief description plus the code sections relevant to the position should be sufficient to identify the issues and prioritize examination resources. Further factual development can take place during the actual examination. It is likely that examining agents would need to perform additional development as to a position regardless of the length of the "concise description." Reducing the length of the description, therefore, would not significantly increase the Service's burden but would significantly decrease the compliance burden on numerous taxpayers.

C. SUPPLEMENTAL QUESTIONS FROM ANNOUNCEMENT 2010-17

Form 8082, Notice of Inconsistent Treatment, and Form 8886, Reportable Transaction Disclosure Statement, serve a similar purpose of alerting the Service to items on the tax return that may warrant closer review. Because not all inconsistent treatments or reportable transactions will require a reserve in financial statements, many of the items reported on these forms will not be disclosed on Schedule UTP. To the extent that an item is reported on Schedule UTP, however, we recommend that such disclosure be treated as if the taxpayer had filed Form 8082 as appropriate, and that the taxpayer need not file that form with respect to that position. Because the Service presumably will still require taxpayers to file Form 8886 with the Office of Tax Shelter Analysis, including it with the taxpayer's return, although arguably unnecessary, requires minimal additional effort.

In addition to excusing the taxpayer from filing other forms, we further recommend that the Service explicitly provide, by regulation, that a complete and accurate disclosure on Schedule UTP constitutes adequate disclosure for purposes of various penalties or statute of limitations provisions, including:

• Accuracy-related penalties, Section 6662(d)(2)(B)(ii)(I)

• Reasonable cause exception for reportable transaction understatements, Section 6664(d)(2)(A)

• Extension of statute of limitations for undisclosed listed transaction, Section 6501(c)(10)

• Extension of statute of limitations for substantial omission of income, Section 6501(e)(l)(A)(ii)

• Extension of statute of limitations for substantial omission of income, Section 6229(c)(2)¹⁷

As discussed above, we recommend that the Service not require taxpayers to disclose the reasons for concluding that a tax position is uncertain. We further recommend that the Service clarify that listing an uncertain tax position on Schedule UTP will be deemed adequate disclosure for the above purposes even if Schedule UTP does not disclose the reasons that the taxpayer considers the position uncertain. In particular, we recommend that Schedule UTP be considered adequate disclosure even without identifying the statutory or regulatory provision or ruling disregarded.¹⁹ Once the taxpayer discloses an uncertain tax position on Schedule UTP, Exam personnel are more than capable of identifying inconsistent statutory or regulatory provisions or rulings. Alternatively, if identification of inconsistent statutory or regulatory provisions or rulings on Schedule UTP will be required to qualify as a deemed Form 8275 or Form 8275-R, the Service should clarify that requirement so that taxpayers understand what they will have to disclose to qualify for penalty protection.

In addition, we have set forth our recommendations with respect to how Schedule UTP should (or should not) apply to pass-through entities and tax-exempt entities, for the Service's consideration in development of future versions of the schedule and instructions. We understand that although pass-through entities and tax-exempt entities are generally not yet required to report uncertain tax positions on Schedule UTP, the Service is still considering how to address such uncertain tax positions and the requirements may be extended to such entities at some point in the future. Our recommendations with respect to partnerships, S corporations, and tax-exempt entities are set forth separately below.

We recommend that the Service confirm that pass-through entities and tax-exempt entities are currently not subject to the disclosure requirements with respect to Schedule UTP. Although the draft instructions do not list Forms 990, 1065, or 1120 S among those for which Schedule UTP must be prepared, it is unclear whether the Service might later assert a penalty based on an argument that the taxpayer should have filed Form 1120 instead. For example, one common uncertain tax position recognized by FIN 48 is whether an entity was properly classified for tax purposes. Yet pass-through entities and tax-exempt entities would not, based on the current instructions, file Schedule UTP, even to report such uncertain tax positions that could result in tax liabilities at the entity level rather than the owner level. We recommend that the Service clarify that it would not assert any penalties for failure to file Schedule UTP even if the Service later determines that a pass-through entity or tax-exempt entity was misclassified and should have filed Form 1120.

With respect to owners of pass-through entities, we interpret the draft instructions as only requiring such owners to file Schedule UTP if they otherwise meet the requirements for reporting uncertain tax positions. That is, they would only file Schedule UTP if: (a) they file Forms 1120, 1120 F, 1120 L, or 1120 PC; (b) they have more than $10 million in assets; and (c) they issue GAAP financial statements including a reserve for uncertain tax positions.

Although it is implied by the draft instructions, we recommend that the Service clarify that owners need report only tax positions concerning items from a pass-through entity for which the owner establishes a reserve, or would have established a reserve but for its intent to litigate or reliance on the Service's general administrative practices, for the position. Owners may not have control over or access to the information necessary to identify potential exposure from the pass-through entity. Second guessing the owners, by requiring them to report items for which they did not establish a reserve, would be unfair in comparison to the treatment of other taxpayers.

If the owners are required to report pass-through tax positions for which they did not establish a reserve, however, we recommend that the Service establish appropriate defenses or "safe harbors" against subsequent claims by the IRS that a position was improperly omitted from Schedule UTP. In addition, because the owners of pass-through entities may have difficulty obtaining the information necessary to accurately complete Schedule UTP, we recommend that the Service should establish clear guidelines with respect to the appropriate due diligence required by owners of interests in pass-through entities to identify items for inclusion on Schedule UTP.

We recommend that a partnership not be required to report other tax positions that would affect only the tax liability of the partners. Although it may be most appropriate to examine such tax positions at the level of the partnership rather than the partners, there is a significant definitional problem. Because those tax positions do not affect the tax liability of the partnership, the partnership presumably will not have established a reserve in its financial statements. Thus, requiring the partnership to report such tax positions would impose a significantly higher compliance burden. For other taxpayers, the Service has stated that it does not intend to challenge the financial statements but instead would "piggyback" on them. The taxpayer need only report the items for which it established a reserve²¹ and the Service will not second guess the decision of whether or not a reserve should have been established. Because the partnership presumably would not establish a reserve for a tax position that would affect only the partners' tax liabilities, requiring the partnership to report such tax positions would require difficult determinations of materiality and level of aggregation and provide no "safe harbor" comparable to that for other taxpayers. Accordingly, we believe that such tax positions should be reported, if at all, only by the partners.

Second, the shareholders in an S corporation will be, or should be, exempt from reporting any tax positions related to their pro rata share items from the S corporation. The shareholders are limited to individuals, estates, certain trusts, and certain tax-exempt entities. Individuals are not subject to reporting of uncertain tax positions. As discussed below, we recommend that tax-exempt entities not be subject to the reporting requirement. We believe that estates and the trusts that are allowed as shareholders of S corporations also will not, or should not, be required to report uncertain tax positions.

The Instructions for Schedule D (Form 990) at Part X. Other Liabilities -- state the following: "Complete Part X if the organization answered Yes on Form 990, Part IV, line 11, and either reported an amount on Form 990, Part X, column (B), line 25 (Other liabilities), or had financial statements for the tax year that include a footnote addressing the organization's liability for uncertain tax positions under FIN 48. Organizations are required to separately report all liabilities for federal income taxes and amounts owed to related organizations on Part X of this schedule."

Part X of Schedule D has two lines. Line 1 requires the organization to list each type of liability not reported on lines 17 through 24 of Form 990, Part X (which is the Balance Sheet in the Form 990). The organization can use any reasonable basis to classify these liabilities. The book value of each liability must be entered and the total of all of those liabilities must be equal to Form 990, Part X, line 25 -- Other Liabilities on the Balance Sheet. This could include disclosed income tax liabilities.

The Instructions for Line 2 -- FIN 48 Footnote -- require the following, "Every organization required to complete Part X must provide the text of the footnote to its financial statements, if applicable, regarding the organization's liability for uncertain tax positions under FIN 48. This includes, for example, the description of a liability for unrelated business income tax, or tax that may be assessed as a result of the revocation of exempt status. Any portion of the FIN 48 footnote that addresses only the filing organization's liability must be provided verbatim. The filing organization can summarize that portion, if any, of the footnote that applies to the liability of multiple organizations including the organization (for example, as a member of a group with consolidated financial statements), to describe the filing organization's share of the liability." The text of the FIN 48 footnote is to be included in Part XIV of Schedule D.

The draft instructions to Schedule UTP, in the Who Must File section at 2, state that the corporation assets are equal to or exceed $10 million. Corporations with less than that level of assets will not be required to attach Schedule UTP. By comparison, there is no minimum asset level in the Schedule D instructions for tax-exempt entities. Therefore, the coverage of organizations required to report uncertain tax positions on Form 990, Schedule D, is broader than the coverage of organizations required to attach Schedule UTP to the corporate tax return.

FASB Accounting Standards Update No. 2009-06 added, as FASB Accounting Standards Codification (ASC) 740-10-55-225, Example 34 that illustrates FIN 48 principles as applied to a tax-exempt organization as follows:

Entity N, a tax-exempt not-for-profit entity, enters into transactions that may be subject to income tax on unrelated business income. Tax positions to consider include but are not limited to:

² The Announcement also requires reporting for certain exceptions by which the taxpayer can avoid the need to record a reserve.

³ 329 U.S. 495 (1947).

⁴ This provision governs discovery proceedings in federal court, but the work-product doctrine is not limited to that context. Courts have also analyzed it in IRS summons enforcement actions.

⁵ Fed. R. Civ. P. 2b(b)(3)(A).

⁶ Fed. R. Civ. P. 26(b)(3)(B).

⁷ 449 U.S. 383 (1981).

⁸Id. at 401-2. "[W]e think a far stronger showing of necessity and unavailability by other means . . . would be necessary to compel disclosure" of such opinion work-product.

⁹See In re Grand Jury Subpoena, 220 F.R.D. 130, 145 (D. Mass. 2004) and cases cited therein.

¹⁰ This approach relies on the taxpayer reporting all uncertain tax positions on Schedule UTP. We believe that omissions should be rare and that the Service need not review tax accrual workpapers to confirm that all uncertain tax positions have been reported. See discussion below concerning potential penalties.

¹¹ Unless otherwise indicated, all "Section" references are to the Internal Revenue Code of 1986, as amended (Title 26, United States Code).

¹²See Section 6651. While the Service has argued that taxpayers who completely omit certain schedules and statements should be subject to failure-to-file penalties (see Gen. Counsel Memo. 38057), case law supports the conclusion that an honest omission of an individual item from Schedule UTP, or a mistake in calculating the maximum tax adjustment, would not subject a taxpayer to failure-to-file penalties. See, e.g., Beard v. Comm'r, 82 T.C. 766, 777-78 (1984), aff'd 793 F.2d 139 (6^th Cir. 1986); Schroeder v. Comm'r, 291 F.2d 649, 654 (8th Cir. 1961).

¹³ We anticipate that omissions will be rare if the tax positions subject to disclosure are properly defined as discussed above. In extreme situations, where there are strong indications that tax positions were included in the reserves but omitted from Schedule UTP, it might be appropriate for the tax return preparer to provide the financial auditor with a copy of Schedule UTP and request confirmation that all items included in the financial statement reserves were reported. Requesting such confirmation, however, should be reserved for extreme situations rather than become part of Exam's standard operating procedure.

¹⁴ A modification to this approach might be necessary if it is clear that the loss or credit carryforwards would otherwise expire. In the example above, if the NOL carryforward instead had expired because it was not used in 2011, the taxpayer's actual maximum tax exposure with respect to the $500 deduction in 2011 is 35% of $400 rather than 35% of $500. The calculation of the maximum tax adjustment for 2011 in that case should include the effect on the NOL carryforward, as the NOL is not simply shifted between years as a result of the disallowed deduction.

¹⁵ FIN 48 § 7(b), as modified in FASB ASC 740-10-25-7(b). Although the discussion of general administrative practices is included with the discussion of the recognition step of the FIN 48 process, it would also apply to the measurement step and thus the taxpayer could avoid recording a tax position based on such general administrative practices.

¹⁶ FIN 48 § A12-A13; FASB ASC 740-10-55-90 to -92, Example 2.

¹⁷ Although this section does not specifically mention adequate disclosure as an exception to the extension of the statute of limitations, the Service has interpreted it in that manner. See FSA 199925016 and cases collected in CC&F Western Operations Ltd. P'ship v. Comm'r, 273 F.3d 402 (1st Cir. 2001).

¹⁸ Section 6662(d)(2)(B)(ii) also requires a reasonable basis for the tax treatment. Section 6664(d)(2) allows the reasonable cause and good faith defense only if there is adequate disclosure, substantial authority for the tax treatment, and a reasonable belief that the tax treatment was more likely than not correct.

¹⁹ See Treas. Reg. § 1.6662-3(c)(2); 1.6662-4(f).

²⁰ As discussed above, we recommend that the Service eliminate the category of uncertain tax positions for which no reserve is established because of the Service's general administrative practices not to challenge a position. With respect to the category of uncertain tax positions for which no reserve is established because of the taxpayer's intent to litigate, we believe this category should not apply to partnerships because the partners rather than the partnership are responsible for any federal income tax litigation. Accordingly, this category of uncertain tax positions should apply only at the partner level rather than to partnerships.

²¹ Taxpayers are also required to report tax positions for which no reserve was established because of the intent to litigate or the Service's general administrative practices not to challenge a position. As noted above, supra note 20, however, we believe those other categories either would not be applicable to pass-through entities or should be eliminated from the reporting requirement.