The IRS "Holistic" Audit: A Misnomer?

Last fall IRS Commissioner, Douglas Schulman, announced the creation of a new "holistic” audit program.

The term “holistic” is defined as that which relates to or is concerned with wholes or with complete systems rather than with the analysis of, treatment of, or dissection into parts. The word itself is most commonly related to medicine where a doctor focuses on the health of a person’s entire body versus just a specific part. Therefore, the word tends to conjure up feelings of well-being. However, this new audit focus will be anything but as it is specifically designed “to crack down on tax evasion and increase the overall tax compliance of wealthy Americans.”1

The New Holistic Audit Program

"You cannot assess compliance among the nation's wealthiest individuals by looking at their 1040s," Schulman said.2 Wealthy individuals often make use of sophisticated financial, business and investment arrangements with complicated legal structures and tax consequences. Rather than auditing each tax return in the enterprise as a single and separate entity, IRS now plans to look at everything that may be connected to a single taxpayer and analyze the entire picture holistically. "Our goal is to better understand the entire economic picture of the enterprise controlled by the wealthy individual and to assess the tax compliance of the overall enterprise."3

Targeted Taxpayers

The holistic audit program targets high wealth taxpayers. Although "high wealth" is still undefined, it is expected to cover individuals with $10 million or more in assets or income.

Income will not be the only criterion. Ownership of certain assets will likely attract IRS attention. Some of these assets include real estate investments, royalty and licensing agreements, revenue-based or equity-sharing agreements and privately-held companies. Also, taxpayers owning, controlling or having a beneficial interest in trusts, foundations, partnerships and other flow-through entities will be under heightened scrutiny as well.

Other tax considerations include international sourcing of income, tax residency, and offshore structures and bank accounts. Dual citizens with assets in another country, legal resident aliens, or individuals who simply have assets outside of the United States may be more likely to be targeted.

The Global High Wealth Industry Group (GHWIG)

In order to implement this holistic audit approach, IRS launched a specialized task force to target wealthy individuals and their related entities. The Global High Wealth Industry Group (GHWIG) will be part of IRS' Large and Mid-Size Business Division (LMSB), which has the most experience dealing with high wealth and understanding complex relationships among various tax entities. Thus, taxpayers targeted by GHWIG can expect to be audited by more experienced agents who are accustomed to complex audits and examination of intricate tax issues. IRS has also embarked on a hiring campaign to add more staff including economists, appraisal experts and technical advisors to provide industry or specialized tax expertise.4

According to Shulman, tax agencies around the world—including Australia, Canada, Germany, Japan and the United Kingdom—have formed similar audit groups focusing on high wealth individuals.5

"Economic Substance" Doctrine

The recent codification of the economic substance doctrine may become an audit tool for IRS to challenge transactions entered into by high wealth individuals.

Before economic substance was codified, common law doctrine was used by IRS to attack transactions that did not result in a meaningful change to a taxpayer's economic position other than a reduction in tax. The codification of the economic substance doctrine clarifies that a transaction (or series of transactions) will not have "economic substance" for purposes of the economic substance doctrine unless:

1. The transaction changes in a "meaningful way" (apart from U.S. federal income tax effects) the taxpayer's economic position.
2. The taxpayer has a "substantial purpose" (apart from U.S. federal income tax effects) for entering into such transaction (or series of transactions).6

The new legislation also imposes substantial strict liability penalties for transactions that are found to lack economic substance—20% on the underpayment of tax for disclosed transactions and 40% for undisclosed transactions, with no exceptions.7 In other words, even if the taxpayer believed that the transaction was bona fide and even if the taxpayer had no tax-avoidance intention in entering into the transaction, the penalty still applies if a transaction is determined to lack economic substance.

In undertaking holistic audits, IRS may use the economic substance doctrine to pierce certain arrangements or transactions of high wealth taxpayers that may literally comply with the Internal Revenue Code but violate the spirit of its provisions.

Planning Ahead

The formation of GHWIG means that the likelihood of audits for high wealth individuals are on the rise and the new holistic strategy will likely make audits more costly and more extensive than they have been in the past.

Taxpayers and their advisors can use information from IRS announcements to prepare for a holistic audit. For example, high wealth taxpayers may want to review the scope of their business and investment affairs with their advisors to determine their risk of being selected for an audit. Furthermore, taxpayers can plan future transactions with their advisors and even maintain written explanations of their objectives and purposes in their advisor's files. Finally, taxpayers and advisors should keep thorough and well-organized files and be prepared to provide significant information if they are selected for an audit by GHWIG.

In order to assist clients in dealing with the intensity of these audits, WTAS has convened a national team, headed by a former IRS trial attorney and supervisor in the General Counsel’s office.

1Remarks of Douglas H. Shulman, Commissioner of Internal Revenue Service, before the AICPA National Conference on Federal Taxation, Oct. 26, 2009, http://www.irs.gov/irs/article/0,,id=215606,00.html (Shulman AICPA Remarks).
2Ibid.
3Ibid.
4Prepared Remarks of IRS Commissioner Doug Shulman to New York State Bar Association Taxation Section Annual Meeting in New York City, Jan. 16, 2010, http://www.irs.gov/newsroom/article/0,,id=218705,00.html (Schulman NYSBA Remarks).
5Schulman AICPA Remarks.
6Internal Revenue Code Section 7701(o).
7H.R. 4872, The Health Care and Education Reconciliation Act of 2010, Section 1409(e).