Barbara de Marigny
Barbara de Marigny
IRS Tiered Issues

Is your return position a lost cause?

January 28, 2010
Barbara de Marigny, JD, LLM

Have you heard someone say, “Watch out — that’s a Tier I audit issue” and wondered exactly what that meant? As the Internal Revenue Service (IRS) system of placing issues in tiers is fairly new and relates primarily to IRS internal procedures, most practitioners are aware of the system but are unsure of its practical impact on return positions. Learning about the system, its impact on resolutions and the specific issues that are currently tiered may help you and your clients sleep better at night.

Issue tiering was introduced in 2006 as an element of Large and Mid-Size Business (LMSB) issue management strategy. It is designed to strengthen LMSB’s ability to identify and prioritize certain issues in a coordinated manner, thereby providing consistency of treatment among taxpayers. The IRS defines the tiers as follows:

Tier I: Tier I issues are of “high strategic importance” to LMSB and have a significant impact on one or more industries. Tier I issues may involve a large number of taxpayers, a significant dollar amount, a substantial compliance risk or high visibility. Issues will be placed in this category if the IRS has an established legal position or LMSB directive out on the issue.

Currently in this tier:

  • All recognized abusive and listed transactions
  • §118 Abuses
  • §199 Domestic Production Deduction
  • Foreign Earnings Repatriation
  • Foreign Tax Credit Generators
  • Mixed Service Product Cost Issues
  • Research Credit Claims
  • Transfer of Intangibles / Offshore Cost Sharing
  • FDAP Withholding §1441

Monitored: backdated stock options, hybrid instruments, universal service support and bio-energy payments, §936 exit strategies, government settlements and mixed service costs (Phase 1).

Tier II: Tier II issues also involve significant compliance risk but are emerging issues or issues with respect to which the IRS needs to further develop its position.

Currently in this tier:

  • Casualty Losses
  • Cost-Sharing Stock-based Compensation
  • Enhanced Oil Recovery Credit §43
  • Extraterritorial Income Exclusion Effective Date
  • Gift Cards — Deferral of Income
  • Merchant Discount Fees
  • Non-performing Loans
  • Specified Liability Losses §172(f)
  • Super Completed Contract Method
  • Fees and Royalties in Biotech/Pharmaceutical Industries

Tier III: Tier III issues are those that present a high compliance risk for a particular industry.

Currently in this tier:

  • Communications, Technology:
  • Amortization of Licensed Program Rights
  • Carriage/Launch Fees Paid to Satellite Operators

  • Financial Services
  • Premium Deficiency Reserves
  • Real Estate Mortgage Investment Conduit (REMIC)

  • Heavy Manufacturing and Transportation
  • Loyalty Programs
  • Motor Vehicle Dealerships and §263A

  • Natural Resources
  • §198 Brownfield Incentives
  • Delay Rentals

  • Retailers
  • Cost Segregation Studies
  • Vendor Allowances

Tiered issues apparently follow the OINO (sometimes referred to as the WINO) system: Once In, Never Out. Once an issue is placed in a tier, it is never removed from that tier. Instead, when guidance and a resolution strategy have been developed, the issue is moved from active to “monitored” status within the same tier.

Tier I issues are assigned an Issue Owner Executive (the IOE), who must assemble an Issue Management Team (IMT) to develop the IRS strategy on the issue. As a practical matter, the IMT controls management of the issue generally. The IMT usually includes a Technical Advisor, an Appeals Guidance Coordinator and representatives from LMSB Counsel and National Office Chief Counsel. Through conference calls and face-to-face meetings, the IMT tries to get a feel for the number of taxpayers and amount of dollars presented by the issue, as well as how the position is spreading, i.e., has the position been adopted by a trade association or sold by accountants? IMT then works to develop audit techniques and settlement guidelines.

You would think that field examiners would be required to examine all Tier I issues. Only abusive and listed transactions are required to be examined, however. Other Tier I issues can be handled in a more customized manner, depending on the specific issue and circumstances. Disallowance of tiered issues is not required either. Although examiners may be more prone to reflexively disallow tiered issues, there have been instances in which taxpayers have prevented a tiered issue from being proposed for adjustment by distinguishing their facts from the paradigm case.

How Should You Handle a Tiered Issue?

Keep an eye on the list to be aware of whether your client has one of these issues. If it appears that a tiered issue is present, review the IRS materials that set out the issue and the IRS position carefully. The Industry Director Directive may indentify the issue but if there is a Generic Legal Advice (GLA), a Coordinated Issue Paper, or a Technical Advice Memorandum (TAM) that has been issued, it will be even more instructive. You may find that your facts can be differentiated from the tiered issue.
Go the extra mile in advance preparation. Forewarned is forearmed: Knowing that the issue is likely to be picked up allows you to devote resources to it. A strong first briefing on the issue should be ready to go. Inevitably, a negative inference will be drawn from stalling on the issue.

The IMT frequently develops a template for audit techniques and Information Document Request (IDR) questions to explore particular tiered issues. This gives you an opportunity to formulate your IDR responses in advance. Do not fall into the trap of IDR answers that echo the IRS characterization: i.e., use of the word “abuse” need not appear in your response to an IDR regarding “§118 abuse.”

On a Tier I Issue, the exam team will have no authority to settle the issue in any manner other than pursuant to the prescribed guidance. Therefore, in order to obtain any type of alternative settlement, taxpayers should try to deal directly with the Industry Directors or IOEs. To do so, you will need to make a request to the audit team (Internal Revenue Manual but escalation is entirely possible. Taxpayers and industry trade associations are allowed and even encouraged to talk directly to the IOE at any phase, including pre-filing.

If you have exceptionally good or distinguishable facts on an issue, push for a quick review and resolution (i.e., Fast-Track procedure) before the IRS takes a one-size-fits-al” approach. Do not assume that appeals have no flexibility: The settlement guidelines present a range of settlement alternatives.

Remember that the imposition of a penalty is a separate issue. Tiering does not — in and of itself — mandate penalties. The very tiering of an issue may itself show that the law is unclear and thus that the taxpayer’s position cannot be considered to have been taken in the face of clear law to the contrary.


A return position that raises a tiered issue is not “a lost cause.” Although tiering makes proposal of a disallowance more likely, a particular settlement is not always mandated. There is a premium on advance preparation but the preparation should prove worthwhile. Besides, look at the bright side: if you do have a tiered issue, it may draw the examiner’s attention away from other aspects of the return, reducing the likelihood of “surprise” issues.

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Barbara de Marigny, JD, LLM, is a partner in Gardere’s Tax Practice Group. She focuses her practice on federal income taxation, partnership taxation, limited liability companies (LLCs), domestic and international joint ventures and tax planning for business transactions. She also has specific expertise in mergers and acquisitions of public and private companies in taxable and tax-free acquisitions of stock, LLC interests and partnership interests. Prior to joining Gardere, de Marigny was a partner at the law firm of Oppenheimer, Blend, Harrison & Tate, Inc. de Marigny served from 1981 to 1999 as an attorney at Baker & McKenzie. She was a partner at the firm from 1989 until her departure in 1999.