Tax Controversy & Litigation—Federal Income Tax Audit, Appeal & Court Case

By July 21, 2010 Commercial Litigation

SIGNIFICANT INCOME TAX OBLIGATION RESOLVED FOR MEDIA MANUFACTURING FIRM

Highlights

  • Cummins & White, LLP, successfully represented a media manufacturing firm in an IRS audit, appeal, and court case involving the proper accrual of royalties paid for using patented technology in the duplication of DVDs and CDs.
  • Cummins & White’s in-depth knowledge of IRS administrative and Tax Court procedures, as well as substantive rules regarding deductions by accrual basis taxpayers helped the Client avoid a $1 million tax bill.
  • The firm also helped the Client avoid future exposure by filing a case in Tax Court.  As part of the proceedings, the IRS issued a final letter of determination, effectively exempting the Client from repeat audits of the same tax years.
  • The two-year process involved sorting through a significant amount of documentation—much of it in disarray—that accumulated when the Client acquired a similar firm, which also paid royalties as part of technology license agreements.

Attorneys

Case Study

Cummins & White, LLP, worked with a manufacturer of DVDs and CDs in an Internal Revenue Service audit, appeal, and court case.  The company utilized proprietary technology and paid layered royalties to patent holders.  During the tax years in question, the company merged with a similar manufacturing firm, requiring that royalties be calculated for both entities and creating a complex tax situation.  Because of the merger transaction, the company’s books were in disarray, making it difficult to prove its business expenses.  Following its audit, the IRS claimed that the company had improperly accrued royalty obligations and other deductions.  In response, attorneys for Cummins & White filed a Tax Court proceeding and then sought to negotiate a resolution with the IRS Appeals Office.  The attorneys collected critical documentation to prove the company’s business expenses and then presented a persuasive case before the IRS Appeals Office.  The IRS accepted most evidence and agreed that the company did not owe additional income tax, saving the Client more than $1 million in proposed income tax deficiencies.  Moreover, the Tax Court case was designed to discourage the IRS from raising additional issues and prevent it from opening future audits of the same tax years.

Background

The Client, a manufacturer of DVDs and CDs, licenses technologies used in the duplication process and pays royalties to the patent holders.  As per its license agreements, the company pays a fixed price for each disc manufactured and sold and layers royalties to several companies.  These royalties are routinely deducted on its yearly federal income tax return.  In 2005, the company merged with a similar manufacturing firm, complicating the royalty payment process because royalties had to be calculated for both groups.  Because of the merger, the company’s books for this period were in disarray.

Subsequently, the Internal Revenue Service audited the company, examining income tax returns for 2005 (the year it entered the merger agreement) and 2006.  The IRS proposed significant changes, claiming that the company did not properly accrue royalty obligations.  Specifically, the IRS requested a reduction in accruals (deductions) by several million dollars, stating that the company did not show sufficient evidence of how much royalty it owed.  The IRS also disallowed other expense deductions for lack of proof.  The IRS income tax audit was further complicated by a simultaneous sales tax audit conducted by the State of California.

Legal Strategy

The company retained Robert Lamm of Cummins & White, LLP, toward the end of the audit when it became clear that it needed help organizing information.  Lamm deployed a multi-pronged approach.  First, he filed a Tax Court case on behalf of the company to discourage the IRS from raising additional issues.  This was critical as the notice of deficiency issued by the IRS raised a new subject of concern—whether the company had sufficient basis to claim the losses reported.  Second, Mr. Lamm waded through significant documentation in order to prove that the company did in fact have basis and that it borrowed money (loans), which increased that basis.  Finally, because the IRS had made its recommendations based on only one technology contract, the attorneys reviewed all royalty contracts with the goal of demonstrating that four, rather than one company, received royalty payments.

Result/Implication

Based on their expertise in federal tax return audits and the appeal process, Cummins & White presented a detailed and persuasive case to the IRS Appeals Office.  The detailed case included:

  • Proving that the company had basis.
  • Demonstrating that because the company had four royalty contracts in place and had paid royalties to all patent holders, it has accurately accrued royalty obligations.
  • Presenting documentation supporting additional liabilities for deductions.

After a two-year process, Mr. Lamm negotiated a settlement with the IRS Appeals Office, as a result of which the IRS agreed that the Client did not owe any income tax deficiencies, saving the Client more than $1 million.

In addition, the strategic decision to file a Tax Court case to discourage the IRS from raising further issues was equally as important.  Normally in an audit, the taxpayer must prove that the IRS is wrong.  By filing a Tax Court case, the attorneys shifted the burden of proof to the IRS for any new issues raised after the audit concluded and exempting the Client from repeat audits of the same tax years.