Tax arbitration and mediation programs were initiated in 1996 in response to the Administrative Dispute Resolution Act and in an attempt to streamline cases in the tax court. These programs are voluntary. In some cases, the court may offer the option if seems as though a positive outcome will result. Otherwise, it is the responsibility of the tax payer to opt for these drastically less expensive options.
Tax Arbitration
Tax arbitration is binding, meaning the decision reached by the arbitrator is the decision used by the court. Tax arbitrators can decide a single factual issue or the entire factual case. The IRS recommends three types of cases for binding arbitration: valuation, reasonable compensation, and IRC section 482 cases.
Valuation cases involve the IRS’s determination of the value of real estate or property such as artwork, stocks, bonds, and even vehicles. These cases are especially common for estate taxes. For example, the IRS may value a home that you inherited at a much lower amount than it is actually worth, resulting in you paying more taxes for the home if you sell it. In order to challenge the IRS’s valuation of the home, you must challenge it in tax court. A case like this is typically very straight forward and does not warrant a formal trial. Instead, you would simply have the house evaluated by an expert home appraiser and then present that evaluation to the arbitrator.
Reasonable compensation cases involve situations where services are exchanged for services. For example, you may have agreed to install your friend’s new shower in exchange for him painting your house. While no money was exchanged, the two of you did exchange valuable services. Remember that there are still taxes owed on these exchanges, but it can be difficult to determine the amount of taxes owed. If the IRS lists a price of compensation for the services rendered that is too high, then it is up to the taxpayer to challenge the assessment in court. Similar to the valuation cases, this is strictly fact based where both sides present a professional evaluation and the decision can be made.
IRC section 482 discusses the IRS’s right to determine whether someone’s income and deductions are legitimate. Among other things, the IRS can determine “gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses” for the purpose of avoiding tax fraud. So, if you list a charitable deduction that seems too high for your income bracket, the IRS may determine it is invalid and require that you pay more taxes. Taxpayers have the right to challenge the IRS’s evaluation. In this case, the arbitrator would be reviewing the business’s logs and determining the actual amounts themselves. As with the above two cases, witnesses can be brought in as necessary.
Any other types of cases can only be assigned to binding arbitration at the discretion of the tax court and all arbitrations are supervised and reviewed by the court. Should it appear during the arbitration process that the arbitrator is unqualified to decide the facts, then either party can file a motion for trial and a case is scheduled for a hearing with the tax court. Decisions made during binding arbitration are binding and the case cannot be re-heard in tax court when it is decided.
Tax Mediation
Tax mediation is a non-binding, confidential process facilitated by a neutral third party. The entire goal of tax arbitration is to reach a settlement, not a judgment. Mediators do not receive any formal evidence or listen to the testimony of any expert witnesses. In fact, mediators cannot even offer legal advice.
Mediation was initially used by the tax court in their Large Business and International (LB&I) Fast Track Dispute Resolution Program and has now been extended for all taxpayers. Unlike tax arbitration where the specific case examples are given, the tax court has held that any fact-based case is acceptable for mediation. The cases that are not appropriate for mediation include industry-wide issues, Appeals Coordinated Issues, or for cases or issues designated for litigation. In other words, any cases that are novel to the IRS or that involve a mistake by not just yourself but many other business owners are not mediation material. In general, as long as the case is not in the appeal process and is not immediately scheduled for trial, then mediation is a viable solution.
Overall, if your case falls into one of the acceptable listed categories, it is a very wise decision to opt for arbitration or mediation. These methods save you money and typically end in a much more favorable decision than the tax court. In order to select between the two, ask yourself whether the IRS has thus far been responsive and willing to negotiate. If they have been unwavering, then arbitration is best route. Remember that arbitration is binding and any cases cannot be appealed. If the IRS has attempted some negotiations, they simply have not been favorable enough, then consider mediation. If you case is new or your arguments are those that have never been recorded in the IRS record, then it would be best to use the tax court instead of alternative measures as your case will most likely end in an appeal.