The IRS Large Business & International Division: How LB&I Examinations Work

What LB&I Covers

According to the IRS, LB&I serves domestic and foreign businesses with a U.S. tax reporting requirement and assets equal to or exceeding $10 million. It also runs the Global High Wealth and International Individual Compliance programs. An LB&I examination may therefore involve a C corporation, an S corporation, a partnership, or an individual whose affairs fall within one of those programs.

LB&I is organized into practice areas, including Pass-Through Entities and Treaty, Transfer Pricing & Cross Border Activities. The practice areas study compliance issues and propose “campaigns,” which are targeted efforts on specific issues. Campaigns use a range of treatments, including issue-based examinations, soft letters, outreach, and educational materials. Campaign topics have included partnership distributions and losses in excess of a partner’s basis, sales of partnership interests, and offshore private banking.

The Three Phases of an LB&I Examination

IRS Publication 5125 describes the LB&I examination process in three phases: planning, execution, and resolution.

Planning

The examination team learns about the taxpayer’s business, organizational structure, and accounting systems, and identifies the issues it intends to examine. The IRS encourages taxpayers to provide an overview of their business early. The resulting examination plan is issue-focused and sets out the issues selected, timelines, and communication agreements.

Execution

The team develops the facts, mainly through Information Document Requests (IDRs). Under the LB&I process, examiners discuss IDRs with the taxpayer before issuing them so that each request identifies the issue and is properly focused. If responses are incomplete or late, Publication 5125 calls for standard enforcement procedures: a delinquency notice, a pre-summons letter, and/or a summons.

When the team concludes that an adjustment is warranted, it issues a Notice of Proposed Adjustment on Form 5701, usually with a written explanation on Form 886-A. The taxpayer is expected to respond to each Form 5701, including a written legal position on any issue in dispute.

Resolution

Agreed issues are closed. For unagreed issues, LB&I requires the examination team to consider Fast Track Settlement. In that program, an official from the IRS Independent Office of Appeals acts as a mediator while the case remains under LB&I jurisdiction. If Fast Track Settlement does not resolve an issue, the taxpayer generally retains its traditional appeal rights.

Issues That Often Receive Attention

Transfer pricing

Under IRC §482, the IRS may reallocate income, deductions, and other items among businesses under common control when necessary to prevent evasion of taxes or to clearly reflect income. Transactions between related entities, such as a real estate company leasing property to an affiliated operating company, are measured against the arm’s-length standard: the result unrelated parties would have reached in comparable circumstances.

Depreciation and cost segregation

Cost segregation studies reclassify parts of a building into shorter-lived property to accelerate depreciation. The IRS Cost Segregation Audit Techniques Guide (Publication 5653) lists the elements of a quality study, including preparation by someone with expertise, a detailed description of the methodology, appropriate documentation, and a reconciliation of allocated costs to actual costs.

Partnership items

LB&I campaigns have addressed partnership distributions and losses in excess of a partner’s basis and the sale of partnership interests. Basis records and the partnership agreement are central to these issues.

Reasonable compensation

For S corporations, the IRS states that the corporation must pay reasonable compensation to a shareholder-employee for services provided before making non-wage distributions to that shareholder-employee.

Transfer Pricing Penalties and Documentation

IRC §6662 imposes a 20% accuracy-related penalty on an underpayment attributable to a substantial valuation misstatement, including one arising from a §482 adjustment, and a 40% penalty for a gross valuation misstatement. Under Treasury Regulation §1.6662-6, a “net adjustment penalty” applies when net §482 adjustments exceed the lesser of $5 million or 10% of gross receipts (for the 40% penalty, the lesser of $20 million or 20% of gross receipts).

The regulations allow certain adjustments to be excluded from that calculation if, among other requirements, the taxpayer maintained documentation showing that it reasonably selected and applied a transfer pricing method. That documentation must be in existence when the return is filed and must be provided to the IRS within 30 days of a request. Documentation prepared after the return is filed does not meet this requirement.

Preparing for an LB&I Examination

Practical steps include:

• Maintain contemporaneous records of the business purpose and terms of significant transactions, including intercompany agreements and the pricing method used.
• Keep records organized so that IDR responses can be complete, accurate, and timely.
• Participate in the planning phase: help the team understand the business, and agree on points of contact and communication protocols.
• Respond to each Form 5701 in writing, addressing both the facts and the law.
• Evaluate early whether Fast Track Settlement or Appeals is appropriate for issues that cannot be agreed.

The Bottom Line

LB&I examinations are organized around issues identified during planning, developed through IDRs, and resolved by agreement, Fast Track Settlement, or Appeals. Contemporaneous documentation and early, organized engagement put a business in a better position to respond.