Taxes: Psst. Want to Read the IRS's Mind?
Private letter rulings give you the inside tax scoop
Do you avoid tax strategies that seem a tad risky? Fantasize about all those profitable tax ploys your growing company might try, if only you could afford the legal experts large corporations have? The good news is that you don't always have to adopt a conservative federal-tax stance simply because your business is small. Thanks to a document known as a private letter ruling, even small companies can probe the Internal Revenue Service's attitudes about state-of-the-art, aggressive tax strategies. Put simply, private letter rulings warn taxpayers when their planned tax moves will trigger audits (along with all those nasty repercussions such as penalties) and when riskier strategies will work. Think of a private letter ruling as a peek into the IRS's crystal ball.
Sound too benevolent to be believable? Most people forget that one of the IRS's secondary missions is to provide guidance about tax regulations and procedures. "Sometimes there are issues taxpayers face that are not directly addressed in existing regulations. In those cases, the IRS has said that it will allow taxpayers to request clarification of the tax laws as they relate to an individual's or a company's very specific set of circumstances," explains Eileen J. O'Connor, a partner in the Washington, D.C., tax office of accounting firm Grant Thornton. A private letter ruling offers that kind of clarification, for a fee payable to the IRS. Although there are no guarantees that anyone other than the taxpayer involved will receive the promised treatment, private letter rulings serve as useful barometers of the IRS's thinking.
Here's an example: Let's say your company is considering a spin-off of part of its business. Your accountant and your lawyer have worked out a deal that they believe should receive tax-free treatment. But . . . what if they're wrong? What if your company gets socked with an astronomical tax bill during an IRS audit years later?
A private letter ruling can help answer your questions -- as long as you don't need a decision right away. If you apply for a ruling, you will probably learn the exact tax consequences of the deal before you do it. "You provide the IRS with a complete description of the facts of your proposed activity. Then you say, 'This is the tax result we expect, given our interpretation of the tax laws.' When the IRS issues its ruling, it either agrees or disagrees with your interpretation," explains Don Rocen, a tax partner in the Washington, D.C., office of Coopers & Lybrand.
Think of a private letter ruling as an insurance policy from the IRS. If, in our hypothetical example, the tax man agrees with your company's judgment about the spin-off's tax-free status, you will be guaranteed that treatment once the deal happens -- with one important caveat. If your description of the proposed activity proves to be inaccurate, or if the deal unfolds in a way that's different from what you expected, the IRS guarantee doesn't hold. Of course, you can always make a request for a new private letter ruling, but you will have to pay the fee again.
Small companies and their owners frequently file requests regarding estate-planning techniques, fringe benefits, and distributions of stock and other corporate assets. One recent letter ruling dealt with a company's effort to set up a scholarship program for employees' children. (The trick was figuring out how the company could maintain the program's tax-deductible status as a nondiscriminatory benefit while still ensuring that the children of the company's owner would qualify for some of the scholarships.) "If you're dealing with an aggressive tax strategy that might save or cost you a six-figure amount, you'd be foolish not to approach the IRS about it first," emphasizes Richard Colombik, a lawyer and certified public accountant based in Schaumburg, Ill. On tax issues with smaller financial consequences, business owners need to make judgment calls, weighing the risks of a future audit against the cost of filing a request for a letter ruling.
Those costs vary, generally depending on the complexity of the topic. Fees change yearly, but the IRS's current charge for a basic request is $3,575. (On some complicated international issues, filing fees can go as high as $25,000.) Expect your accountant's or lawyer's fee to add several thousand dollars or more to your tab.
However, there are bargains, says O'Connor. She notes that small, fast-growing companies sometimes need to figure out how to correct a tax mistake they've been making for years, such as classifying as expenses certain equipment costs that should have been capitalized over time. "If the IRS ever came in and detected that error, the company would be socked with huge fines and back-interest charges," O'Connor says. "So there's a special kind of private letter ruling companies can request that gives them the right to change their accounting methods and correct previous errors without incurring penalties." That type of letter ruling, called a "method change" ruling, costs only $900.
Who says the IRS can't be friendly? Consult your accountant to see if a private letter ruling could help you or your company.
JUST THE FACTS
Everything you never knew you needed to know about private letter rulings
Who should prepare your request?
It's a must to rely on a certified public accountant or a lawyer with experience in this area. Successful requests generally include plenty of documentation as well as discussions of relevant tax laws and precedents.
Where can you go to learn about private letter rulings?
After issuing its decisions, the IRS sanitizes its rulings, purging all confidential details, and then distributes them each week to the IRS Freedom of Information Reading Room, in Washington, D.C. You can subscribe to a handful of costly services that track those rulings. But it's easier to rely on your accountant; a good CPA firm can keep clients up-to-date on important rulings.
When should you apply?
Timing is crucial. You can't wait until after you've done the deal and filed your personal or corporate tax return; the IRS won't rule on a filed tax return. Send your request early, and request a filing extension if you're still waiting for a reply.
How long will it take to receive a response?
Remember, this is the federal government. It can take 45 days just to get an acknowledgment of your request and another three months or longer to receive a final decision. As a result, a private letter ruling isn't an option when you need a decision next week; it's more appropriate for long-term issues like estate planning.