Monday, April 20, 2009

IRS Audit Risk Survey: Final Results

Sum2 is please to report the final results of the IRS Audit Risk Survey for Fund Managers. Sum2 has commissioned the survey to determine financial services industry awareness and readiness for IRS audit risk factors. The survey sought to determine industry awareness and readiness to address IRS Industry Focus Issue (IFI) risk exposures for hedge funds, private equity firms, RIAs, CTAs and corporations using offshore structures.

Survey Background

Due to the pressing revenue requirements of the United States Treasury and the need to raise funds by recognizing new sources of taxable revenue; hedge funds, private equity firms, CTA's and other corporations that utilize elaborate corporate structures, engage in sophisticated transactions and recognize uncommon forms of revenue, losses and tax credits will increasingly fall under the considered focus of the IRS.

Since 2007 the IRS began to transition its organizational posture from a benign customer service resource to a more activist posture that is intent on assuring compliance and enforcement of US tax laws. Specifically the IRS has invested in its Large and Mid-Size Business Division (LMSB) to enhance its expertise and resources to more effectively address the tax audit challenges that the complexity and sophistication of investment management complexes present. The IRS has developed its industry issue competencies within its LMSB Division. It has developed a focused organizational structure that assigns issue ownership to specific executives and issue management teams. This vertical expertise is further enhanced with issue specialists to deepen the agencies competency capital and industry issue coordinators that lends administrative and agency management efficiency by ranking and coordinating responses to specific industry issues. IRS is building up its portfolio of skills and industry expertise to address the sophisticated agility of hedge fund industry tax professionals.

To better focus the resources of the agency the IRS has developed a Three Tiered Industry Focus Issues (IFI). Tier I issues are deemed most worthy of indepth examinations and any fund management company with exposure in these areas need to exercise more diligence in its preparation and response. Tier I issues are ranked by the IRS as being of high strategic importance when opening an audit examination. This is followed by Tier II and Tier III focus issues that include examination issues ranked according to strategic tax compliance risk and significance to the market vertical. Clearly the IRS is investing significant organizational and human capital to address complex tax issues of the industry. The IRS is making a significant institutional investment to discover potentially lucrative tax revenue streams that will help to address the massive budget deficits of the federal government.

Survey Results

The survey was open to fund management executives, corporate treasury, tax managers and industry service providers. CPAs, tax attorneys, compliance professions, administrators, custodians and prime brokers were also invited to participate in the study. The survey was viewed by 478 people. The survey was completed by 43% of participants who began the survey.
Geographical breakdown of the survey participants were as follows:
  • North America 73%
  • Europe 21%
  • Asia 6%
The survey asked nine questions. The questions asked participants about their awareness of IFI that pertain to their fund or fund management practice and potential mitigation actions that they are considering to address audit risk.

The survey posed the following questions:
  • Are you aware of the Industry Focus Issues (IFI) the IRS has developed to determine a fund managers audit risk profile?
  • Are you aware of the organizational changes the IRS has made and how it may effect your firms response during an audit?
  • Are you aware of the Three IFI Tiers the IRS has developed to assess a funds audit risk profile?
  • Are you aware of how the Three IFI Tiers may affect your audit risk exposures?
  • Have you conducted any special planning sessions with internal staff to prepare for IFI audit risk exposures?
  • Has your outside auditor or tax attorney notified you of the potential impact of IFI risk?
  • Have you held any special planning meetings with your outside auditors or tax attorneys to mitigate IFI risk?
  • Have you had meetings with your prime brokers, custodians and administrators to address the information requirements of IFI risk?
  • Have you or do you plan to communicate the potential impact of IFI risk exposures to fund partners and investors?
Survey highlights included:
  • 21% of survey participants were aware of IFI
  • 7% of survey respondents planned to implement specific strategies to address IFI audit risk
  • 6% of survey respondents have received action alerts from CPA's and tax attorney's concerning IFI audit risk
  • 26% of survey respondents plan to alert fund investors to potential impact of IFI audit risk
Recommendations

Sum2 believes that survey results indicate extremely low awareness of IFI audit risk. Considering the recent trauma of the credit crisis, sensational fraud events and the devastating impact of last years adverse market conditions; fund managers and industry service providers must remain vigilant to mitigate this emerging risk factor.

These market developments and the prevailing political climate surrounding the financial services sector will bring the industry under heightened scrutiny by tax authorities and regulatory agencies. Unregulated hedge funds may be immune from some regulatory issues but added compliance and disclosure discipline may be imposed by significant counter-parties, such as prime brokers and custodians that are regulated institutions.

Market and regulatory developments has clearly raised the tax compliance and regulatory risk factors for hedge funds and other fund managers. Issues concerning FAS 157 security valuation, partnership domiciles and structure, fund liquidation and restructuring and complex transactions has increased the audit risk profile for the industry. Significant tax liabilities, penalties and expenses can be incurred if this risk factor is not met with well a well considered risk management program.

In response to this industry threat, Sum2 has developed an IRS Audit Risk Program (IARP) that prepares fund management CFO's and industry service tax professionals to ascertain, manage and mitigate its IRS risk exposures within the Three IFI Tiers. The IARP provides a threat scoring methodology to ascertain risk levels for each IFI risk factor and aggregates overall IFI Tier exposures. The IARP uses a scoring methodology to determine level of preparedness to meet each of the 36 audit risk factors.

The IARP helps managers to outline mitigation actions required to address audit risk factors and determine potential exposures of each risk. The IARP calculates expenses associated with mitigation initiatives and assigns mitigation responsibility to staff members or service providers. The IARP links users to issue specific IRS resources, forms and documentation that will help you determine an IFI risk relevancy and the resources you need to address it.

The IARP will prove a valuable resource to help you manage your response to a tax audit. It will also prove itself to be a critical tool to coordinate and align internal and external resources to expeditiously manage and close protracted audit engagements, arbitration or litigation events. The IARP product is a vertical application of Sum2's Profit|Optimizer product series.

The Profit|Optimizer is a C Level risk management tool that assists managers to uncover and mitigate business threats and spot opportunities to maintain profitability and sustainable growth.
The IARP product is available for down load on Amazon.com.

The product can also be purchased with a PayPal account: Sum2 e-commerce

Sum2 wishes to thank all who anonymously took part in the survey.

If you have any questions or would like to order an IARP please contact Sum2, LLC at 973.287.7535 or by email at customer.service@sum2.com.