Further thoughts on the usefulness of litigation risk assessments for the management of tax controversies

A year ago I had the opportunity to share with readers of The Tax Executive some thoughts about the usefulness of litigation risk assessments for the management of tax controversies in an article entitled "A Systematic Approach to Tax Controversy Management." 49 Tax Executive 223. (May-June 1997). This article, which is being published in two parts, elaborates on the value that litigation risk assessment can bring to the process of resolving tax controversies. The first part discusses two circumstances in which companies used litigation risk assessments to achieve settlements. The second part discusses the use of litigation risk assessments as a tool for effective and cost-efficient management of disputes that are not settled, including the establishment of a common information base from which a company and its outside counsel can negotiate an alternative fee agreement.

Background

Before discussing the role of assessments for achieving settlements, it is useful to review some of the basics. The management of a tax dispute depends on a series of predictions about uncertain future events, which must be made on the basis of incomplete information. You must identify each of the uncertain, relevant issues, analyze how each of them will be resolved, and trace the resolution of the various issues through to the ultimate outcomes. Two of the assessment tools -- decision trees and influence diagrams -- are invaluable for this process. They help ensure that you conduct the analysis in an orderly and logical manner. They increase your ability to identify the important issues and understand their relationships.

Further, you identify each of the potential outcomes of litigation and obtain valuable information and insights about each of the potential outcomes. You know the probability, stated as a percentage, and present dollar value of each potential outcome. You know the overall "expected value" of litigating the dispute. Expected value is most usefully described in the context of a tax controversy as "a weighted average of' possible results that reflects one's knowledge and judgment." Marshall & Oliver, Decision Making and Forecasting 35. It is the mathematically weighted average of the probabilities and present dollar values of the potential litigation outcomes. The expected value from litigating can be compared with other uncertain events or amounts. It is also helpful in comparing the uncertain litigation result with a certain alternative, such as a proposed settlement offer.

Probability, present value, and expected value data are easily understood and communicated to other members of company management. They are much clearer than the descriptive language, such as "reasonably likely," that has traditionally been used to describe potential outcomes. The improved clarity minimizes the possibility of misunderstandings.

The assessment data are also more useful for making fight or settle and other litigation management decisions.

The comparison of a settlement offer with potential litigation outcomes that are described with percentage probabilities and present value dollars is meaningful, whereas the comparison is more difficult when subjective terms are used to describe the potential results.

Probabilities present value, and expected value are only the beginning of the information that you can obtain. The assessment tools give you the means to further sharpen your inquiry when needed.

Discussion

Generally, the information available to tax managers as they try to settle a tax dispute is of limited usefulness. The only objective fact is the amount of the proposed adjustment or disallowance. The rest of the information consists largely of subjective values: the strength of the company's position; the strength of the taxing authority's position; and how much the case is worth for settlement purposes. For example, the tax manager may have received an opinion from counsel that the company's position is strong and that the company is likely to prevail if the matter is litigated. The tax manager may have received the further opinion that "20 cents on the dollar" is a reasonable settlement amount. These opinions may be an off the top of the head "guesstimate." In most cases, however, they are the product of a more careful analysis. Regardless of their basis, opinions stated in these terms are of limited value in developing a reasonable settlement amount. The subjective nature of the opinions is not the problem. Such judgments are unavoidable. As discussed in my previous article, subjective judgments are at the core of a litigation risk assessment.

The problem is the marginal utility of opinions stated in descriptive language for comparing potential outcomes of' litigation with a proposed settlement amount. For example, how do you compare a "substantial possibility" of losing $12.5 million with a $7.75 million settlement offer? The comparison is more meaningful if you have information telling you that there is a 32.6-percent chance of losing the $12.5 million, a 67.4-percent probability of no tax liability, and an approximately $4.1 million expected value from litigating the dispute.

The percentages and dollar amounts used in the prior paragraph are taken from the master decision tree for a hypothetical inventory tax accounting dispute that is set forth on the following page.

In a recent case, the company used the probability, present value, and expected value data as the foundation for fashioning a settlement offer. The company offered to pay an amount to settle that was less than the expected value of litigating the dispute. The taxing authority countered with an offer that would have required the company to pay an amount greater than the expected value. We used assessment tools to assist the company and its outside counsel in evaluating this counteroffer. One of the company's concerns was the sensitivity of the results of the assessment to errors in the probabilities assigned to the outcomes of the various issues. We used different assessment tools to answer that question. We first prepared a "tornado" diagram, which can be used to compare the effect of changes in the probabilities of different issues on the expected value of litigating the dispute. To illustrate such a use, see the tornado diagram for four of the issues from the hypothetical inventory accounting dispute that appears on this page.

The horizontal width of each bar indicates the effect of the variable on the expected value decision tree. The widest bar is for "Accuracy of Company's Shrinkage Accounting" issue. This indicates that of the four issues shown in the diagram, changes in the value of the probability of the taxpayer's inventory accounting being found accurate have the greatest effect on the tree's expected value.

As shown by the master tree, the probability assigned to the taxpayer's prevailing on the accuracy issue is 81.7 percent. That is a very high percentage. Given the effect of that issue on the outcome, a company is likely to want to further analyze the effect of a change in the probability of prevailing on that issue on the expected outcome.

There are several ways to do this. One of the most useful, and one that we performed for the company, was an analysis of the effect of a change in the probability of prevailing on a single issue on the probability of prevailing overall.

The hypothetical tax accounting dispute can be used to illustrate this approach. For example, substituting probabilities of 20, 40, and 60 percent for the assigned probability of 81.7 percent produces the following probabilities of the taxpayer wining the tax dispute:

Probability of Taxpayer Method   Probability of Taxpayer Winning
Being Found Accurate             The Tax Dispute (No Liability)

   81.7%                              67.4%
   60.0%                              594%
   40.0%                              51.4%
   20.0%                              43.8%

After performing this and other types of analyses, the company accepted the taxing authority's counteroffer. The acceptance was premised on the assessment results, as well as two other factors: the projected cost of litigating the dispute, and a desire to put the controversy behind the company. The company and its outside counsel had used the information developed during the assessment as the starting point for projecting litigation costs.

Occasionally, tax managers face pressure from upper management to settle at almost any cost. In another case, the tax manager had the opposite experience. Management believed that the company's position was very strong and refused to authorize a settlement offer that the tax manager proposed. At the time, the tax manager had reason to believe that the taxing authority would accept the proposed offer.

Subsequently, we assisted the company in performing a litigation risk assessment. It showed that if the dispute were litigated, the likely tax liability would be significantly higher than the amount that the tax manager had proposed paying to settle. Using the results of the analysis, the tax manager again asked for settlement authority. This time he received it.

Unfortunately, that was not the end of the story. The taxing authority had grown somewhat more bullish about its position in the interim and would not accept the original offer. It did, however, agree to settle for a somewhat higher amount. The company settled on that basis. In large part the company's willingness to settle was premised on the fact that the settlement amount was considerably lower than the expected value of litigating the issue. The ability to save substantial litigation costs was another factor leading to settlement.

Conclusion

The lesson from these experiences is that a litigation risk assessment can be very helpful for the formulation and consideration of a settlement offer. The performance of an assessment either prior to or as part of the settlement process generates important information for an intelligent settlement decision.

CRAIG D. MILLER is a principal in The Miller Group in Washington, D.C., and Savannah, Georgia. He is a former member of the Washington, D.C., law firm of Miller & Chevalier.

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