[Editor’s Note: The following article was published in the May 2, 2005, issue (Vol. 46, No. 9) of Tax Management Memorandum. Accordingly, it reflects T.D. 9165, the final Circular 230 regulations published in the December 20, 2004, Federal Register, but does not reflect T.D. 9201, published in the May 19, 2005, Federal Register. The latter Treasury Decision amended §10.35 of Circular 230, “Requirements for covered opinions,” by: (1) expanding the definition of “excluded advice” in §10.35(b)(2)(ii) to include certain advice provided after a return is filed, certain advice provided to a practitioner’s employer, and certain negative advice; (2) modifying the definition of “prominently disclosed” in §10.35(b)(8); and (3) modifying the definition of “the principal purpose” in §10.35(b)(10) by adding language similar to Regs. § 1.6662-4(g)(2)(ii) (to the effect that tax avoidance is not the principal purpose—although tax avoidance may be a significant purpose—if the purpose is to claim tax benefits “in a manner consistent with the statute and Congressional purpose”). Editor’s Notes have been added below to alert readers to significant changes made by T.D. 9201.]
I.R.C. §§6011, 6111, 6112, 6662, 6662A, 6664, 6707, 6707A; Regs. §1.6011-4; 2004 American Jobs Creation Act, P.L. 108-357; Circular 230.
The Treasury Department and the Internal Revenue Service (IRS) have confronted daunting, if not insurmountable, challenges in their efforts to combat abusive tax shelters.1 The government faces a formidable opponent—a tax shelter industry acting in concert and, until recently, shrouded in secret.2 To date, the focus of the government has been on enforcement action, strengthening the standards of professional conduct, and applying stiffer sanctions.
Congress, the Securities and Exchange Commission (SEC), and the Public Company Accounting Oversight Board (PCAOB) have stopped short of ensuring auditor independence by separating tax consulting from the audit function.3 Under recently issued PCAOB proposed rules concerning auditor independence, a registered public accounting firm would lose its independence, for audit purposes, if it engages in providing any of the following three types of tax services to their audit clients:4 (1) contingent fee arrangements;5 (2) services related to tax planning or advice on certain types of potentially abusive tax transactions;6 and (3) tax compliance and planning services for senior officials who oversee an audit client's financial reporting.7 Registered public accounting firms can continue to provide routine tax consulting to audit clients, as long as the services are pre-approved by the client company's audit committee.8
Congress also has responded by enacting legislation aimed at abusive tax avoidance transactions and the various participants. The American Jobs Creation Act of 20049 (AJCA) includes 15 different tax shelter provisions. The new provisions generally rewrite the old tax shelter registration and list maintenance rules of §§6111 and 611210 to bring the statutory language in line with the reportable transaction disclosure regulations under §6011.11 In addition to providing new and increased penalties for taxpayers and their advisors, the AJCA amended 31 USC §330 to grant the Treasury and the IRS expanded authority to impose Circular 230 standards for written advice and monetary penalties against practitioners who violate any provision of Circular 230.
The new statutory and regulatory requirements and their related penalties seek to achieve a balance between the conflicting goals of curbing abusive tax transactions while avoiding onerous burdens on routine commerce. One theme underlying the new rules is to create tax transparency between taxpayers and their advisors. Another theme is to require practitioner adherence to higher standards of professional conduct and voluntary compliance with aspirational "best practices." The final theme is to impose stiffer penalties in order to deter taxpayers and their advisors from engaging in misconduct.
The discussion that follows addresses these recent statutory and regulatory developments affecting federal tax practice. To that end, this memorandum begins with a summary of the final regulations under Circular 230, which provide "best practices" for tax advice generally and standards for Covered Opinions and Other Written Advice. Next, this memorandum discusses the reportable transaction disclosure rules and the related penalty provisions affecting taxpayers and their advisors following the AJCA. Then, this memorandum addresses the opinion standards for protection against the accuracy-related penalties in light of revised Circular 230 and the AJCA.
CIRCULAR 230 "BEST PRACTICES" AND WRITTEN ADVICE STANDARDS
On December 20, 2004, the Treasury Department and the IRS published final regulations under Circular 230 in the Federal Register.12 These regulations, which establish standards for an estimated 100,000 disclosing "practitioners" providing Covered Opinions and Other Written Advice (as defined herein),13 were designed "[t]o restore, promote, and maintain the public's confidence in those individuals and firms" providing tax advice.14 The final regulations also set forth "best practices" applicable to all tax advice. The discussion that follows addresses these new Circular 230 rules, which apply to written advice addressing estate and gift tax issues as well as income tax issues.15
There is a real urgency for understanding, and compliance with, the new Circular 230 practice rules, especially in light of the possibility of sanctions for their violation.16 For the head of a firm's tax practice, the urgency is even greater, because he or she faces special sanctions for failure to ensure compliance.17 To allow practitioners sufficient time for compliance and to educate their clients so that expectations can be adjusted going forward, the effective date of the final regulations was delayed until after June 20, 2005 (six months after publication of the final regulations in the Federal Register).18
Aspirational "Best Practices"
Section 10.33 of Circular 230 establishes "best practices" for tax advisors providing advice to taxpayers relating to federal tax issues or submissions to the IRS. The rule incorporates by reference all of the Circular 230 professional standards as "best practices." The final regulations make it clear that the "best practices" are intended as aspirational standards only. Although the Preamble underscores the need to observe the "best practices" in order to preserve public confidence in the tax system, §10.52 specifically removes the best practices of §10.33 from those rules subject to sanction.
To render the highest quality of representation in providing tax advice and preparing an IRS submission, tax advisors are urged to adhere to "best practices" that include compliance with the following as well as all other Circular 230 professional standards:19 (1) communicating clearly with the client regarding the terms of the engagement; (2) establishing the facts by determining which facts are relevant, evaluating the reasonableness of any assumptions or representations, relating the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arriving at a conclusion supported by the law and the facts; (3) advising the client regarding the import of the conclusions reached, including whether a taxpayer who relies on the advice may avoid accuracy-related penalties; and (4) acting fairly and with integrity in practice before the IRS. Tax advisors with responsibility for overseeing a firm's practice are required to take reasonable steps to ensure that the firm's procedures for all members, associates, and employees are consistent with these "best practices."20
Standards for Covered Opinions
A "Covered Opinion" is defined in §10.35(b)(2) as any written advice (including electronic communications) by a practitioner that concerns one or more federal tax issue(s) arising from—
A transaction that is substantially similar to a listed transaction under Regs. §1.6011-4(b)(2) (Listed Transaction);21
Any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, the principal purpose of which is the avoidance or evasion of any tax (Principal Purpose Transaction); or
Any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, a significant purpose of which is the avoidance or evasion of tax (Significant Purpose Transaction)
—if the opinion is a Reliance Opinion, a Marketed Opinion, is subject to conditions of confidentiality, or is subject to contractual protection.
A "Reliance Opinion" is written advice that concludes at a confidence level of at least "more likely than not" (a greater than 50% likelihood) that one or more significant federal tax issues would be resolved in the taxpayer's favor.22 Although a Reliance Opinion generally is prepared to provide protection from penalties that might be imposed on the taxpayer, the Covered Opinion requirements are not dependent on the offering of penalty protection, but rather are triggered by rendering a "more likely than not" opinion intended for the taxpayer's reliance. Written advice (not involving a Listed Transaction or Principal Purpose Transaction) with certain predominantly disclosed opt-out language is exempt from treatment as a Reliance Opinion.
Written advice is a "Marketed Opinion" if the practitioner knows or has reason to know that the written advice will be used or referred to by a person other than the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) in promoting, marketing, or recommending a partnership or other entity, investment plan, or arrangement to one or more taxpayer(s).23 Written advice (not involving a Listed Transaction or Principal Purpose Transaction) with certain predominantly disclosed opt-out language is exempt from treatment as a Marketed Opinion.
Written advice is subject to "conditions of confidentiality" if the practitioner imposes on one or more recipients of the written advice a limitation on disclosure of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that practitioner's tax strategies, regardless of whether the limitation on disclosure is legally binding.24 A claim that a transaction is proprietary or exclusive is not a limitation on disclosure if the practitioner confirms to all recipients of the written advice that there is no limitation on disclosure of the tax treatment or tax structure of the transaction that is the subject of the written advice.25
Written advice is subject to "contractual protection" if the taxpayer has the right to a full or partial refund of fees paid to the practitioner (or a person who is a member of, associated with, or employed by the practitioner's firm) if all or a part of the intended tax consequences from the matters addressed in the written advice are not sustained, or if the fees paid are contingent on realization of the tax benefits from the transaction.26
A Covered Opinion, by definition, exempts four categories of advice. First and most obvious, all oral advice is excluded from the Covered Opinion requirements, since a Covered Opinion refers only to written advice.
Second, a Covered Opinion, by definition, excludes any written advice with less than the threshold avoidance intent evidenced by subject matter, namely, written advice that does not concern the tax treatment of a Listed Transaction, Principal Purpose Transaction, or Significant Purpose Transaction. Such written advice, though not a Covered Opinion, would nevertheless be subject to the Circular 230 requirements for Other Written Advice, discussed below.
Third, a Covered Opinion, by definition, excludes written advice (other than a Marketed Opinion) that would otherwise be treated as a Reliance Opinion but does not involve a "significant" federal tax issue. A federal tax issue is "significant" if the IRS has a reasonable basis for a successful challenge and its resolution could have a significant impact, either beneficial or adverse under any reasonably foreseeable circumstance, on the overall federal tax treatment of the transaction(s) or matter(s) addressed in the opinion.27 Written advice concluding that the IRS has no reasonable basis for a successful challenge to the claimed tax treatment would not implicate a "significant" federal tax issue. Such written advice, without satisfying the Covered Opinion requirements, could be relied upon for penalty protection, but the opinion would still be required to satisfy the Circular 230 requirements for Other Written Advice.
The fourth and last category of excluded written advice also falls outside the definition of a Reliance Opinion. A Reliance Opinion is defined in terms of written advice concluding at a confidence level of "more likely than not" that one or more significant federal tax issues would be resolved in the taxpayer's favor. Written advice that concludes at a lower confidence level, such as a "substantial authority" opinion, could escape the Covered Opinion requirements without any prominent disclosures, assuming such written advice is not otherwise a Covered Opinion.
Section 10.35(b)(2)(ii) specifically lists the following excluded advice: (A) preliminary advice as to which a Covered Opinion is reasonably expected to follow and (B) written advice (other than advice pertaining to a Listed Transaction or a Principal Purpose Transaction) that concerns the qualification of a qualified plan, is a state or local bond opinion,28 or is included in documents filed with the SEC.29 [Editor’s Note: T.D. 9201, 70 Fed. Reg. 28824 (5/19/05), added to the list of “excluded advice”: (C) written advice prepared for and provided to the taxpayer after the taxpayer has filed a return reflecting the tax benefits of the transaction, unless the practitioner knows or has reason to know that the taxpayer will rely on the written advice to take a position on an amended return or on a subsequently filed return; (D) written advice provided to the practitioner’s employer in the practitioner’s capacity as an employee solely for purposes of determining the employer’s tax liability; and (E) written advice that does not resolve a Federal tax issue favorably to the taxpayer at any level of confidence (e.g., not frivolous), but only with respect to that issue.]
Also exempt from the Covered Opinion requirements is written advice (not concerning a Listed Transaction or Principal Purpose Transaction) that would otherwise constitute a Reliance Opinion or a Marketed Opinion but contains certain prominently disclosed "opt-out" language. Language is considered "prominently disclosed" if set forth in a separate section at the beginning of the written advice in a bolded typeface that is larger than any other typeface used in the written advice.30 [Editor’s Note: T.D. 9201 modified the definition of “prominently displayed” to provide somewhat greater flexibility in how the disclosure language may be displayed. See the Editor’s Note accompanying footnote 30, below.] The "opt-out" disclosures for avoiding Reliance and Marketed Opinions are set forth below:
Disclosure to "Opt-out" of a Reliance Opinion: This advice was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.
Disclosure to "Opt-out" of a Marketed Opinion: This advice was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. The advice was written to support the promotion or marketing of the transaction(s) or matter(s) addressed by the written advice. The taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.
Although the "opt-out" disclosures offer "bright-line" exceptions from the Covered Opinion rules and are straightforward enough, implementing them will not be so easy. Even informal written communications will now be required to include onerous "opt-out" disclosure language not easily explained to clients.31
The "opt-out" disclosures will have obvious consequences for penalty protection purposes. According to the Preamble to the Circular 230 final regulations, Regs. §1.6664-4 will be amended to clarify that a taxpayer cannot rely upon written advice that contains the "opt-out" disclosure for avoiding treatment as a Reliance Opinion or Marketed Opinion in order to establish the "reasonable cause and good faith" defense to the accuracy-related penalties.
After taking into account the foregoing exceptions, it becomes clear that certain written advice constitutes a per seCovered Opinion. No exceptions are available for written advice subject to conditions of confidentiality or written advice subject to contractual protection. Similarly, no exceptions from the Covered Opinion definition are provided for either a Reliance Opinion or a Marketed Opinion that concerns a Listed Transaction or Principal Purpose Transaction. Practitioners should not be surprised by, and most probably would not complain about the application of the more stringent Covered Opinion rules to these categories of tax opinions.
Covered Opinion Requirements
Circular 230 begins with the basic requirement that the practitioner providing a Covered Opinion must be competent to render such written advice by being knowledgeable in all aspects of the relevant federal tax law. However, Circular 230 acknowledges that there may be occasions when a practitioner rendering a Covered Opinion may need to rely on another practitioner more qualified in an area of federal tax law relevant to one or more significant federal tax issues that the Covered Opinion must address. Unless the practitioner knows or should have reason to know that the other practitioner is not qualified, a practitioner is allowed to rely on the opinion of another practitioner, as long as the opinion identifies the other opinion relied upon and sets forth the conclusions in that other opinion.32
A practitioner providing a Covered Opinion must comply with each of the requirements set forth in §10.35(c) of Circular 230. Yet, no assurance is given that compliance with the Covered Opinion requirements will shield a taxpayer from the imposition of a penalty, since the persuasiveness of, and the taxpayer's good faith reliance on the Covered Opinion will be evaluated separately.33 Following is a summary of the Covered Opinion requirements:
Due Diligence. The practitioner must use reasonable efforts to identify and ascertain all relevant facts, including facts relating to future events if the transaction is prospective or proposed, and the opinion must identify and consider all facts that the practitioner determines to be relevant.
No unreasonable factual assumptions. The practitioner must not base the opinion on any unreasonable factual assumptions (including assumptions as to future events), and the opinion must identify in a separate section all factual assumptions (including a projection, financial forecast, or appraisal) relied upon by the practitioner. For example, Circular 230 provides that it is unreasonable for a practitioner to assume that a transaction has a business purpose or is potentially profitable apart from tax benefits, or to make an assumption with respect to a material valuation issue. It is also unreasonable to rely on a projection, financial forecast, or appraisal if the practitioner knows or has reason to know that the report is incorrect or incomplete or was prepared by an unqualified person.
No unreasonable factual representations, statements, or findings. The practitioner must not base the opinion on any unreasonable factual representations, statements or findings of the taxpayer or any other person, and the opinion must identify in a separate section all factual representations, statements or findings of the taxpayer relied upon by the practitioner. It is unreasonable to rely on a factual representation that the practitioner knows or should know is incorrect or incomplete. For example, a practitioner may not rely on a factual representation that a transaction has a business purpose if the representation does not include a specific description of the business purpose or the practitioner knows or should know is incorrect or incomplete.
Application of law to facts. The opinion must relate the applicable law (including potentially applicable judicial doctrines) to the relevant facts and must not contain any internally inconsistent legal analyses or conclusions. The practitioner must not assume the favorable resolution of any significant federal tax issue, except as permitted in a Limited Scope Opinion, as discussed below, or an opinion that relies in part on another opinion, or otherwise base an opinion on any unreasonable legal assumptions, representations, or conclusions.
Evaluation of all significant federal tax issues. The opinion must consider all significant federal tax issues, except as permitted in a Limited Scope Opinion or an opinion that relies in part on another opinion, and the opinion must provide the practitioner's conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each significant federal tax issue, or else state that the practitioner is unable to reach a conclusion with respect to one or more issues, and describe the reasons for the conclusion(s) or failure to reach such conclusion(s). If the practitioner fails to reach a "more likely than not" conclusion with respect to one or more significant federal tax issue, the opinion must include the appropriate disclosure(s), described below. In evaluating the significant federal tax issue(s), the opinion must not take into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issued will be resolved through settlement if raised.
Overall conclusion. The opinion must provide the practitioner's overall conclusion as to the likelihood that the federal tax treatment of the subject transaction or matter is the proper treatment and the reasons for the conclusion. If the practitioner is unable to reach an overall conclusion, the opinion must state that the practitioner is unable to reach an overall conclusion and describe the reasons for the inability to reach a conclusion. A marketed opinion must provide the practitioner's overall conclusion that the federal tax treatment of the subject transaction or matter is the proper treatment at a confidence level of at least "more likely than not."
Limited Scope Opinion. A practitioner may provide a "Limited Scope Opinion" that considers less than all of the significant federal tax issues, provided that (1) the practitioner and the taxpayer agree that reliance for penalty avoidance purposes is limited to the federal tax issue(s) addressed in the opinion; (2) the opinion does not involve a Listed Transaction, Principal Purpose Transaction, or a Marketed Opinion; and (3) the opinion includes the required disclosure(s). A practitioner may make a reasonable assumption regarding the favorable resolution of a federal tax issue but must identify in a separate section of the opinion all issues for which a favorable resolution is assumed.
Marketed Opinion special rules. A Marketed Opinion must include the required disclosure(s). A Marketed Opinion must evaluate all of the significant federal tax issues and provide a conclusion that the taxpayer will prevail on the merits at a confidence level of at least "more likely than not" conclusion with respect to each significant federal tax issue addressed. The practitioner is not permitted to provide a Marketed Opinion if unable to reach a "more like than not" conclusion with respect to each significant federal tax issue. In that case, the practitioner may render written advice only if the non-marketed opinion "opt-out" disclosure is provided.
Of the Covered Opinion requirements, two are most troublesome, especially as applied to what previously were informal tax opinions. One is the extensive factual due diligence that must be undertaken and recorded in the opinion. Practitioners frequently rely on factual assumptions in rendering informal advice, but are now told that it is unreasonable, for example, to make a valuation assumption (if value is a material issue) or to assume that a transaction has a business purpose. Similarly, the informal opinion practice of relying on factual descriptions provided by a colleague close to the transaction would not satisfy the factual due diligence requirement of a Covered Opinion. The opinion can make reasonable assumptions concerning a projection, financial forecast, or appraisal, as long as the report is evaluated for completeness and correctness. Any and all factual assumptions must be identified in a separate section of the opinion. Likewise, practitioners can continue to rely on reasonable taxpayer factual representations through an Officer's Certificate or a third-party factual representation, provided the opinion identifies in a separate section all such representations, statements, or findings relied upon.
The other troublesome requirement is the detailed analysis required in applying the law to the facts. Practitioners well aware of the applicable judicial doctrines have a sense of when a step transaction analysis, for example, is appropriate under the circumstances. For deals driven by genuine business considerations, an analysis of the economic substance might have been thought unnecessary when opining informally. Whether it is appropriate to conduct an extensive analysis of the facts under the applicable judicial doctrines is no longer a matter of seasoned professional judgment in informal opinions. The Covered Opinion requirements apply with equal force to informal opinions. Yet, many clients accustomed to receiving informal opinions do not want to pay for such an extensive analysis.
Certainly, with many routine transactions, the tax treatment may be clear and may not raise a "significant" federal tax issue. In such cases, the tax practitioner is free to give informal written advice not subject to the Covered Opinion requirements. In other cases, however, the tax practitioner faces a quandary. Assuming the subject transaction is not a Listed Transaction or a Principal Purpose Transaction, the tax practitioner can provide either written tax advice with "opt-out" disclosure language—leaving the client with little confidence in the advice given—or else a full-blown Covered Opinion—at significantly greater cost to the client.
For the client who requests targeted advice but still expects penalty protection, the compromise offered by Circular 230 is a Limited Scope Opinion with disclosure. The Limited Scope Opinion enables a practitioner to provide a "more likely than not" opinion on selected significant federal tax issues, without having to comply with the Covered Opinion requirements for the other federal tax issues. However, as discussed below, the Limited Scope Opinion must prominently disclose that it cannot be used for penalty protection purposes on the federal tax issues not addressed therein. Unfortunately, this disclosure language may suggest a lack of confidence in the advice and will likely have a chilling effect on the client relations.
Covered Opinion Disclosures
The Covered Opinion must include certain required disclosures that are designed to provide taxpayers with the information necessary to evaluate and rely on the written advice. The practitioner cannot provide advice that is contrary to or inconsistent with a required disclosure. The required disclosures are as follows:35