Disclosure for opinion that fails to reach a "more likely than not" conclusion: An opinion that fails to reach a confidence level of at least "more likely than not" with respect to a significant federal tax issue must prominently disclose that (1) the opinion does not reach a conclusion at a confidence level of at least "more likely than not" with respect to one or more significant federal tax issues addressed by the opinion; and (2) with respect to those significant federal tax issues, the opinion was not written, and cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.
As a practical matter, the new Circular 230 rules effectively shut down the ability to issue and mass market a Marketed Opinion concerning a Listed Transaction or a Principal Purpose Transaction because of the more onerous requirements that attach to this form of Covered Opinion. The Marketed Opinion must reach an overall conclusion at a confidence level of "more likely than not." To reach such a conclusion, the Marketed Opinion must address each significant federal tax issue and satisfy all of the Covered Opinion requirements, without exception, since a Marketed Opinion cannot be a Limited Scope Opinion. Factual assumptions relating to business purpose or that the transaction is potentially profitable apart from the tax benefits are not permitted in a Covered Opinion. The Marketed Opinion must also include certain required disclosures and, to the extent applicable, disclosures concerning conditions of confidentiality, contractual protection, and any relationship between the promoter and practitioner.
Standards for Other Written Advice
Standards for written advice outside the definition of a Covered Opinion are governed by §10.37. A practitioner must not give Other Written Advice if the practitioner (1) bases the written advice on unreasonable factual or legal assumptions; (2) unreasonably relies upon representations, statements, finding or agreement of the taxpayer or any other person; (3) fails to consider all relevant facts; or (4) takes into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be settled.
As discussed, most written tax advice will fall outside of the Covered Opinion definition and will be subject to these rather vague rules for Other Written Advice. We are simply told that the scope of the engagement and the type and specificity of the advice sought by the client, in addition to other facts and circumstances, will be considered in determining whether a practitioner has failed to comply with the requirements. A more useful directive is found in the Preamble, which states that §10.37, unlike §10.35, does not require the practitioner to describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, or the practitioner's conclusion with respect to the law and the facts.
Also unclear is the extent of the tax practitioner's accountability under Circular 230 for Other Written Advice conveyed to a client by another firm attorney. The tax practitioner in a firm often provides oral or informal written tax advice concerning the structuring of a transaction to a transaction attorney, who is responsible for implementing the recommended tax structure. The tax practitioner may send an internal e-mail suggesting a tax structure to the transaction attorney, who then communicates the information to the client orally or may even forward the tax practitioner's e-mail to the client. Because the tax practitioner presumably would be responsible for such tax advice conveyed by another firm attorney to the client and the forwarded e-mail would be subject to scrutiny under Circular 230, tax practitioners will now have to monitor these internal communications more closely.
DISCLOSURE FRAMEWORK POST-AJCA
Historically, Congress and the IRS have attempted to discourage taxpayers from participating in and tax practitioners from promoting abusive tax shelters through a series of required disclosures—reportable transaction disclosures by taxpayers, tax shelter registration by advisors and investor list maintenance rules. As discussed more fully below, the enactment of the AJCA not only modified this framework but more importantly added several new penalty provisions that impose significant penalties on taxpayers and their advisors for failing to make the required disclosures.
Taxpayer Disclosure of Reportable Transactions
The regulations under §6011 provide that any taxpayer, including an individual, trust, estate, partnership, S corporation, or other corporation, that has participated36 in a reportable transaction and is required to file a U.S. federal income tax return or information return must attach a disclosure statement to its tax return. There are six categories of reportable transactions, sometimes also referred to as "filters"—(1) Listed Transactions,37 (2) confidential transactions,38 (3) transactions with contractual protection,39 (4) loss transactions,40 (5) transactions with a significant book-tax difference,41 and (6) transactions involving a brief asset holding period.42 The regulations also provide that the status of a particular transaction as a reportable transaction under Regs. §1.6011-4(b) does not affect the legal determination of whether the taxpayer's treatment of the transaction is proper.43
To disclose participation in a reportable transaction, the regulations require most taxpayers to complete and attach Form 8886, Reportable Transaction Disclosure Statement, to their returns (or amended returns in the case of a loss carry-back that results in a reportable transaction).44 Such taxpayers must also send a copy of Form 8886 to the Office of Tax Shelter Analysis (OTSA) at the same time.45 For taxable years ending on or after December 31, 2004, certain corporate taxpayers may satisfy the disclosure requirement for significant book-tax differences by filing a completed Schedule M-3, rather than Form 8886, with its timely filed original tax return for the taxable year at issue.46 Such taxpayers also must send a copy of their Schedule M-3 to the OTSA. Schedule M-3, Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More, is a new attachment to Form 1120, U.S. Corporation Income Tax Return. Of course, corporate taxpayers filing Schedule M-3 must file Form 8886 if they participate in a transaction that falls within one of the other five reportable transaction categories.
Penalties for Failure to Disclose Reportable Transactions
Through the AJCA, Congress recently added new §6707A,47 which imposes penalties on taxpayers who fail to disclose reportable transactions. Under this provision, the penalty for failing to disclose a reportable transaction (other than a Listed Transaction) is $10,000 for individuals and $50,000 for all other taxpayers.48 The penalty for failing to disclose a Listed Transaction is $100,000 for individuals and $200,000 for all other taxpayers.49 Taxpayers required to file periodic reports with the SEC must disclose the imposition of this penalty on their SEC filings.50 Specifically, SEC filing companies must disclose payment of penalties under §§6707A (penalty for failure to disclose a any reportable transaction under §6011), 6662A (30% penalty relating to understatement attributable to undisclosed Listed Transaction and reportable avoidance transaction), and 6662(h) (gross valuation misstatement penalty attributable to undisclosed Listed Transaction or reportable avoidance transaction). The failure to make this disclosure to the SEC is considered a failure to disclose a Listed Transaction.51
In advance of forthcoming regulations under §6707A, the IRS has issued interim guidance providing that the penalty under §6707A applies to each failure to disclose a reportable transaction in a timely manner and in the prescribed form.52 Thus, for example, if a taxpayer dutifully attaches Form 8886 to its original or amended federal income tax return but fails to provide a copy of Form 8886 to the OTSA, the §6707A penalty will apply because the taxpayer failed to comply with both disclosure requirements.
With the exception of penalties imposed for failing to disclose a Listed Transaction, which have strict liability, the IRS may rescind all or any portion of the penalty imposed under §6707A if rescinding the penalty would promote compliance with the tax laws and effective tax administration.53 Because the IRS Commissioner must report annually to Congress regarding the total number and aggregate amount of penalties imposed and rescinded under §6707A,54 the IRS may be even less inclined to waive §6707A penalties. The IRS's denial of a rescission request is not subject to judicial review.55
The §6707A penalty applies to tax returns and statements due after October 22, 2004, the date of AJCA's enactment. A potential trap for the unwary can arise if a transaction becomes a Listed Transaction after the taxpayer has filed the tax return for the relevant taxable year but before the taxable year has closed. In such case, the regulations under §6011 require the taxpayer to file Form 8886 as an attachment to its next tax return filed after the date the transaction was listed disclosing that it participated in a Listed Transaction in a prior taxable year even though the transaction at issue was not a Listed Transaction when the taxpayer filed its tax return for the prior taxable year.56 Disclosure is required not only in the subsequent year in which the transaction becomes a Listed Transaction, but for each year that the taxpayer participates in and receives tax benefits from the transaction. Failing to disclose a subsequently declared Listed Transaction after October 22, 2004, will trigger a penalty under §6707A.
To avoid foot-faulting into the failure to disclose penalty, taxpayers must closely monitor the IRS's published guidance regarding new Listed Transactions to determine whether transactions from prior taxable years that remain open are the same or substantially similar to a new Listed Transaction. It is unclear whether written advice opining as to whether a transaction completed in a prior open taxable year is substantially similar to a transaction characterized as a Listed Transaction in a subsequent taxable year constitutes a Circular 230 Covered Opinion if the tax practitioner does not opine as to the proper tax treatment of the transaction at issue. To err on the side of caution and ensure avoidance of the Covered Opinion requirements, the written advice could include the Limited Scope Opinion disclosure.
Amended Accuracy-Related Penalty
With a few notable exceptions discussed below, the AJCA left the accuracy-related penalty under §6662(a) largely unchanged. Section 6662(a) imposes a penalty equal to 20% of the tax underpayment attributable to certain types of misconduct. Section 6662(b) specifies five categories of misconduct: (1) negligence or disregard of the rules or regulations;57 (2) any substantial understatement of income tax; (3) any substantial valuation misstatement; (4) any substantial overstatement of pension liabilities; and (5) any substantial estate or gift tax valuation understatement. Section 6662 includes special rules that apply to tax shelters.
For purposes of §6662, a "tax shelter" is defined as a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, "if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax" (a "Tax Shelter").58 Thus, post-AJCA, a Tax Shelter includes any Reportable Avoidance Transaction and any other transaction with a significant purpose of tax avoidance or evasion. Transactions that are reportable under Regs. §1.6011-4 but lack a significant purpose of tax avoidance, by definition, should not qualify as a Tax Shelter.
The accuracy-related penalty is tied to key definitions in §6662(d). A "substantial understatement" is defined as the excess of the amount of tax required to be shown on the return over the amount that is shown on the return.59 The AJCA modified the substantial understatement threshold for corporations to be the lesser of (1) 10% of the tax required to be shown on the return (or, if greater, $10,000), or (2) $10,000,000.60 An understatement does not include amounts attributable to: (1) a position (not involving a tax shelter) that is supported by substantial authority,61 or (2) a position that has a reasonable basis and is adequately disclosed.62 Pre-AJCA, the reasonable basis and adequate disclosure exception described above was available to non-corporate taxpayers if there was substantial authority for the taxpayer's position and the taxpayer was able to demonstrate that at the time he filed the return he reasonably believed that his treatment of the Tax Shelter item was more likely than not the proper treatment.63 This relief was not available to corporate taxpayers.
Congress attempted to close this loophole by amending §6662(d)(2)(C)(i) to provide that no taxpayer may reduce the amount of its understatement attributable to a Tax Shelter item.64 Perhaps, an unintended consequence of this statutory change was that any attempt post-AJCA to reduce or eliminate the accuracy-related penalty attributable to a Tax Shelter item relies exclusively upon the "reasonable cause and good faith" exception of §6664(c), which effectively reinstates the pre-AJCA distinction between corporate and non-corporate taxpayers.
The existing regulations under §6664(c) provide a special rule for corporate taxpayers that have participated in a Tax Shelter. Specifically, the rule provides that in order for a corporate participant in a Tax Shelter to qualify for the "reasonable cause and good faith" exception, the corporation must be able to demonstrate that it reasonably believed, at the time the return was filed, that its tax treatment of the transaction was more likely than not the proper treatment.65 In most cases, such belief would be evidenced by reliance upon an opinion of a nondisqualified tax advisor concluding that there was a greater than 50% likelihood that the taxpayer's treatment of the transaction was correct. In contrast, non-corporate taxpayers may invoke the "reasonable cause and good faith" exception upon a showing of a "reasonable basis" for the tax reporting position.66 The "reasonable basis" standard is greater than "substantial authority" but less "more likely than not," which effectively reinstates pre-AJCA distinction in pre-2004 AJCA §6662(d)(2)(C)(i). Presumably, the IRS can resolve this issue easily by amending the regulations under §6664 to expand the "more likely than not" standard of belief to all taxpayers, not just corporations, that participate in a Tax Shelter.
Disclosures under certain circumstances affect the ability to establish the exception, however.67 A taxpayer may not rely on an opinion or advice that a regulation is invalid, unless the taxpayer adequately disclosed the position that the regulation in question is invalid.68 Further, if any portion of an underpayment is attributable to a "reportable transaction," within in the meaning of §6011, then failure by the taxpayer to disclose the transaction is a strong indication that the taxpayer did not act in good faith with respect to the portion of the underpayment attributable to the reportable transaction.69
One final point worth noting with respect to the accuracy-related penalty of §6662, and any other penalty for that matter, is that in June of 2004, the IRS released a Chief Counsel's Notice (CC-2004-036) reminding attorneys in the Office of Chief Counsel that they should not use the waiver of penalties as a bargaining tool in taxpayer settlement discussions, because doing so undermines the role of penalties in tax administration. In particular, this notice admonishes Chief Counsel attorneys to evaluate penalties based on their respective merits and hazards of litigation independent of the underlying tax adjustments.
Heightened Accuracy-Related Penalty for Certain Reportable Transactions
As part of the government's effort to discourage taxpayers from participating in tax shelters and other tax avoidance transactions, Congress enacted new §6662A, effective for taxable years ending after October 22, 2004.70 Section 6662A imposes a new accuracy-related penalty on any Listed Transaction and any reportable transaction (other than a Listed Transaction) the significant purpose of which is the avoidance or evasion of U.S. federal income tax (Reportable Avoidance Transaction).71 Unlike a Listed Transaction, a Reportable Avoidance Transaction may have a potential for tax avoidance but the return position ultimately may be sustained on the merits and accepted by the IRS.
The Reportable Avoidance Transaction concept is particularly problematic due to the difficulty of actually determining what constitutes "a significant purpose of tax avoidance or evasion." Moreover, the similarity between a Reportable Avoidance Transaction, for purposes of §6662A, and a Significant Purpose Transaction, within the meaning of Circular 230, further complicates matters. Conceptually, a Reportable Avoidance Transaction represents a subset of the Significant Purpose Transaction, namely, those Significant Purpose Transactions that fall within one of the six filters for which disclosure is required under §6011. To date, the IRS has not issued meaningful guidance with respect to the meaning of a Significant Purpose Transaction or "a significant purpose of tax avoidance or evasion." Such guidance is necessary given the significance placed upon the phrase "a significant purpose of tax avoidance or evasion" in Circular 230 and the reportable transaction disclosure framework post-AJCA.
Certain reportable transactions filters, such as contractual protection, confidentiality, or the brief asset holding period, are more likely to have a significant purpose of tax avoidance or evasion and, thus, to trigger the §6662A penalty. Each of the other two reportable transaction filters, losses, and significant book-tax differences, may have a real business nexus and, under certain circumstances, should arguably be subject only to the §6662 accuracy-related penalty. Section 6662 will continue to apply to those Reportable Avoidance Transactions not described in §6662A.
In contrast to the accuracy-related penalty of §6662, which only applies if there is a substantial understatement of taxes due, the new accuracy-related penalty under §6662A applies if there is an increase in taxable income or a reduction in tax credits allowed due to the disallowance of the intended tax benefits of the reportable transaction. Accordingly, a taxpayer may be subject to a penalty under §6662A even though there is no understatement (e.g., the taxpayer has a net operating loss before and after the IRS's adjustment). Although any tax understatement upon which a penalty is imposed under §6662A is not also subject to the accuracy-related penalty of §6662, the amount of the tax understatement will be increased by the amount of the reportable transaction understatement for purposes of determining whether the tax understatement is substantial under §6662, as amended by the AJCA.72
To illustrate the interplay between the two accuracy-related penalties, assume that Corporation X reports and pays taxes of $10 million on its 2005 return. Two years later, following an audit of this return, the IRS disallows $10 million of losses claimed on the return in connection with a Reportable Avoidance Transaction and recharacterized $3 million of previously deducted expenses as non-deductible capital expenditures. These adjustments resulted in a $4.5 million understatement, of which $3.5 million was attributable to the Reportable Avoidance Transaction and $1 million was attributable to the recharacterization of the capital expenditures. Assuming the reasonable cause and good faith exception does not apply, $3.5 million of the gross understatement will be subject to §6662A (the "reportable transaction understatement"). As noted above, the reportable transaction understatement also factors into determining whether the remaining portion of the understatement is "substantial" for purposes of §6662. Without the $3.5 million reportable transaction understatement, the remaining $1 million of the gross understatement would not be "substantial" under §6662(d) ($1 million does not exceed 10% of the $14.5 million in taxes due in 2005 or $10 million). However, when the reportable transaction understatement is taken into account for this purpose, the $1 million understatement is deemed to be "substantial" for purposes of §6662, as amended by the AJCA.
The penalty rate under §6662A is 20% of the understatement attributable to the offending transaction if the taxpayer previously disclosed its participation in the transaction pursuant to the regulations under §6011, and 30% if the taxpayer did not adequately disclose the relevant facts affecting the tax treatment of the transaction.73 Like payment of a §6707A penalty, a taxpayer required to file periodic reports with the SEC must disclose payment of a §6662A penalty in its SEC filings if the applicable §6662A rate is 30%.74 Failing to make this disclosure could result in the imposition of an additional $200,000 penalty under §6707A.75
To determine the amount of the §6662A penalty, the applicable rate is applied to the amount of the "reportable transaction understatement," which, as noted above, is not synonymous with a "substantial understatement of income tax" within the meaning of §6662. The "reportable transaction understatement" is calculated as follows:
(a) Determine the increase, if any, in taxable income that results from the proper tax treatment of an item affected by a reportable transaction subject to §6662A.
(b) Multiply the above increase by the highest applicable tax (35% for both corporations and individuals).
(c) Plus the decrease, if any, in the aggregate amount of tax credits due to the proper tax treatment of the reportable transaction.76
Unlike the §6707A penalty, which does not have a "reasonable cause and good faith" exception, Congress provided such an exception for the §6662A accuracy-related penalty.77 New §6664(d) provides that a showing of reasonable cause is predicated upon (1) the taxpayer's disclosure of the reportable transaction under Regs. §1.6011-4,78 (2) substantial authority for the taxpayer's treatment, and (3) a finding that the taxpayer reasonably believed that its treatment of the transaction was more likely than not the proper treatment.79 Because the reasonable cause exception requires that the taxpayer adequately have disclosed its participation in a reportable transaction, the failure to do so not only precludes the taxpayer from qualifying for the reasonable cause exception, it also increases the §6662A penalty rate from 20% to 30%. Put another way, the reasonable cause exception of §6664(d) only seems to apply if the applicable §6662A penalty rate is 20%.
A taxpayer will be considered to have a reasonable belief with respect to the tax treatment of an item only if such belief (1) is based on the facts and law in existence at the time the taxpayer filed its tax return for the year in question; and (2) relates solely to the taxpayer's chances of success on the merits and does not take into account the possibility that (i) a return will not be audited, (ii) the treatment will not be raised on audit, or (iii) the treatment will be resolved through settlement if raised.80 As discussed below, the "reasonable belief" rules of §6664(d)(3) contemplate that the taxpayer may rely on a tax opinion and are similar to the Circular 230 Covered Opinion requirements.
Material Advisor Disclosure of Reportable Transactions
As part of the AJCA, Congress replaced the registration of tax shelters concept under former §6111 with the requirement that each material advisor with respect to any reportable transaction (within the meaning of the §6011 regulations) timely file an information return with the IRS.81 Amended §6111 provides that the information return will include (1) information identifying and describing the transaction, (2) information describing any potential tax benefits expected to result form the transaction, and (3) such other information the Secretary of the Treasury may require.82 For purposes of amended §6111, the term "material advisor" means any person (1) who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction; and (2) who directly or indirectly derives gross income from such advice or assistance in excess of certain minimum thresholds ($50,000 for noncorporate persons or $250,000 for corporations).83 For Listed Transactions, the minimum fee threshold is reduced to $10,000 for noncorporate persons and $50,000 for corporations.84
The IRS has issued interim guidance for material advisors specifying that material advisors use Form 8264, Application for Tax Shelter Registration, with certain modifications to comply with amended §6111 until it revises this form or issues another form for this purpose.85 Notice 2005-2286 provides that a person will be treated as becoming a material advisor upon the occurrence of each of the following events: (1) material advisor makes a tax statement, (2) material advisor receives (or expects to receive) the minimum fee, and (3) the taxpayer enters into the transaction. A material advisor must file Form 8264 by the last day of the month that follows the end of the calendar quarter in which the advisor becomes a material advisor.87 Thus, if a person became a material advisor after October 22, 2004, and on or before March 31, 2005, that person must file Form 8264 before April 30, 2005. For substantially similar transactions, a material advisor is required to file only one Form 8264.88
The AJCA also significantly amended §6707,89 which previously imposed a penalty on persons who failed to register tax shelters under former §6111. Effective for information returns due after October 22, 2004, amended §6707 now imposes a penalty on any material advisor who fails to file the information return required under amended §6111, or who files a false or incomplete information return.90 The amount of the penalty is $50,000, unless the reportable transaction is a Listed Transaction, in which case the amount of the penalty increases to the greater of (1) $200,000, or (2) 50% (75% in the case of an intentional disregard of the requirement to file an information return) of the gross income derived by such person from the transaction.91 Amended §6707 incorporates by reference the limited waiver authority of new §6707A.92 As with waivers of the §6707A penalty, the IRS Commissioner must report to Congress regarding waivers of penalties under §6707.
Investor List Maintenance Rules
The AJCA amended §6112 to provide that each material advisor with respect to any reportable transaction is required to maintain a list that identifies each person with respect to whom such advisor acted as a material advisor with respect to the reportable transaction.93 Any person who is required to maintain this list is required to make the list available to the IRS for inspection upon its written request.94 If a material advisor fails to provide the investor list material to the IRS within 20 business of the request, §6708, which was also amended by the AJCA,95 imposes a $10,000 per day penalty for each day after the 20th day.96
Extended Statute of Limitations for Undisclosed Listed Transactions
In addition to the §6707A penalty for failure to disclose a reportable transaction, new §6501(c)(10) extends the statute of limitations for assessment of the tax liability associated with the Listed Transaction until one year after the earlier of (1) the date on which the taxpayer makes the required disclosure under §6011, or (2) the date a material advisor makes its required investor list maintenance disclosure. For example, if a transaction undertaken in 2005 becomes a Listed Transaction in 2007 and the taxpayer fails to disclose the transaction as required, the transaction is subject to the extended statute of limitations, and the §6707A failure to disclose penalty can apply as well.97 The amendment is effective for tax years that are still open on the date of enactment, October 22, 2004.
OPINION STANDARDS FOR ACCURACY-RELATED PENALTY PROTECTION POST-AJCA
Taxpayers have long been able to rely on an opinion from a professional tax advisor in support of various exceptions, including the §6664(c) "reasonable cause and good faith" exception, to the accuracy-related penalties under §6662.98 While leaving intact this "reasonable cause and good faith" exception as a defense to the accuracy-related penalty of §6662, the AJCA introduced a new "reasonable cause and good faith" exception in §6664(d) applicable to the heightened penalties under §6662A for Listed Transactions and Reportable Avoidance Transactions.
For any penalty protection opinion issued post-AJCA, careful crafting of the tax opinion cannot be overestimated. A tax opinion, even one rendered by a prominent law firm, is not per se penalty protection for the taxpayer. This is the lesson to be learned not only from the new Circular 230 rules and the disclosure framework but also from the recent decision in Long Term Capital Holdings.99
In denying the hedge fund's capital losses by either disregarding the transaction or recasting it under the step transaction doctrine, the U.S. District Court in Long Term Capital Holdingsconcluded that the tax shelter transaction had no business purpose other than tax avoidance and lacked economic substance beyond the creation of tax benefits. Of significance here is that the court upheld the IRS's application of the 40% gross valuation misstatement penalty under §6662(h) or, in the alternative, the 20% substantial understatement penalty under §6662(a). In doing so, the court took pains to provide a 40-page critique of the underlying legal opinions.
The facts and circumstances failed to demonstrate reasonable reliance on any pre-filing tax advice for several reasons. No written opinion was issued before the filing date of the tax return, and the testimony concerning reliance on prior oral advice was either too vague or inconsistent to support a finding of reasonable reliance. The court concluded that the written opinion, even if provided prior to the filing date, would have failed to satisfy the threshold requirements for reasonable good faith reliance. The opinion expressly relied on, without independent evaluation, various representations and assumptions concerning business purpose and the expectation of a material pre-tax profit. The opinion also contained what appeared to be a canned discussion of the judicial doctrines, since no attempt was made to analyze the applicable law of the Second Circuit. Nor was there any file memoranda providing further analysis in support of the opinion. Though aspects of the decision may be subject to criticism,100 practitioners must heed the teachings of Long Term Capital Holdings, which sound very similar to the Covered Opinion requirements under Circular 230.
As discussed below, the Covered Opinion requirements under Circular 230 largely parallel the AJCA disclosure and penalty framework. The Reliance Opinion confidence level tracks the penalty protection confidence level required for a transaction with "a significant purpose of tax avoidance or evasion." Certainly, in the view of Long Term Capital Holdings, many of the other Covered Opinion requirements reflect the standards already required of a tax shelter opinion intended for penalty protection purposes. Post-AJCA, the Covered Opinion requirements are legislated by §6664(d) as well as Circular 230.
Depending on the exception applicable to the misconduct, the confidence level standard for a tax opinion ranges from "reasonable basis," "realistic possibility," and "substantial authority" to "more likely than not."101 The "reasonable basis" position generally has been viewed, despite disagreement among commentators, as having a 10-20% or 20-25% likelihood of success.102 The "realistic possibility" standard is a reporting position that has a one-in-three, or greater, possibility of being sustained on the merits.103 The "substantial authority" position reflects some percentage higher than a "reasonable basis" position but below "a greater than 50%" certainty.104 The "more likely than not" standard is defined as a greater than 50% likelihood of the reporting position being upheld.105
Technically, there are two confidence level standards for a tax opinion prepared for protection from the accuracy-related penalties post-AJCA. In the case of a non-Tax Shelter item or a transaction without "a significant purpose of tax avoidance or evasion," a tax opinion could conclude at a confidence level of at least a "reasonable basis" for purposes of §6662 penalty protection. In the case of a corporate Tax Shelter item under §6662 or for purposes of the reportable transaction understatement penalty under §6662A,106 the tax opinion must conclude at the higher confidence level of at least "more likely than not." Although a tax opinion could still provide penalty protection for a non-shelter item based on a confidence level of less than "more likely than not," few taxpayers would be willing to pay for opinions offering such limited protection, absent government clarification of what constitutes "a significant purpose of tax avoidance or evasion."
The higher confidence level is required whenever a transaction has "a significant purpose of tax avoidance or evasion"—namely, a corporate Tax Shelter under §6662(d), a Reportable Avoidance Transaction under §6662A, or a Significant Purpose Transaction under the Circular 230 definition of a Covered Opinion. Unfortunately, the phrase "a significant purpose of tax avoidance or evasion," despite its prevalence in federal tax law, is not easily defined. Any transaction resulting in a significant tax savings arguably is caught by this web.
On the other hand, statutorily permitted tax-free exchanges, such as a non-recognition transaction under §1031 or §368, arguably should escape the web, if the transaction falls within well-defined regulatory or other published guidelines. That is to say, if the IRS would have no reasonable basis for challenging a federal tax issue material to the transaction's qualification for tax-free treatment, then the transaction should lack "a significant purpose of tax avoidance or evasion." At least this proffered distinction is consistent with the definition of a Reliance Opinion. Written advice does not constitute a Reliance Opinion and, thus, need not satisfy the Covered Opinion requirements, if the written advice concerns a transaction that does not implicate a "significant" federal tax issue as to which the IRS has a reasonable basis to challenge.
Further guidance defining "a significant purpose of tax avoidance or evasion" would obviously be helpful. Whether such guidance will be forthcoming is another matter. The government may simply be reluctant to issue "angel lists" similar to those provided for reportable transaction disclosure under §6011. Given the difficulty in determining what constitutes "a significant purpose of tax avoidance or evasion," in the absence of clear guidance, the better practice—and certainly the more prudent practice—would be to use a "more likely than not" confidence level in all tax opinions written for purposes of penalty protection.
Therefore, as a practical matter, a Reliance Opinion concluding with a confidence level of "more likely than not" has been legislated for nearly all written advice intended to be used for penalty protection purposes. If a tax practitioner uses another confidence level standard, even a higher standard such as "should" or "will," which is not defined under the current statutory or regulatory framework, it would be necessary to explain how that confidence level relates to the "more likely than not" standard.
The heightened "reasonable cause and good faith" exception of §6664(d) that accompanies the new §6662A accuracy-related penalty contains other defined terms that correspond to, but do not track as neatly, the Circular 230 Covered Opinion definitions. To avoid the heightened accuracy-related penalty for reportable transaction understatements, a taxpayer may not rely upon the opinion of a "disqualified tax advisor" or a "disqualified opinion" to establish its reasonable belief regarding the proper tax treatment of the transaction.107
A "disqualified tax advisor" is any advisor who (1) is a material advisor (within the meaning of §6111(b)(1), as amended)108 and participates in the organization, management, promotion, or sale of the transaction or is related to any person who so participates; (2) is compensated directly or indirectly by a material advisor with respect to the transaction; (3) has a fee arrangement with respect to the transaction which is contingent on all or part of the intended tax benefits from the transaction being sustained; or (4) has a disqualifying financial interest in the transaction.109 To be tainted as a "disqualified tax advisor," the material advisor must "participate" in the "organization, management, promotion, or sale" of the Listed Transaction or Reportable Avoidance Transaction. The "participation" by the material advisor here appears to require greater involvement than the level of activity—"any material aid, assistance, or advice with respect to … carrying out a reportable transaction"—within the meaning of the definition of "material advisor" under §6111(b)(1)(A). Although it sounds like the material advisor must be a promoter in order to become a "disqualified tax advisor," what, if anything, was intended by the difference in the material advisor's level of activity is not entirely clear.
No guidance on this issue can be gleaned from Circular 230, which does not employ the term "material advisor." More striking, the Covered Opinion requirements contain no proscription relating to a "disqualified tax advisor" similar to §6664(d)(3)(B)(ii). Under the Circular 230 rules, it is sufficient if the practitioner prominently discloses the promoter relationship in the Covered Opinion.110 Moreover, a Covered Opinion, by definition, can even include written advice subject to "contractual protection." Although revised rules under Circular 230 are expected to address contingent fee issues, it remains to be seen whether these new rules will coordinate with the rules under the post-AJCA disclosure framework and the PCAOB proposed rule concerning auditor independence and contingent fees.111
In light of the "disqualified tax advisor" rules under the "reasonable cause and good faith" exception of §6664(d), a taxpayer who received an opinion as to the proper tax treatment of a prospective transaction should consider obtaining a second tax opinion from another tax advisor after the transaction is consummated but before the tax return is prepared. A second opinion from an independent tax advisor would be necessary if subsequent events cause the practitioner who rendered the first tax opinion to become a "disqualified tax advisor." For example, a practitioner could became a "material advisor" later if the total fees paid to his or her firm, including subsequent fees paid for documenting the transaction, ultimately exceeded the threshold amount. Or, if the IRS subsequently declared the transaction in question to be a Listed Transaction, the taxpayer would not be able to rely upon an earlier opinion to support a reasonable belief at the time the return is filed that the reported position reflects the proper tax treatment of the transaction.
Written advice becomes a "disqualified opinion" if it (1) is based on unreasonable factual or legal assumptions (including assumptions as to future events); (2) unreasonably relies on representations, statements, findings, or agreements of the taxpayer or any other person; (3) does not identify and consider all relevant facts; or (4) fails to meet any other requirements prescribed the Secretary of the Treasury.112 These due diligence requirements sound very similar to the new Covered Opinion requirements under Circular 230. However, §35.10(f) of Circular 230 specifically states that even if the written advice meets the Covered Opinion requirements, the persuasiveness of the opinion and the taxpayer's good faith reliance on the opinion will be determined separately.
Still, the Covered Opinion requirements should provide a roadmap for avoiding the taint of a "disqualified opinion" under §6664(d)(3)(B)(iii). The current regulations under §6664(c) already cross-reference the Circular 230 rules.113 It would not be surprising if the full panoply of Covered Opinion requirements is eventually incorporated into the "reasonable cause and good faith belief" exceptions of §6664(c) and (d) to the accuracy-related penalties of §§6662 and 6662A. Nor would it be surprising if the "disqualified tax advisor" and "disqualified opinion" taints under §6664(d) find their way into the law under §6664(c).
Given the new reportable transaction disclosure and penalty framework post-AJCA, the Covered Opinion requirements under Circular 230 were not unexpected. What is perhaps most troubling is the treatment given to informal tax advice. Many forms of informal tax advice now must include the "opt-out" disclosure language or else be subject to the Covered Opinion requirements. A policy decision was clearly made in favor of forcing this choice whenever written advice addresses a Significant Purpose Transaction. Unfortunately, the free-flow of tax advice may suffer as a result.
In sum, we question whether the new AJCA provisions and Circular 230 rules will portend the sea change in tax practice about which many practitioners have complained. To be sure, tax advisors issuing Covered Opinions will face new requirements, some of which are onerous and difficult to explain to clients or even colleagues who are not tax practitioners. Yet many of the Covered Opinion rules are embodied in the §6664(c) and (d) "reasonable cause and good faith" exceptions and have always constituted "best practices." The new rules may simply limit the viability of a Marketed Opinion and put an end to "informal" advice, which now must be identified as such through "opt-out" disclosure language if the Covered Opinion requirements are to be avoided.
On the enforcement side, certainly the higher penalty amounts will deter a greater number of taxpayers from engaging in Reportable Avoidance Transactions. In addition, the IRS arsenal has been equipped with new weapons that may signal a new era of enforcement against delinquent taxpayers and practitioners. But if past experience is any guide, IRS enforcement efforts will remain limited. The agency's ability to engage in effective enforcement is hampered by inadequate funding, personnel shortages, and lack of resources. Malpractice litigation, more so than the Director of the Office of Professional Responsibility, has served to enforce professional standards.
To a large extent, a chilling effect on the tax shelter industry has already occurred from the public attention drawn to the misconduct of certain high profile companies and corporate officers, their selected prosecution, and the identification of Listed Transactions. In the end, the responsibility for compliance remains with the tax practitioner who must police both the client and his or her own tax practice. While the majority of practitioners have always aspired to "best practices," it remains to be seen whether stiffer penalties, greater transparency, and the self-policing framework will prove sufficient to deter the misconduct of those who are driven more by the culture of greed.
* Susan T. Edlavitch is a partner and Brian S. Masterson is an associate in Venable LLP's tax practice.
1 Recently, the IRS announced that it had collected more than $3.2 billion from taxpayers in the Son-of-BOSS tax settlement initiative. IRS News Release 2005-37 (3/24/05). While this figure is noteworthy, it pales in comparison to the estimated annual net tax gap of more than $250 billion. IRS News Release 2005-38 (3/29/05).
2 As revealed in the Nov. 2003 hearings on tax shelters held by the Permanent Subcommittee on Investigations of the U.S. Senate Committee on Governmental Affairs, the "tax shelter industry" consists of registered public accounting firms, investment advisory firms, international financial institutions, and major law firms, on the one hand, and wealthy individuals, corporations, and other taxpayers eagerly seeking methods to effect tax arbitrage, on the other hand. SeeU.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals, Hearings before the Permanent Subcommittee on Investigations of the Senate Committee on Governmental Affairs, 108thCong., 1st Sess.(2003); and S. Rep. No. 34, 108th Cong., (2003). See also Staff of the Joint Comm. on Tax'n, 108th Cong., Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (Comm. Print 2003).
A recent study highlights the financial benefits derived from corporate use of tax shelters. Because tax shelters lower taxes, a corporate taxpayer has less incentive to take on debt in order to lower taxes through accrued interest deductions. Tax-sheltering companies had debt-to-asset ratios that were one-third lower than companies that did not use tax shelters. The artificially inflated financial statements that result from tax shelters make these tax-sheltering companies more attractive to investors. Using tax shelters instead of debt-related tax deductions also reduces debt costs and improves the company's credit rating. See Graham & Tucker, "Tax Shelters and Corporate Debt Policy" (Dec. 2004), reprinted in Daily Tax Rep. (12/2/04), available in TaxCore-Miscellaneous Documents.
The U.S. Government Accountability Office reported that 207 of the Fortune 500 companies engaged in tax shelter transactions during 1998–2003 with an estimated potential tax revenue loss of nearly $56 billion. Of these, sixty-one companies obtained tax shelter services from their external auditors. SeeGAO Report to the Ranking Minority Member, U.S. Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and Governmental Affairs, Tax Shelters—Services Provided by External Auditors (Feb. 2005).
3 Section 201(a) of the Public Company Accounting Reform and Investor Protection Act of 2002, P.L. 107-204 (popularly known as the Sarbanes-Oxley Act), expressly prohibits eight types of non-audit services as well as other services that the PCAOB determines is impermissible for auditors to provide to their public company audit clients, but allows a registered publicly accounting firm to engage in non-audit tax services if approved in advance by the issuer's audit committee. As directed by the Sarbanes-Oxley Act, the SEC adopted new auditor independence rules prohibiting auditors from furnishing non-audit services to audit clients. The SEC rules also implemented the requirement that all auditing and non-audit services, including tax services, which are not expressly prohibited, be pre-approved by a client company's audit committee. See Revision of the Commission's Auditor Independence Requirements, Securities Act Release No. 33-7919 (11/21/00); and Strengthening the Commission's Requirements Regarding Auditor Independence, Securities Act Release No. 33-8183 (1/28/03).
4 SeeProposed Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees (PCAOB Rulemaking Docket Matter No. 017), PCAOB Release No. 2004-015 (12/14/04). Section 103(b) of the 2002 Sarbanes-Oxley Act directs the PCAOB to establish rules on auditor independence and ethics standards for registered public auditors.
5 PCAOB Proposed Rule 3521. Fees fixed by courts or other public authorities and not dependent on a finding or result would be excluded from the definition of "contingent fee." The proposed rule would eliminate the "tax matters" exception in SEC Rule §210.2-01(f)(10) for tax matters fees if determined based on the results of judicial proceedings or the findings of governmental agencies.
6 PCAOB Proposed Rule 3522(a), (b), and (c).
7 PCAOB Proposed Rule 3523.
8 Such routine tax consulting would include tax return preparation, tax compliance, general tax planning and advice, international assignment tax services, and employee personal tax services. SeeProposed Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees (PCAOB Rulemaking Docket Matter No. 017), PCAOB Release No. 2004-015 (12/14/04).
9 P.L. 108-357.
10 Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
11 At the same time, the AJCA amended §7525 to except from the confidentiality privilege written communications in connection with a "tax shelter," as defined broadly by §6662(d)(2)(C)(ii) to include any plan or arrangement with a significant purpose of a tax avoidance. Whereas, the common law protection of attorney client privilege remains, the privilege for written tax advice from accountants has effectively been eliminated because of the broad definition of tax shelter.
12 Regulations Governing Practice Before the Internal Revenue Service, T.D. 9165, 69 Fed. Reg. 75839 (12/20/04) (to be codified at 31 CFR pt. 10). [Editor’s Note: T.D. 9201, 70 Fed. Reg. 28824 (5/19/05), revised § 10.35 in certain respects. See the Editor’s Note at the beginning of this article.]
13 Circular 230 sets forth the rules governing the practice before the IRS. T.D. 9165, 69 Fed. Reg. 75839 (12/20/04), which adopts the 2003 proposed rules as revised, was promulgated pursuant to 31 USC §330 granting authority to the Secretary of the Treasury to regulate practice before the Treasury Department. As defined in §10.2(e), a "practitioner" means any attorney, certified public account, enrolled agent, or enrolled actuary who is not currently under suspension or disbarment from practice before the IRS, as described in §10.3(a), (b), (c), or (d), respectively. Other individuals qualifying under §10.5(d) (temporary recognition by the Director of Practice) and §10.7(d) (special appearances) are eligible to practice before the IRS to the extent provided therein.
14 See Preamble to T.D. 9165, 69 Fed. Reg. 75839 (12/20/04).
15 The discussion does not address state and local bond opinions, excluded from the definition of a Covered Opinion, for which proposed regulations (REG-159824-04, 69 Fed. Reg. 75887 (12/20/04)) were issued concurrently with T.D. 9165. The discussion also does not address the final regulation (§10.38) providing for advisory committees on the integrity of tax professionals. Nor does the discussion address other professional standards that apply to practitioners.
16 Section 10.52 of Circular 230 provides that a practitioner may be censured, suspended, or disbarred from practice before the IRS for the following "prohibited conduct:" (1) willfully violating any of the Circular 230 rules (other than the §10.33 "best practices"); or (2) recklessly or through gross incompetence violating these final regulations (§§10.35, 10.36 or 10.37) and §10.34 (standards for advising with respect to tax return positions and for preparing or signing returns). Under an amendment to 31 USC §330 made by the AJCA, the Treasury and the IRS now have authority to impose a monetary penalty against a practitioner who violates any provision of Circular 230.
17 Section 10.36 of Circular 230 provides that the practitioner who has principal authority and responsibility for overseeing a firm's tax practice must take reasonable steps to ensure that the firm has adequate procedures in effect to ensure compliance with the Covered Opinion rules of §10.35.
By requiring the tax department head to take steps to ensure that adequate procedures for compliance with the Covered Opinion requirements are in place, the new rules give recognition to the reality that the firm culture can influence tax practice. To demonstrate the quality controls, a tax department head should disseminate the required procedures in writing, conduct meetings to communicate the procedures to affected practitioners, and establish a plan for monitoring written advice prepared by practitioners. Rules that address the firm-wide tax practice are clearly a step in the right direction, though some have argued that the rules do not go far enough. SeeSheppard, "Shelter Penalties: Or Else What? Part 2," 106 Tax Notes141 (1/10/05).
18 The complexity of the Circular 230 rules is illustrated graphically by the decision matrixes provided in Giancana, "Circular 230 Decision Matrixes," 106 Tax Notes1295 (3/14/05); and a flowchart by Jeffrey H. Paravano and Melinda Reynolds, Baker & Hosteller LLP, reproduced in Sheppard, "Shelter Penalties: Or Else What? Part 3," 106 Tax Notes899 (2/21/05). Many practitioners have already incorporated the new rules, notwithstanding difficulties in implementation, as part of their "best practices."
19 Circular 230 §10.33(a).
20 Id. §10.33(b).
21 To date, the IRS has identified 31 "listed transactions" as abusive tax shelters in notices or other published guidance. See Notice 2005-13, 2005-9 I.R.B. 630 (designating sale-in, lease-out arrangements as a Listed Transaction). The current list can be viewed on the IRS website at www.irs.gov.
22 Circular 230 §10.35(b)(4).
23 Id. §10.35(b)(5).
24 Id.§10.35(b)(6). But for the minimum fee requirement applicable in the reportable transaction context, Circular 230 defines "conditions of confidentiality" in similar fashion to the definitions found in the reportable transaction regulations discussed below. Compare Circular 230 §10.35(b)(6), with Regs. §1.6011-4(b)(3).
25 At least one commentator has gone so far as to suggest that tax practitioners should consider adding a waiver of confidentiality to written advice not intended to be a Covered Opinion. Lipton et al., "The World Changes: Broad Sweep of New Tax Shelter Rules in AJCA and Circular 230 Affect Everyone," J. Tax'n 134, 147 (Mar. 2005).
26 The meaning of the phrase "contractual protection" in Circular 230 is essentially identical to the meaning of such term in the reportable transaction regulations. Compare Circular 230 §10.35(b)(7), with Regs. §1.6011-4(b)(4).
27 Circular 230 §10.35(b)(3). A "federal tax issue" is a question concerning the federal tax treatment of an item of income, gain, loss, deduction, or credit, the existence or absence of a taxable transfer of property, or the value of property for federal tax purposes.
28 Section 10.35(b)(9) of Circular 230 defines a "State or local bond opinion" as written advice included in any materials delivered to a purchaser of a state or local bond in connection with the issuance of the bond in a public or private offering, including an official statement that concerns the gross income exclusion under §103, application of §55, the status of a state or local bond as a qualified tax-exempt obligation under §265(b)(3), the status of a state or local bond as a qualified zone academy bond under §1397E, or any combination of the above.
29 Circular 230 §10.35(b)(2)(ii).
30 Id. §10.35(b)(8). [