IRS Raises Standard for Tax Practitioners Providing Tax Opinions

By Robert E. Demmett

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Tax Opinions That Support Tax-Motivated Transactions

In December 2003, the Treasury Department proposed modifications to Circular 230 (regulations that govern individuals eligible to practice before the IRS). Section 10.33 was amended to provide that tax professionals should adhere to “best practices” when providing tax advice. The IRS describes best practices as including:

• Ensuring that the taxpayer understands the scope, purpose, and use of the advice.
• Establishing the facts and evaluating the reasonableness of assumptions or representations.
• Relating the applicable law (including potentially applicable judicial doctrines) to the relevant facts.
• Arriving at a conclusion that is supported by the law and the facts.
• Advising the taxpayer of the import of the conclusion, including whether penalties can be avoided if he relies on the advice.
• Acting fairly and with integrity in practice before the IRS.

Previously, section 10.33 provided rules for practitioners regarding tax shelter opinions. Generally, a practitioner was required to inquire about all relevant facts and to be satisfied about the accuracy and completeness of all material facts. The tax professional could accept a valuation or a projection from the taxpayer as long as it was prepared by a competent person and made sense on its face.

The old section 10.33 was replaced with the new section 10.35, which provides requirements for issuing tax shelter opinions. Section 10.35 applies to “more likely than not” tax shelter opinions and “marketed” tax shelter opinions. A “more likely than not” tax shelter opinion is an opinion that reaches the conclusion that the taxpayer’s position has a more than 50% chance to be resolved in her favor. A “marketed” tax shelter opinion will be used by someone other than the author in promoting, marketing, or recommending the tax shelter.

The new section 10.35 requires reasonable efforts to identify and ascertain all relevant facts. In addition, the tax professional must not base the opinion on any unreasonable factual assumptions or representations that the practitioner knows or should know are incorrect. The practitioner must relate the applicable law to the relevant facts and must not base an opinion on unreasonable legal assumptions, representations, or conclusions.

Section 10.35 allows limited-scope opinions (except for in “marketed” tax shelter opinions), which must disclose in their opening paragraph their limitation to one or more tax issues that have been agreed upon by the taxpayer. Limited-scope opinions, as well as all other opinions, must clearly state the tax advisor’s overall conclusion about the likelihood that the federal tax treatment of the tax shelter item is proper, as well as the reasons for that conclusion. If the advisor cannot reach an overall conclusion, the opinion must describe the reasons why.

The proposed modifications to Circular 230 supersede proposed amendments issued in January 2001. While the definition of “tax shelter” in section 6662 remains, the IRS excluded preliminary advice from the definition of a tax shelter opinion in circumstances where an opinion that satisfies the requirements of section 10.35 will subsequently be provided.

Section 10.35 also provides for certain mandatory disclosures in the beginning of the opinion. Any compensation or referral arrangement between the tax advisor and the promoter or marketer must be disclosed. In addition, a “marketed” tax shelter opinion must state that the taxpayer should seek advice from her own tax advisor based upon individual circumstances, and it must state that the opinion may not be sufficient to avoid penalties.

To ensure compliance, section 10.35 requires that tax advisors overseeing a firm’s practice of providing tax opinions implement procedures to be followed by all members, associates, and employees of the firm. Failure to take reasonable steps to establish procedures will subject the practitioner to disciplinary action.

Defenses to the Accuracy-Related Penalty

One way to defend against the imposition of the 20% penalty for negligence or disregard of rules and regulations is to show that the taxpayer had reasonable cause and acted in good faith. Reliance on tax advice generally demonstrates that the taxpayer acted in good faith. Regulations proposed in December 2002, however, provided that this exception was not available to taxpayers who failed to disclose a “reportable” transaction as defined in Treasury Regulations section 1.6011-4(b). In response to comments by the public, the Treasury Department relaxed this provision in the final regulations it issued in December 2003. The final regulations provide that failure to disclose is a strong indication that a taxpayer failed to act in good faith, but does not automatically prevent the taxpayer from raising the reasonable-cause defense to the penalty.

The proposed regulation also provided that taxpayers taking a position that a regulation is invalid must disclose this position in order to raise the reasonable-cause and good-faith defense to the penalty. While some practitioners complained that taxpayers might not know whether an advisor is taking a position that a regulation is invalid, this provision was retained in the final regulations.

Disclosure of Confidential Transactions

Section 6011 and the regulations thereunder require disclosure of reportable transactions. Reportable transactions are defined as transactions that fall into any of six listed categories. One category included transactions marketed under conditions of confidentiality. In February 2003, the Treasury Department issued final regulations under section 6011, including a definition of “conditions of confidentiality.” The Treasury received numerous comments from practitioners that the definition of a confidential transaction in the final regulations was overly broad. As a result, in December 2003 the Treasury Department issued changes to the final regulation which clarified that a confidential transaction does not include a transaction in which confidentiality is imposed by a party to the transaction. A confidential transaction is limited to situations in which an advisor is paid a minimum fee and imposes a limitation on disclosure that protects the confidentiality of his tax strategy. The changes to the regulation define the minimum fee for such purpose and describe what services are includible in determining the fee.

Additional Responsibilities

While some of the changes described above provide taxpayers with some relief, others create additional responsibility for tax advisors. The Treasury Department made it clear in its announcement that it was increasing the standards placed on tax advisors. A top priority for the Treasury Department is to stop the promotion of tax shelters, and it has shown that it will continue to change the rules to accomplish this, even after the rules are finalized. The government’s strategy is to force disclosure to ensure that it becomes aware of tax shelters faster, and to penalize taxpayers that enter into the transactions, as well as the tax advisors that promote them.