Aggressive Tax Strategies and Client Expectations

By John F. Raspante

Business partners Emory Hammer and Preston Wood own six hardware stores and lumberyards, which are considered six separate S corporations, in the Buffalo-Rochester area. The partners own equal shares of 100 percent of the stock of the six corporations.

Hammer and Wood are both interested in retiring and selling the assets of the corporations, if the gain on the sales can be deferred for state and federal income tax purposes and enough estate tax savings can be realized.

Their attorney, Joe Cartwright, devises a plan whereby Hammer’s and Wood’s children would form a Limited Liability Corporation (LLC) with a minimal amount of cash. The LLC would enter into an agreement with each of the six corporations whereby the corporations would sell their assets to the LLC on an installment basis.

Hammer and Wood would then cause each of the corporations to be liquidated so that they would receive six installment obligations. The LLC would enter into negotiations to sell the newly acquired assets to a third party for cash and/or securities.

Cartwright drafts a research memorandum for the clients, covering the technical aspects of how the tax codes treat the various provisions of his plan, and sends a copy of the memo to the partners’ accountant, Bob Waverly.

Waverly reviews the memo and talks with Cartwright by telephone to present his arguments that the sale of assets to the LLC may be deemed a related-party or controlled-group transaction by the taxing authorities, thereby negating any tax advantages of the plan. Waverly also acknowledges in his conversation with Cartwright that the taxing authorities may apply different rules first, resulting in a positive result for the plan. Waverly takes no concluding position in the conversation with Cartwright.

Subsequent communications between Cartwright and Waverly are haphazard, partly because the attorney disagrees with the CPA’s opinion that the plan may not work. Meanwhile, Hammer and Wood proceed with the plans to sell their assets, operating under the assumption that there will be minimal taxes paid. Cartwright ultimately decides to go forward with the plan, and the transactions are consummated. Waverly follows the attorney’s lead, preparing and signing the tax returns as the preparer.

A year later, the Internal Revenue Service audits all of the S corporations’ tax returns for the year they were sold and issues a notice of proposed assessment for each corporation. Hammer and Wood consult with other legal and tax advisors, who inform them that there are tax complications as a result of the transactions, including substantial additional tax liabilities. The partners engage another attorney, Ambrose Chase, to sue Cartwright and Waverly for malpractice.

Loss Prevention Tips

Attorney Chase asserts that if Waverly had reservations about Cartwright’s plan, he should not have signed and filed the tax returns, but his opinion is not entirely correct. As long as “the CPA has a good faith belief that a position has a realistic possibility of being sustained administratively or judicially on its merits if challenged” and “is not frivolous,” the CPA can recommend a gray or aggressive tax position to a client.

Where Waverly could have improved his risk management is in the education of Hammer and Wood on the consequences and risks of the return, and in his documentation. A significant number of tax claims against CPAs result when clients are given oral advice. Make it a policy to put all tax planning advice in writing, specifically, an “informed consent” letter outlining the pros, cons and options (in terms the clients will understand), and obtain the clients’ consent to the risks before filing the return. The informed consent letter clarifies that the professional advises and informs, and the client decides. Without this letter, it is easier for claimants to make it appear that the professional made the decisions.

AICPA SSTS 1.02(d) states: “In recommending a certain tax return position and signing the return in which a tax position is taken, a CPA should, where relevant, advise the client as to the potential penalty consequences of the recommended tax return position, and the opportunity, if any, to avoid such penalties through disclosure.”

SSTS 1.11 states: “Where particular facts and circumstances lead the CPA to believe that a taxpayer penalty might be asserted, CPAs should so advise the client and should discuss with the client issues related to disclosure on the tax return...”

Disclosures can be useful on returns that stand a good chance of being penalized for “frivolous” positions or substantial underpayments, but they may also throw up red flags to auditors. If your client takes a gray position without disclosing it on a tax return, confirm the client’s decision (and that the client shall bear responsibility for all tax, penalty or interest exposure) in a letter. It is sometimes advisable to insist on a defense and indemnity agreement built into an engagement letter with respect to the gray position.

After completing your due diligence, if you are still uncertain whether the position the client wants you to take is reasonable, it may be appropriate to have the client provide you with an opinion from tax counsel confirming that the position has a realistic possibility of being sustained on its merits if challenged.

If a taxing authority audits your client, and the auditor is taking a position on a tax return decision that you told your client would pass muster, call your risk advisor or tax counsel. You may need help presenting your position. If the audit is going south and the client is grumbling that this is your fault, take the client’s grumbling seriously, no matter how baseless it may sound, and call your advisors.