IRS Raises Standard for Tax Practitioners Providing Tax Opinions

CPA Journal, The, Nov 2004 by Demmett, Robert E

In the U.S. Treasury Department's continuing effort to stop abusive tax shelters and restore integrity to the tax system, the 1RS announced earlier this year three provisions that make it more difficult for tax advisors to issue tax opinions and for taxpayers to avoid the imposition of the tax accuracy-related penalties. The first provision holds tax advisors to a higher standard when issuing tax opinions. The second and third provisions require taxpayers to make additional disclosures that would assist the 1RS in identifying abusive tax positions in a more timely manner. In addition, the disclosure provisions act as a deterrent to taxpayers entering into taxmotivated transactions.

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 1RS 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 1RS 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 1.601 l-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.