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Thomas
Wechter

IRS eases rules on written advice on tax shelters

Proposal would revoke the covered opinion rules in Circular 230 and substitute new rules for written advice.

October 11, 2012

By Thomas R. Wechter, J.D.

In 2004, in response to the tide of abusive and illegal tax shelters, the IRS finalized amendments to Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), setting forth best practices for tax advisers and providing complex and costly standards for written advice and opinions regarding tax shelters. From the outset, the changes were met with a torrent of criticism by tax practitioners with respect to the difficulty and cost of complying with the changes and the overly broad nature of the new rules. In addition, practitioners criticized the new rules as not necessarily producing higher-quality tax advice since the new rules increase the likelihood that practitioners would provide oral advice to clients when written advice is more appropriate.

Finding that the benefit of the rules regarding tax shelter opinions were not justified by the additional costs of practitioner compliance, on Sept. 14 the IRS proposed revoking the current rules dealing with tax shelter opinions and substituting a single, basic new standard governing all written tax advice. This article reviews what the rules were and what the IRS is proposing as new rules (REG-138367-06) for all tax advice.

The current rules of Circular 230

Circular 230, Section 10.35, contains rules for so-called covered opinions, which include written advice on tax issues that arise from a number of transactions. Those transactions include:

(A) listed transactions or substantially similar transactions;
(B) transactions that have as a principal purpose the avoidance or evasion of tax; and
(C) transactions that have as a significant purpose the avoidance or evasion of tax, if the written advice
(1) is a “reliance opinion,” one that concludes it is more likely than not that the taxpayer will prevail on a significant tax issue,
(2) is a “marketed opinion,” one that the tax adviser knows or has reason to know will be used to promote the transaction,
(3) is subject to confidentiality, or
(4) is subject to contractual protection, meaning that the taxpayer has the right to a full or partial refund of the fees if all or a part of the intended tax consequences are not realized.

Certain opinions are excluded from the rigors of the covered opinion rules. Those opinions include: (1) preliminary advice if a practitioner, at a later date, is reasonably expected to provide written advice meeting the requirements of a covered opinion; (2) opinions on retirement plan qualification, state or local bond opinions, and opinions required to be filed with the SEC as long as the opinion is not on a listed or principal purposes transaction; (3) opinions given after a tax return is filed, reflecting the tax benefits of the transaction; (4) negative advice opinions concluding that the taxpayer will not prevail on the issue at any level of confidence; and (5) opinions rendered by a practitioner to his or her employer regarding the employer’s tax liabilities.

Covered opinion standards

Very detailed standards are set forth for the issuance of a covered opinion. Included among those requirements, the tax practitioner must (1) determine the facts; (2) relate the facts to the law; (3) evaluate the significant tax issues and reach a conclusion about each one; and (4) reach an overall conclusion about the tax treatment of the transaction.

Due diligence

Circular 230 imposes requirements for factual due diligence and legal analysis. The tax practitioner must use reasonable efforts to ascertain the relevant facts and disclose the relevant facts in the opinion. A factual representation is unreasonable if the tax practitioner knows or should know that the representation is incorrect. In addition, no unreasonable assumption of the facts may be made, and all assumptions of the facts have to be disclosed in a separate section of the opinion.

Significant federal tax issues

A covered opinion has to cover all “significant federal tax issues.” Circular 230 includes a far-reaching definition of significant federal tax issue as one that meets a materiality threshold, i.e., the IRS has a reasonable basis for a successful challenge and the resolution could have a significant impact on the overall federal tax treatment of the transaction. The opinion must provide a conclusion as to the taxpayer’s likelihood of success on the merits of each significant federal tax issue considered in the opinion. In arriving at that conclusion, the practitioner cannot take into account the possibility that the return will not be audited or that the issue will not be raised or, if raised, will be resolved through settlement.

Opt out and prominent disclosure

Except for opinions issued with respect to listed transactions or transactions with the principal purpose of avoiding or evading taxes, the tax practitioner can opt out of the requirements of Circular 230, Section 10.35, by prominently disclosing in the opinion that the advice is not intended or written to be used and cannot be used by the taxpayer for purposes of avoiding tax penalties. “Prominent disclosure” means that the disclosure must be set forth in a separate section, not a footnote, in a type face of the same size or larger than the typeface of the opinion itself. The opt-out provision has led to the inclusion of the opt-out language on every email and letter sent by practitioners, whether or not the correspondence contains tax advice.

In addition to the opt-out language that has to be prominently displayed, Circular 230 lists a number of opinions that also have to be prominently displayed, including opinions that do not reach a more-likely-than-not conclusion, practitioner fee arrangements with promoters or marketers of the transaction subject to the opinion, and limited nature opinions.

Proposed new rules for written advice

General

Acknowledging that the covered opinion rules were complex and costly, interfered with client relationships, provided only minimal taxpayer protection, and that the benefits were insufficient to justify the additional costs associated with compliance, the IRS on Sept. 14 proposed revoking the covered opinion standards in Circular 230 and substituting in their place one standard for all written advice.

The new standard in proposed Section 10.37 provides that a practitioner must base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the practitioner knows or should know. In addition, a practitioner must also use reasonable efforts to identify and ascertain the facts relevant to the written advice on a federal tax matter.

However, a practitioner, in evaluating the federal tax matter, cannot take into consideration the low probability of audit or that an issue will not be raised on audit. But, unlike the current provisions governing covered opinions, a practitioner under the proposed provisions can take into account the possibility that an issue, if raised, will be resolved through settlement.

A practitioner would no longer have to fully describe the relevant facts and the application of the law to the facts in the written advice as now required under the covered opinion rules. As stated by the IRS, no longer will practitioners have to use the standard Circular 230 disclaimers—which currently are used by practitioners on all written and electronic communications—that the reader cannot rely on the contained advice for avoidance of penalties.

Practitioner reliance standards

The proposed written advice rules provide that a practitioner can rely on the advice of another practitioner if that advice is reasonable and the reliance is in good faith based upon all of the facts and circumstances. But a practitioner cannot rely on the advice of another practitioner when the practitioner knows that the other practitioner is not competent or lacks the necessary qualifications or that the other practitioner has a conflict of interest.

Management responsibility for proposed written advice rules

Of some importance to multimember firms, the IRS has shifted the policing of the proposed written advice rules by providing that the firm management with the principal authority and responsibility for overseeing a firm’s practice governed by Circular 230 is responsible for establishing procedures to ensure compliance with all provisions of Circular 230, not just tax advice and tax return preparation.

IRS standard of review

In determining whether the proposed written advice standards have been complied with, the IRS will apply a reasonableness standard, considering all the facts and circumstances. However, with respect to a marketed opinion or other arrangement where there exists a significant purpose of tax avoidance or evasion, the IRS will use a heightened standard of review.

Effective date

The effective date of the proposed written advice provisions will be when the provisions are published as final in the Federal Register. A public hearing is scheduled for Dec. 7.

Conclusion

The revocation of the covered opinion provisions in Circular 230 is long overdue and welcome. Hopefully, the proposed written advice rules will have the beneficial effect that motivated the IRS to revoke the covered opinion rules. At the very least, it will remove the incomprehensible Circular 230 disclaimers indiscriminately used by practitioners on all written and electronic communications, whether or not the communication contains tax advice, to the consternation of the client.

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Thomas R. Wechter, J.D., LL.M. (Tax), is a partner with Duane Morris LLP in the Chicago office and concentrates his practice in tax planning for individuals, corporations, and partnerships and in tax controversy matters in front of the IRS and before the Tax Court, U.S. Court of Federal Claims, and the district courts.