An analysis of SSTS interpretation no. 1-2.

EXECUTIVE SUMMARY

* Interpretation No. 1-2 clarifies how SSTSs Nos. 1 and 8 apply in a variety of tax planning and tax shelter situations.

* SSTS No. 1 and Interpretations Nos. 1-1 and 1-2 help members to determine whether a tax position has a realistic possibility of success and whether a member can recommend a nonfrivolous position.

* Familiarity with legal standards, such as the realistic possibility of success, more-likely-than-not, substantial authority and economic-substance and sham-transaction doctrines, as well as the tax shelter disclosure and listing rules, is crucial in recommending a position.

Interpretation No. 1-2 provides official guidance on AICPA member responsibilities in tax planning and interprets Statements on Standards for Tax Services Nos. 1 and 8. This two-part article discusses and analyzes the Interpretation as it applies to tax planning and tax shelters.

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During the past four years, accountants in general, and CPAs in particular, have received substantial negative publicity following Enron and other corporate scandals. Besides that, to counter questionable tax shelter behavior, Congress considered legislation that would restrict tax shelters, and the Service issued a flurry of regulatory initiatives on tax shelter registration and disclosure. CPAs are thus operating under increased scrutiny by all levels of government and the media. Because this often leads to more government regulation, self-regulation of the profession is mandatory to minimize government's involvement. (1)

Interpretation No. 1-2, "Tax Planning," of Statements on Standards for Tax Services (SSTS) No. 1, continues the AICPA's efforts at self-regulating tax practice standards for AICPA members. It provides official guidance on a member's responsibilities in tax planning and interprets SSTSs No. 1, Tax Return Positions, and No. 8, Form and Content of Advice to Taxpayers. (2) Interpretation No. 1-2, however, specifically states that it "does not change or elevate any level of conduct prescribed by any standard. Its goal is to clarify existing standards."

Part I of this two-part article, below, provides general background on Interpretation No. 1-2 and considers how it applies to tax planning and tax shelters. It also analyzes seven of the Interpretation's illustrations. Part II, in the August 2004 issue, will discuss the remaining illustrations and offer practical tips and general recommendations.

Tax Practice Standards

The preface to the SSTSs states, "practice standards are the hallmark of calling one's self a professionS. Members should fulfill their responsibilities as professionals by instituting and maintaining standards against which their professional performance can be measured." The SSTSs were written "in as simple and objective a manner as possible." Concepts and terminology used in the SSTSs (and its two Interpretations) are based on readily comprehensible tax concepts. These professional ethical standards "provide for an appropriate range of behavior that recognizes the need for interpretations to meet a broad range of personal and professional situations." Enforcement of the SSTSs is designed to "be undertaken with flexibility in mind and handled on a case-by-case basis."

The SSTSs are binding on AICPA members who practice in Federal, state and local jurisdictions before agencies that range from the IRS to local property tax districts. Some state statutes may also call (either directly or indirectly) for the adoption of professional standards promulgated by the AICPA. Additionally, professional liability insurance carriers may require their policyholders to follow these standards as part of their practice as CPAs. Thus, familiarity with SSTSs Nos. 1 and 8 and Interpretation No. 1-1, along with recently issued Interpretation No. 1-2, is critical. In addition to the SSTSs, other legal and regulatory standards issued at the Federal, state and local levels may apply for other purposes. For example, Sec. 6694 regulations cover preparer penalties at the Federal level; the tax return position standards under Sec. 6694 could change in the future. Additional tax practice standards are also found in Circular 230, (3) which regulates practice by CPAs, attorneys and enrolled agents before the IRS. Regulatory and statutory standards at the state and local level may also affect tax practice. (4)

The AICPA'S Tax Division continues to expose its membership to their professional and legal responsibilities through presentations at professional meetings and with continuing education. It also continually monitors practice situations that may need to be addressed by the SSTSs.

Issuance of Interpretation No. 1-2

The effort that led to the issuance of Interpretation No. 1-2 began in 2000, with discussion about tax shelters. The Tax Division's Tax Executive Committee (TEC), which is the AICPA'S tax standard setting body, formed a task force to evaluate the SSTSs' applicability to tax shelters. The task force recommended the issuance of an interpretation to SSTS No. 1. As a result, the TEC exposed Interpretation No. 1-2 in November 2002 and requested stakeholders' comments by April 30, 2003. The comments on the exposure draft were reviewed by the task force and Tax Practice Responsibilities Committee in May-June 2003, and the interpretation received final approval at the Aug. 22, 2003,TEC meeting.

The draft recognized that tax shelters and abusive transaction are controversial and continually discussed by courts, the AICPA and various professional organizations and taxing authorities. Although the Introduction to the exposure draft stressed the difficulty in defining a tax shelter, it noted the "compelling need for a comprehensive interpretation of a member's responsibilities in connection with tax planning, with the recognition that such guidance would clarify how those standards would apply across the spectrum of tax planning, including those situations involving tax shelters...."

Tax planning is a significant area of tax practice for many members. (5) The background section to Interpretation No. 1-2 stresses "that taxpayers have a legitimate interest in arranging their affairs so as to pay no more than the taxes they owe." CPA tax practitioners play a role in advancing these legitimate efforts. Because of this legitimate interest on the one hand and the policy of stamping out abusive tax shelters on the other, a member's responsibility may turn out to be a balancing act. Tax shelters are not per se illegal; rather, the tax professional's job is to distinguish between legitimate tax shelters and those that serve no purpose other than to gain a tax benefit. As the courts have stated on many occasions," a taxpayer has the right to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by any means the law permits." (6) The AICPA recognizes this duty of a tax professional.

However," [t]he freedom to arrange one's affairs to minimize taxes does not include the right to engage in financial fantasies with the expectation that the IRS and the courts will play along. The Commissioner and the courts are empowered, and in fact duty-bound, to look beyond the contrived forms of the transactions to their economic substance and to apply the tax laws accordingly." (7) Clearly, this presents a conflict: taxpayers have a right to minimize taxes, but only if there is a substantive business aspect, unless the taxpayer is taking advantage of a specific tax provision that has a nonbusiness purpose.

The AICPA Tax Division recognizes the balance between legitimate (and legal) tax planning situations and abusive tax shelters that need to be eliminated. (8) The AICPA has explicitly stated to Congress that it opposes abuse of the tax system. In a letter addressed to the Chairman and ranking members of the Senate Finance and House Ways and Means Committees, Robert Zarzar (writing for the TEC) stated:"The American Institute of Certified Public Accountants has a clear position on abusive tax transactions--they should be eradicated. They insult the large majority of honest taxpayers and their CPA advisers who strive every day to obey increasingly complex tax laws." (9)

Practitioners must keep abreast of the continually evolving statutes and regulations on disclosure (as well as listed transactions). They must also stay aware of current case law and related administrative pronouncements. (10)

Tax Planning under Interpretation No. 1-2

Currently, SSTS No. 1 establishes standards for an AICPA member to use when recommending a tax return position, as well as for preparing and signing returns. A return position for SSTS No. 1 purposes includes "(a) a position reflected on the tax return as to which the taxpayer has been specifically advised by a member or (b) a position about which a member has knowledge of all material facts and, on the basis of those facts, has concluded whether the position is appropriate." A member should not recommend any return position for any item, unless he or she has a good faith belief that the position has a realistic possibility of being sustained either judicially on its merits if challenged, or administratively. A nonfrivolous position can be recommended with disclosure. When it is relevant to do so, a member should inform the taxpayer about potential penalty exposure and the opportunity (if any) to avoid any penalties through disclosure. A taxpayer, for SSTS purposes, includes the member's employer, a third-party recipient of tax services or a client. (11)

Summary of General Interpretation

Interpretation No. 1-2 outlines several responsibilities in connection with tax planning. This guidance clarifies how the SSTS applies across the spectrum of tax shelter and tax planning situations. It also provides a "General Interpretation" section, followed by specific illustrations. A summary of paragraphs 4-11 of the "General Interpretation" section follows.

Paragraph 4: The realistic possibility standard outlined in SSTS No. 1 and Interpretation 1-1 applies to a member who provides professional tax planning services. In addition, a member may recommend a nonfrivolous position, provided that the member also recommend appropriate disclosure.

Paragraph 5: "Tax planning" is defined to include any oral or written recommendation or expression of an opinion in a prospective or completed transaction on either a return position or on a specific tax plan by the member, the taxpayer or a third party.

Paragraph 6: When issuing an opinion that reflects the results of the tax planning service, a member should establish the relevant background facts, consider the reasonableness of the representations and assumptions, apply the pertinent authorities to the relevant facts, consider the transaction's economic substance and business purpose, if relevant to the tax consequences of the transaction, and reach a conclusion supported by the authorities.

Paragraph 7: While assisting a taxpayer during a tax planning transaction for which the taxpayer has obtained a third party opinion that the taxpayer is looking for the member to evaluate, the member should be satisfied as to the source, relevance and persuasiveness of the opinion, by considering whether the third party has followed all of the steps (which are the same as for paragraph 6 above).

Paragraph 8." In establishing the relevant background facts, due diligence requires that a member consider whether it is appropriate to rely on assumptions concerning facts, in lieu of other procedures to support the advice or a representation made by the taxpayer or another person. The member should also consider whether his or her tax advice will be shared with third parties, especially third parties who may not be knowledgeable or who are not receiving independent tax advice about this transaction.

Paragraph 9: In a tax planning situation, members often rely on representations and assumptions. In determining the reasonableness, the member should consider their source and consistency with other information the member knows. For example, depending on the circumstance, if the source is the taxpayer, it may be reasonable to rely on the representation; if the source is the transaction's seller or promoter, such reliance may not be reasonable.

Paragraph 10: In any tax planning situation, a member should understand the transaction's business purpose and economic substance, when relevant to the tax consequences. When the transaction has been proposed by a third person (other than the taxpayer), the member should consider whether the third party's assumptions are consistent with the (acts of the taxpayer's situation. If the member's advice will be in writing, it should generally describe the business purpose. Further, if the business reasons are relevant to the tax consequences, it is not sufficient for the member "to merely assume that a transaction is entered into for valid business reasons without specifying what those reasons are."

Paragraph 11: In every situation, the member must determine the scope of the engagement and then diligently apply appropriate procedures under the circumstances to evaluate and understand the entire transaction. Obviously, the specific procedures a member will perform will vary depending on the scope of the engagement and the circumstances.

Interpretation No. 1-2 and Case Law

The tax planning process outlined in paragraphs 4-11 above involves all pertinent and applicable authorities, including consideration of a transaction's economic substance and business purpose. All of the standards under SSTS No. 1 and its interpretations are applicable in determining whether a realistic possibility exists or whether the member can recommend a nonfrivolous position with appropriate disclosure. For further clarification, members should also examine SSTS No. 3, Certain Procedural Aspects of Preparing Returns, which outlines "standards for members concerning the obligation to examine or verify certain supporting data or to consider information related to another taxpayer when preparing a taxpayer's tax return."

To understand a transaction's business purpose and economic substance (when applicable), the practitioner must first understand how the courts apply these concepts. An understanding of the legal authorities will help tax advisers make informed professional judgments based on the guidelines in Interpretation No. 1-2.

As to these concepts, in Horn, (12) the former DC Circuit stated, "[f]rom the foregoing discussion, we extract the following two propositions: first, the sham transaction doctrine is simply an aid to identifying tax-motivated transactions that Congress did not intend to include within the scope of a given benefit-granting statute; and second, a transaction will not be considered a sham if it is undertaken for profit or for other legitimate nontax business purposes." In Rose, (13) the Tax Court stated:

A transaction is without its intended effect
for Federal income tax purposes if (1) it is a
sham, being a mere paper chase or is otherwise
fictitious (Falsetti v. Commissioner, 85
T.C. 332 (1985)), or (2) the transaction is
devoid of economic substance consonant
with its intended tax effects (Frank Lyon Co.
v. United States, 435 U.S. 561, 573 (1978);
Knetch v. United States, 364 U.S. 361, 366
(1960)). The substance of the transaction,
not its form, determines its tax consequences. The
transaction must have economic
substance "which is compelled or
encouraged by business or regulatory realities,
is imbued with tax-independent considerations,
and is not shaped solely by tax
avoidance--features that have meaningless
labels attached." (Frank Lyon Co. v. United
States, 435 U.S. at 583-584; Estate of Thomas
v. Commissioner, 84 T.C.412 (1985); Hilton v.
Commissioner; 74 T.C. 305 (1980), affd. per
curiam 671 F.2d 316 (9th Cir. 1982)).

The fundamental legal principle gleaned from these cases is that a transaction must have a business purpose; if there is no business purpose, the transaction must have actual economic substance. This is not an easy rule to apply, because the courts do not always clearly distinguish between business purpose and economic substance. As at least one author points out,"[t]he economic substance doctrine to some extent incorporates other common law doctrines. This is most apparent in the 'subjective' leg of the doctrine, which explicitly incorporates the business purpose doctrine." (14) Also, even when the courts clearly separate the two doctrines, "[t]he precise degree of business motive or economic substance that must be present in a transaction for tax recognition is not clearly defined." (15)

Illustrations

The illustrations from Interpretation No. 1-2 summarize general fact patterns, and provide a basis for application of the general interpretations.

Illustration 1: This covers a nontax shelter situation. According to Illustration 1, the relevant tax code (e.g., in a particular jurisdiction) imposes penalties for substantial understatements, unless the associated positions are based on substantial authority. Any member who aids a taxpayer in such a situation should inform the taxpayer of any penalty risks associated with the recommended tax return position "with respect to any plan under consideration that satisfies the realistic possibility of success, but does not possess sufficient authority to satisfy the substantial authority standard."

Members should be acquainted with both the "realistic possibility" and the "substantial authority" standards. SSTS No. 1, Paragraph 2a and Interpretation No. 1-1, define realistic possibility for AICPA purposes. Similar, but not exact, language is contained for Federal tax practice in the Sec. 6694 regulations and in Circular 230, Section 10.34. The substantial authority standard is defined for nontax shelter situations under the Sec. 6662 regulations. The jurisdiction in which a member practices should he checked to ascertain whether there are other or similar taxpayer standards for return positions. (16)

Illustration 2: This involves a tax shelter (as defined in the relevant tax code for that jurisdiction) in which a taxpayer will be subject to penalties, unless he or she decides that the tax return position associated with the tax shelter "is, more likely than not, the correct position." A member should inform the taxpayer of any penalty risks related to any tax planning being considered that satisfies the realistic possibility standard for practitioners, but "does not possess sufficient authority to satisfy the more likely than not standard."

Familiarity with the realistic possibility and the more-likely-than not standard is again essential. The more-likely-than-not standard is defined for Federal tax shelters in the Sec. 6662 regulations. Different terminology, might apply at the state or local level, so practitioners should check their local tax codes to make sure that the taxpayer is in compliance with the standards applicable in their jurisdictions.

Illustration 3: This illustration presents a situation in which a member may have to resolve a disclosure issue with a client or not sign the return. The relevant tax regulations provide that certain information on a specific transaction or its details must be attached to the return, regardless of support for the associated tax return position (i.e., "own if there is substantial authority or a higher level of comfort for the position"). The member is aware of the attachment requirement during preparation of the taxpayer's return. Generally, the member may sign the return if the taxpayer agrees to include the attachment and the associated position meets the realistic possibility standard under SSTS No. 1. If the taxpayer refuses to include the attachment, the member should not sign the return. However, the member may sign the return if the realistic possibility standard is met and there are reasonable grounds for the taxpayer's position as to the required attachment. A member should consider SSTS No. 2, Answers to Questions on Returns, which states in part that questions include "requests for information on the return, in the instructions, or in the regulations, whether or not stated in the form of a question." No member should omit an answer to a question (as defined in SSTS No. 2) "merely because it might prove disadvantageous to a taxpayer."

Assuming that the nondisclosure cannot be resolved, SSTS No. 6, Knowledge of Error: Tax Return Preparation, outlines steps that a member can consider in deciding whether to withdraw from preparing the return or to continue all employment or professional relationship with the taxpayer. The operative word is to "consider" either of these options--not that the member must take either of these steps.

Illustrations 4-6: These illustrations generally involve "certain potentially abusive transactions" that relevant tax regulations designate as listed transactions requiring return attachments, "regardless of the support for the associated tax return position (i.e., even if there is substantial authority or a higher level of support for the position)." The regulations provide additional penalty risks if the listed transaction is not disclosed. In Illustration 4, the member concludes that a proposed transaction is a listed transaction during research about the tax consequences of the proposed transaction. He or she may nonetheless recommend a tax return position if the member concludes the proposed tax return position meets the realistic possibility standard. However, even so, "a member should inform the taxpayer of the enhanced disclosure requirements of listed transactions and the additional penalty risks for nondisclosure."

In Illustration 5, the member first becomes aware that a taxpayer has entered into a transaction during the preparation of the return for the transaction year. If research about the transaction's tax consequences results in the member concluding that the transaction is a listed transaction, the member should inform the taxpayer about the enhanced disclosure requirements and additional penalty risks if the listed transaction is not disclosed. Assuming the taxpayer agrees to make the required disclosure, the member may sign the return if he or she concludes that the associated return position meets the realistic possibility standard. Illustration 5 states that "reasonable grounds for nondisclosure ... generally are not present for a listed transaction." Thus, the member should not sign the return if there is no disclosure of the transaction, a member who is a nonsigning preparer should recommend disclosure of this transaction by the taxpayer. (17)

The final change in facts appears in Illustration 6, in which the member, while researching the transaction's tax consequences (when preparing the taxpayer's return for the transaction year), concludes that there is uncertainty about whether the transaction is a listed transaction. Once again, a member should inform the taxpayer about the enhanced disclosure requirement and the additional penalty risks for nondisclosure. If the taxpayer agrees to make the required disclosure, and the member concludes that the associated return position satisfies the realistic possibility standard under SSTS No. 1, the member can sign the return. However, if the taxpayer does not want to make the disclosure because there is uncertainty about whether the transaction is listed, the member can still sign the return if he or she concludes that the realistic possibility, standard is met for the associated return position and reasonable grounds exist for the taxpayer's position on nondisclosure. SSTS No. 2 indicates that "the degree of uncertainty regarding the meaning of a question on a return may affect whether them are reasonable grounds for not responding to the question."

Members often have to decide about the application of particular cases to specific facts. Courts may differ on an identical legal issue, such as how a specific statute applies. Thus, a member may be able to recommend a number of options that would meet the realistic possibility, standard. Interpretation 1-1, Paragraph 10, states that "a member may conclude that more than one position meets the realistic possibility standard."

Illustration 7: In this illustration, a member is advising a taxpayer about the tax consequences of a transaction involving a loan from a U.S. bank. During a review of documents associated with this proposed transaction, the member discovers a reference to a deposit the taxpayer's wholly owned subsidiary had made with a foreign branch of the U.S. bank. The document seems to indicate that this "deposit is linked" to the U.S. bank's granting of the loan. Illustration 7 concludes that the member should consider the effect, if any, of the deposit when rendering advice to the taxpayer about this proposed transaction.

Illustration 7's conclusion is consistent with good business practice and the due diligence required by the AICPA's general Code of Conduct, as well as the general discussion section of Interpretation No. 1-2. Often, a lack of due diligence can lead to liability claims by clients who blame the practitioner if a particular transaction does not achieve its desired results. (18)

Conclusion

Part II, in the August 2004 issue, will discuss the remaining illustrations in Interpretation No. 1-2, along with some of the more significant court decisions on economic substance and business purpose. It will provide additional practical analysis and conclude with general observations for tax professionals involved in tax planning and tax shelters.

(1) See Doering, "The Final Disclosure and List Maintenance Regulations," 81 Taxes 31 (May 2003).

(2) The SSTSs are available at aicpa.org/download/tax/sstsfinal.pdf.

(3) Treasury' Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents and Appraisers Before the Internal Revenue Service (hereinafter, "Circular 230"). Proposed amendments to Circular 230, covering tax shelters and other practitioner standards, will likely be finalized in 2004.

(4) See Swails, "New Standards for Tax Practice," 190 JOA 79 (November 2000); Cogdell, "Practice Before the IRS; Attorney's Fees in Tax Proceedings," Portfolio 620 TCM (BNA 1995-2003).

(5) TEC, Exposure Draft, Proposed Interpretation No. 1-2, "Tax Planning," of SSTS No. 1. Tax Return Positions (11/11/02).

(6) Sec, e.g., Gregory v. Helvering, 293 US 465 (1935) and ACM Partnership, 157 F3d 231 (3d Cir. 1998).

7 Compaq Computer Comp., 113 TC 214 (1999), rev'd, 277 F3d 778 (5th Cir. 2001).

(8) In a Letter to Members (3/24/03) regarding abusive tax shelters, Robert Zarzar and Barry Melancon state that abusive tax shelters "should be eradicated." However, the letter also stresses that "tax minimization is a basic taxpayer right."

(9) See Letter to the Honorable Charles Grassley, Max Baucus, William Thomas and Charles Rangel, from Robert Zarzar, AICPA TEC Chair (9/2/03).

(10) Sec, e.g., Mendelson, Bhikha and Emilian, "Tax Shelter Temp. Regs (Parts I and II)," 34 The Tax Adviser 86 (February 2003) and 34 The Tax Adviser 142 (March 2003) and Mendelson and Emilian, "Tax Shelter Final Regs," 34 The Tax Adviser 338 (June 2003).

(11) SSTS No. 1 states, in part, that "when recommending a tax return position, a member has both a right and responsibility to be an advocate for the taxpayer...."

(12) Terence J. Horn, 968 F2d 1229, 1238 (DC Cir. 1992).

(13.) James L. Rose, 88 TC 386, 410 (1987), aff'd, 868 F2d 851 (6th Cir. 1989).

(14) See Bankman, "Articles and Essays: The Economic Substance Doctrine," 74 S. Cal. L. Rev. 5, 12 (2000).

(15) See Rose, note 13 supra, quoting Rice's Toyota World, Inc., 81 TC 184 (1983), aff'd in part and rev'd in part, 752 F2d 89 (4th Cir. 1985).

(16.) See Collins. Practitioner Guide to IRS Penalties (CCH, 2002); Cogdell, note 4 supra; and Circular 230.

(17) See the discussion in Illustration 3.

(18) Sec Wolfman, Holden and Harris, Standards of Tax Practice, [paragraph] 601-606 (Tax Analysts, 5th ed., 1999).

John C. Gardner, Ph.D., CPA

Professor of Accountancy

University of Wisconsin La Crosse

La Crosse, WI

Bruce E. May, D.B.A., J.D.

Associate Dean and Professor of Management

University, of Wisconsin-La Crosse

La Crosse, WI

Roger Reinsch, J.D.

Associate Professor of Business Law

Northeastern Illinois University

Chicago, IL