An analysis of SSTS interpretation no. 1-2.

EXECUTIVE SUMMARY

* Illustrations 8 and 9 involve a member's reliance on assumptions about residual value in equipment leasing transactions.

* Illustrations 13-16 present situations in which a member is considering whether to rely on an attorney's opinion in applying the realistic possibility standard to a client's proposed transaction.

* The remaining illustrations in Interpretation No. 1-2 focus on a member's reliance on taxpayer and third-party representations, reliance on taxpayer instructions, rendering oral versus written advice and responsibilities in formulating tax advice.

Interpretation No. 1-2 is a guide to responsible tax planning for AICPA members and an interpretation of Statements on Standards for Tax Services Nos. 1 and 8. This two-part article discusses how it applies to tax planning and tax shelters. Part II covers Illustrations 8-20 of the Interpretation, reviews some significant tax shelter cases and provides recommendations.

AICPA members are working in a very litigious environment and are under scrutiny by regulators, the public and parties to various business and personal transactions. To avoid problems, this two-part article analyzes Interpretation No. 1-2, "Tax Planning," of Statements on Standards for Tax Services (SSTS) No. 1, which offers guidance on AICPA member responsibilities in tax planning and tax shelters. Part I, in the July 2004 issue, discussed the background on Interpretation No. 1-2, and analyzed the general interpretations and the first seven illustrations. Part II, below, will discuss the remaining illustrations and some leading case law in this area and provide general recommendations.

Illustrations 8-20

Interpretation No. 1-2 includes illustrations that provide members with guidance on prudent steps to take in the tax planning process. Illustrations 8-20 cover issues such as reliance on assumptions and representations, responsibilities in formulating tax advice, taxpayer instructions and oral advice.

Reliance on Assumptions

Illustrations 8-9: Illustration 8 is a leasing transaction in which the tax consequences depend on whether the leased property is reasonably expected to have a residual value of 15% of its value at the beginning of the lease. A member relied on the taxpayer's instructions to use a particular assumption about the residual value. Such reliance may be appropriate when the assumption is supported by (1) the CPA's review of information provided by a third party or the taxpayer, (2) the member's own analysis or knowledge or (3) the taxpayer's expertise.

Illustration 9 involves a taxpayer receiving assistance from a member in an evaluation of a proposed equipment leasing transaction. Again, critical to the lease's tax consequences is the equipment's estimated residual value at the lease's end. However, in this illustration, the broker, who is arranging the lease transaction, has prepared an analysis that explicitly describes an assumption about such value. The illustration's conclusion is that the member assisting the taxpayer (and giving advice) should consider whether it is appropriate to rely on the broker's assumption instead of performing other procedures to validate the estimated residual value or obtaining a representation from the broker about such residual value. The member should consider such factors as the broker's methodology, whether alternative information sources are reasonably available and the broker's experience in such transactions.

Tax shelters have often been established in the equipment leasing area. This may raise concerns about economic substance and business purpose, the reputation of the brokers and promoters and the level of due diligence required for such transactions. Further, tax advisers may be subject to liability claims if a court subsequently rules that they did not follow professional standards (e.g., Interpretation No. 1-2), or sufficiently document or exercise the necessary care in evaluating these transactions.

Legal authority: Both Illustrations 8 and 9 are similar to Rice's Toyota World, Inc., (19) in which the court makes clear that a taxpayer should not rely on information from those who have a vested (and, thus, biased) interest in the transaction. Thus, a member should make an independent investigation of the facts and reach an independent conclusion, using independent experts, if needed, to help make that determination. This is the minimum requirement in a due diligence review.

Rice's Toyota World involved a purchase-and-leaseback arrangement between Rice's Toyota World and a computer equipment leasing company. The taxpayer purchased a computer and leased it back to the computer company. The purchase price was $1,455,227--paid with a four-year, $250,000 promissory note and two other nonrecourse notes payable over eight years. The computer company claimed that the monthly rental would cover the amortization of the nonrecourse notes and generate a $10,000 annual cashflow to the taxpayer. However, no attempt was made to independently verify that claim.

Rice's accountant looked at information about the transaction, including a document entitled, "Rules of Thumb for Pricing Used Computers" prepared by the Stanford Research Institute. He "determined that the $10,000 yearly cash flow made good economic sense. In his analysis, he assumed some residual value, and he also considered the possibility of releasing the property at the end of the lease." Despite this review, the Tax Court decided that the transaction was a sham; the Fourth Circuit affirmed. Even though the accountant and a tax attorney had reviewed the proposal and considered the economics, they had relied on facts supplied by the seller. As the Tax Court stated:

He (Mr. Rice) knew nothing about computers, yet he relied upon the representations of the deal's promoter, of a friend, and the 'gut' feeling that it was a good deal. Petitioner's tax lawyer and accountant barely touched on the economics with Mr. Rice except to warn him that residual value was critical to an economic profit. Yet he made no effort to determine whether Rice Toyota was purchasing an obsolete computer or one that would have a high residual value. Mr. Rice remembered discussion only about the tax benefits.

With that, the court decided that the transaction had no business purpose, after which it focused on the transaction's economic substance:

Our analysis does not end here, Mr. Rice's failure to focus on the business or non-tax aspects of the transaction is not necessarily fatal to petitioner's claim. If an objective analysis of the investment indicates a realistic opportunity for economic profit that would justify the form of the transaction, it will not be classified as a sham. In order to make this determination, we must probe beneath the labels given by the parties and view the transaction in the context of its surrounding facts and circumstances.

However, the court also found that the transaction had no economic substance. This was affirmed by the Fourth Circuit:

All in all, Rice's failure to seriously evaluate the likely residual value of the computer, its willingness to pay an inflated purchase

price, and its use of nonrecourse debt that would facilitate abandonment of the transaction provide ample support for the tax court's finding that Rice did not have profit motivation apart from tax benefits.

This case is similar to Illustration 9, and indicates that the tax adviser should independently investigate the relevant facts and make an independent determination. (20)

Taxpayer Representations

Illustration 10: In this illustration, the tax results of a reorganization partially depend on a corporation's majority shareholder not disposing of stock that he received under a prearranged disposal agreement. In this case, the question is whether it is appropriate to (1) assume that the disposition will not occur or (2) request a written representation of the shareholder's intent, as a condition for issuing an opinion on the reorganization. The facts play a critical role in this situation; the representation will help to avoid any future misunderstanding with the client about the transaction. Further, liability carriers encourage documentation that would eliminate later misunderstandings between a practitioner and a client in any future claims that might lead to litigation.

The issue of a representation from a taxpayer is a familiar one to any member who has requested a letter ruling. (21) Representations are required, for example, in Sec. 355 reorganizations, as well as in international tax transactions. Members are well advised to request representations signed by taxpayers, instead of relying on assumptions. However, Interpretation 1-2 merely states that obtaining a representation is a consideration, not a requirement.

Formulating Tax Advice

Illustrations 11 and 12: In Illustration 11, both the taxpayer's attorney and the taxpayer advise the member that he or she is responsible for advising the taxpayer on the tax consequences of a proposed transaction. The member should consider paragraph 6 of Interpretation 1-2 (summarized in Part I of this article, in the July 2004 issue) and review all of the relevant draft documents when formulating tax advice on the transaction.

Illustration 12 describes a situation in which a member is responsible for providing advice on the tax consequences of a taxpayer's estate plan. This entails reviewing the will, as well as all other relevant documents, in order to assess whether the implementation or formulation of the estate plan appears to raise any tax issues.

In general, when rendering advice, members are also accountable for upholding the realistic possibility standard. Paragraph 4 of Interpretation No. 1-2, and Interpretation No. 1-1, address this standard in detail.

Again, as some cases illustrate (especially Rice's Toyota World and James L. Rose (22)), an independent determination based on the facts and al] of the relevant issues is required to justify advice. Members are responsible for knowing the limits of their expertise and when they should rely on other independent authorities. In the end, the member's responsibility will be scrutinized, regardless of who asked the member for advice.

Legal Opinions

Illustrations 13-16: In Illustration 13, a member assists a taxpayer with a proposed transaction recommended by an investment bank. To support its recommendation, the bank provides a law firm's opinion on the transaction's tax consequences. The member notes, while reading the legal opinion, that the opinion is based not on the taxpayer's facts, but on a hypothetical situation.

The member may rely on the legal opinion in determining whether SSTS No. 1's realistic possibility standard is met, as long as he or she is satisfied about the opinion's relevance, source and persuasiveness. However, the member should also be diligent in taking steps that are appropriate, under the circumstances, to evaluate the transaction and understand how it applies to the taxpayer's specific situation, which includes establishing the relevant background facts, considering the reasonableness of representations and assumptions and applying the pertinent authorities. The member also needs to consider the transaction's economic substance and business purpose, if relevant to the transaction's tax consequences. Generally, merely relying on a representation of economic substance or business purpose is insufficient.

Illustration 14 adds a slight twist to Illustration 13; the law firm that prepared the opinion has a reputation for being knowledgeable about tax issues associated with the proposed transaction. Regardless of this, the member should take the steps outlined in Illustration 13 above to verify the bank's recommendation.

Illustration 15 involves a situation similar to Illustrations 13 and 14, except that the law firm's opinion "is carefully tailored to the taxpayer's facts." Thus, a member may rely on the opinion in determining whether the realistic possibility standard is met as to the taxpayer's participation in the transaction, as long as he or she is satisfied with the opinion's relevance, source and persuasiveness. In making this determination, the member should consider whether the opinion indicates that the law firm actually took all the steps outlined in Illustration 13.

Illustration 16 reiterates the conclusion of Illustration 15, even though the law firm has a reputation of being knowledgeable about the tax issues related to the proposed transaction.

SSTS No. 8, Form and Content of Advice to Taxpayers, provides guidance on opinions given to taxpayers. Additionally, a member may wish to review published guidance on relying on outside expertise when evaluating a business transaction.

Legal authority: In Rose, the taxpayer purchased photographic transparencies of Picasso paintings and related production rights from Jackie Fine Arts--more than $1 million worth of these materials--with the intent to sell them. The sale involved some financing and other arrangements that generated substantial tax benefits. The Tax Court decided that the main purpose of the transactions was to gain tax benefits and that they had virtually no economic substance; the Sixth Circuit affirmed.

The Tax Court, in making its decision, quoted from Rice's Toyota World:

Mr. Rice's failure to focus on the business or non-tax aspects of the transaction is not necessarily fatal to petitioner's claim. If an objective analysis of the investment indicates a realistic opportunity for economic profit which would justify the form of the transaction, it will not be classified as a sham.

The point is that tax advisers "must probe beneath the labels given by the parties and view the transaction in the context of its surrounding facts and circumstances." The case illustrates that courts will look at substance over form and at specific factors to determine whether the transaction had economic substance.

In Rose, the sale of lithograph tax shelters was very "businesslike," in that all the contracts and other information were detailed and complete. The court noted that "[i]n marketing the Picasso packages, Jackie provided to prospective purchasers a series of materials, including 'Information Memoranda,' tax opinions, 'Fact Sheets,' and letters. Each emphasized at great length the purported tax benefits of the acquisition of art masters." Jackie Fine Arts also provided tax opinions from two well-known law firms:

The availability of a substantial portion of these tax benefits depends on a factual determination that the purchaser is acquiring the art master with the intent to engage in the business of exploiting the art master in order to make a profit (aside from tax benefits), and that the fair market value of the art master is at least equal to the purchase price. The opinions are therefore issued in reliance on the existence of such facts.

Even though the taxpayer attempted to sell some of the prints, the Tax Court said, "[p]etitioners did not have an actual and honest profit objective in acquiring the Picasso packages, and the transactions were devoid of economic substance."

The bottom line is that no matter how sophisticated and professional the parties to the transaction are, that, in itself, is irrelevant when the transaction is devoid of substance. The court emphasized that independent fact-gathering is extremely vital and that an independent, objective review and analysis of those facts by the taxpayer and/or his or her professional advisers is imperative. When applicable, cases such as Rose and Rice's Toyota World, and the steps out lined in the general interpretation section of Interpretation No. 1-2, offer members powerful guidance on these issues.

Taxpayer Instructions

Illustration 17: In this illustration, a member, while assisting a taxpayer with year-end planning for a proposed contribution of closely held stock to a charitable organization, is instructed to calculate the anticipated tax liability based on a fair market value (FMV) of $100 per share for a 10,000 share contribution. However, the member is aware that on the prior-year's gift tax return, the taxpayer indicated that the stock's FMV was $50 per share. In this situation, the advice given in paragraphs 8 and 9 of the general interpretation section of Interpretation No. 1-2 is very valuable. Although the shares' FMV may have substantially appreciated during the year, the member should consider the consistency of any other information known when preparing the projection, as well as the reasonableness of the assumption. He or she should also consider whether to document discussions with the taxpayer on the stock's increased value.

What degree of documentation should be maintained in situations such as Illustration 17? Members should use professional judgment about whether to document the steps taken under paragraphs 8 and 9 of Interpretation No. 1-2. Blind reliance on a taxpayer's instructions may eventually lead to liability claims. Many such liability claims can arise from valuation questions and whether the valuation is ultimately sustained either during an administrative proceeding or by a court. Under these circumstances, it is advisable to consider an independent appraisal of the stock's value, both to protect the taxpayer and to sustain any eventual challenge by a taxing authority.

Third-Party Representations

Illustration 18: This illustration presents a discussion of the tax consequences to a target corporation's shareholders of an acquisition, turning, in part, on the acquiring corporation's continuance of the target's business for some period after the acquisition. A member is preparing a tax opinion that will be addressed to the target's shareholders. The member's colleague has drafted a tax opinion for the member's review that explicitly assumes that the acquiring corporation will continue the target's business for two years after the acquisition. The illustration concludes that, in conducting due diligence to establish the acquisition's relevant background facts, the member should consider whether it is appropriate to rely on assumptions about facts instead of a representation from "another person." It is recommended that the member make reasonable efforts to have the acquiring corporation provide a representation (preferably written) about its plans to continue the target's business.

Many liability claims have resulted from conflicts about the reasonableness of assumptions and the facts of specific transactions, especially if the tax benefits are ultimately denied within a particular jurisdiction, during either an administrative proceeding or subsequent litigation with the taxing authority. Written documentation by the taxpayer about the transaction's facts and assumptions both clarifies the transaction and protects the practitioner and the firm. SSTS No. 8 covers both the form and content of advice provided by members to taxpayers.

Written vs. Oral Advice

Illustrations 19-20: In Illustration 19, a taxpayer (a corporation's sole shareholder) phones a member and states that he is thinking about exchanging the corporation's stock for stock in a publicly traded business. During the conversation, the member explains how to structure the transaction so it will be a tax-free acquisition. This illustration's conclusion is that, even though oral advice may serve a taxpayer's needs appropriately in well-defined areas or routine matters, written communications are recommended in important, complicated or unusual transactions. A member should use professional judgment about the need to document oral advice.

An example of a routine matter is provided in Illustration 20, which involves a phone call from a taxpayer to a member about whether the former should purchase or lease an automobile. The member explains how to structure this arrangement to meet the taxpayer's objectives. Based on the facts, the member's oral response conforms to Interpretation No. 1-2, because the situation involves well-defined tax issues in a routine inquiry. However, the conclusion also stresses that "the member should evaluate whether other considerations, such as avoiding misunderstanding with the taxpayer, suggests that the conversation should be documented."

For any member who gives oral tax advice, SSTS No. 8 can help prevent liability claims and ensure that advice is based on a careful understanding of the facts. Members should review, with their liability carrier, steps on documenting oral advice and providing advice that will ultimately withstand a liability claim.

Other Cases

In considering the realistic possibility of success, business purpose and economic substance, members often have to decide about the application of particular cases to specific facts; however, courts may differ on the identical legal issue. ACM Partnership (23) and Compaq Computer Corp. (24) do not fit any of the particular illustrations used above, but they do offer some additional insight into the court's thinking.

Compaq involved purchases of American depository receipts (ADRs) as follows:

In a prearranged transaction designed to eliminate typical market risks, (Compaq) purchased and immediately resold American Depository Receipts (ADR's) of a foreign corporation on the floor of the NYSE. As a result of the transaction, (Compaq) was the shareholder of record of 10 million ADR's on the dividend record date and received a dividend of $22,545,800 less withheld foreign taxes of $3,381,870. Compaq also recognized a $20,652,816 capital loss on the sale of the ADR's, which was offset against previously realized capital gains. The net cash-flow from the transaction, without regard to tax consequences, was a $1,486,755 loss.

The Tax Court decided that this transaction lacked economic substance and disallowed the foreign tax credit (FTC), concluding that the taxpayer was acquiring FTCs, not substantive ownership of the ADRs. However, the Fifth Circuit reversed, noting that identical ADR transactions were upheld by the Eighth Circuit in IES Industries, Inc. (25) The court stated, "... the ADR transaction had both a reasonable possibility of profit attended by a real risk of loss and an adequate non-tax business purpose. The transaction was not a mere formality or artifice but occurred in a real market, subject to real risk."

In some cases, real losses associated with a transaction could be deductible, even if the transaction is partially a sham. For example, ACM involved a complex, multimillion-dollar transaction--ACM Partner ship was created to acquire a corporation's debt and make it "disappear" from the books. This would help the corporation look better to investors and reduce its likelihood of being the target of a hostile takeover. These transactions also generated substantial tax benefits. The Third Circuit affirmed most of the Tax Court's decision disallowing most of those tax benefits; however, it did allow the portion that, in fact, created actual economic losses. It engaged in a detailed factual analysis to determine whether there was any economic substance to the transaction and quoted tests and legal authority from Rose, Rice's Toyota World and other cases. The court stated, "we will affirm the Tax Court's application of ACM's application of the contingent installment sale provisions and the ratable basis recovery rules.... We will, however, reverse the Tax Court's decision insofar as it disallowed the deductions arising from the actual economic losses associated with ACM's ownership of the LIBOR notes...." This decision supports the view that real losses associated with a transaction are deductible, even if part of the transaction is a sham.

Conclusion

Members should become familiar with Interpretation No. 1-2, including the general interpretation section, as well as with the 20 illustrations. A good strategy is to examine common tax planning situations in which a practitioner or firm works the steps needed to comply with particular tax planning engagements. Participation in continuing education and a review of the cases discussed above, and other cases that illustrate tax planning strengths and Failures, will help members follow the steps outlined in Intreperation No. 1-2. A review of the cases may also assist practitioners in understanding the legal nuances. Cases provide opportunities to discuss ways to make the general interpretations in paragraphs 4-11 workable within a professional situation. Liability carriers and legal counsel can answer questions about developing documentation and procedures for record maintenance. In the long run, defensive practices can prevent liability claims and lead to better client communications.

(19) Rice's Toyota World, 81 TC 184 (1983), aff'd in part and rev'd in part, 752 F2d 89 (4th Cir. 1985).

(20) See also Interpretation No. 1-2, Paragraph 9, discussed in Part I of this article, in the July 2004 issue.

(21) The following sources provide examples of required representations from taxpayers: IRS Letter Ruling 9541043 (7/6/95); Rev. Proc. 2003-48, IRB 2003-29, 86, modifying Rev. Proc. 96-30. 1996-1 CB 696; and Rev. Proc. 2003-3, IRB 2003-1, 113.

(22) James L. Rose, 88 TC 386 (1987), aff'd, 861 F2d 851 (6th Cir. 1989).

(23) ACM Partnership, 157 F3d 231 (3d Cir. 1998), cert. den.

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

(25) IES Industries, Inc., 253 F3d 380 (8th Cir. 2001).

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