Will a tax opinion still prevent penalties?

The U.S. Department of the Treasury and Internal Revenue Service recently limited the use of tax opinions to avoid penalties. First, under new regulations, the government provided that a taxpayer may use a tax opinion to defend against penalties only if the taxpayer disclosed the underlying transaction appropriately. Second, the IRS announced a new penalty policy under which a taxpayer may use the tax opinion to avoid penalties only if the adviser (i.e., the opinion-writer) is independent from any promoter of the transaction. Given the IRS's current hostility toward tax shelters and those connected with them, taxpayers should expect the IRS to enforce these deterrent measures aggressively. As a result, taxpayers must select their advice, and their advisers, carefully to avoid penalties.

This article describes the new rules for tax opinions and suggests how taxpayers may best use tax advice to avoid penalties. After summarizing the Internal Revenue Code's accuracy-related penalties and the Treasury Department's current disclosure rules, the article describes the new penalty regulations and policy. Next, the significance of the new rules to taxpayers is analyzed. Finally, the article concludes with a description of several penalty proposals that are pending in Congress.

Penalties and Defenses

Taxpayers are subject to an "accuracy-related" penalty for understatements under section 6662 of the Code. (1) Negligence or disregard of the tax laws, as well as a substantial understatement of income tax, triggers the penalty. (2) For corporations, an understatement, which is the difference between the correct amount of tax due and the amount of tax actually paid, is substantial if the understatement exceeds the greater of 10 percent of the annual tax due or $10,000. Whatever the cause of the penalty, i.e., negligence, substantial understatement, or both, the amount of the accuracy-related penalty equals 20 percent of the understatement.

A taxpayer that demonstrates reasonable cause and good faith for the underpayment may avoid the accuracy-related penalty. (3) Establishing reasonable cause is a facts-and-circumstances determination. The most important factor is the taxpayer's efforts to ascertain its correct tax liability. According to the Internal Revenue Manual, the IRS generally grants "reasonable cause relief" from penalties when the taxpayer "exercises ordinary business care and prudence," which the IRS determines by reviewing (i) the taxpayer's reason for the underpayment, (ii) the taxpayer's history of tax payments, (iii) the duration of time between the underpayment and subsequent correct payment of tax, and (iv) whether circumstances beyond the taxpayer's control caused the underpayment. (4)

A taxpayer also may use a tax opinion to satisfy the reasonable cause exception. (5) Under the regulations, the taxpayer must, at a minimum, disclose all relevant facts to the adviser. In addition, the adviser must base the opinion on the relevant facts and law and must not rely on unreasonable factual or legal assumptions or taxpayer representations. Under the case law, a factor to determine whether a taxpayer reasonably relied on tax advice is whether the adviser was financially independent from the promoter. (6)

Finally, last year, the Treasury promulgated final regulations (under section 6011) to require taxpayers to disclose "reportable transactions" on their tax returns. (7) The six categories of report able transactions are (i) transactions identified by the IRS as tax avoidance transactions ("listed transactions"), (ii) confidential transactions, (iii) transactions with contractual protection (of the purported tax benefits), (iv) loss transactions (for a corporation, a transaction with more than a $10 million loss in a single year), (v) transactions with a significant (i.e., greater than $10 million) book-tax difference, and (vi) transactions involving a brief asset holding period. These categories are surprisingly broad. Fortunately, there has been some disclosure relief (described in the accompanying story) for routine commercial transactions. There currently are no statutory penalties for a taxpayer that fails to disclose a reportable transaction. (8)

New Regulations and Policy

At the end of 2003, the IRS issued final penalty regulations, which are effective for returns filed after December 31, 2002, for transactions entered into after that date. (9) The Preamble to the regulations states that the IRS intended to narrow "a taxpayer's ability to establish good faith and reasonable cause as a defense." (10) Contemporaneously with the promulgation of the new penalty regulations, IRS Commissioner Mark Everson announced a policy, effective immediately, to scrutinize opinions of tax promoters. (11) These two actions (the new penalty regulations and policy) raise the bar for taxpayers that seek to use a tax opinion to show reasonable cause to avoid penalties.

First, the new penalty regulations effectively neutralize a tax opinion if the taxpayer failed to disclose a reportable transaction as required by regulation s under section 6011. (12) The penalty regulations provide that a taxpayer's failure to disclose a reportable transaction is a "strong indication" that the taxpayer did not act with the good faith necessary to prevent penalties. (13) The Treasury and the IRS also "believe that good faith requires taxpayers to be forthcoming and that taxpayers should construe the [disclosure regulations] broadly in favor of disclosure." (14) As Assistant Treasury Secretary Pamela Olson explained when the penalty regulations were proposed, "taxpayers who choose to hide their transactions from the IRS will lose their ability to rely on a tax opinion as a penalty defense." (15)

In addition, the penalty regulations specify that a taxpayer's education, sophistication, and business experience are relevant to determine whether the taxpayer's reliance on tax advice was reasonable and in good faith. The IRS will focus on these subjective factors for every transaction, not just for reportable transactions.

Under the new "penalty policy statement," Commissioner Everson declared that a taxpayer "may not rely on the advice of a tax advisor that has a financial arrangement or referral agreement with a tax shelter promoter." (16) Stressing that such an arrangement or agreement "compromise[s]" an advisor's independence, the Commissioner explained that the IRS would question the reasonableness and good faith of taxpayers that "know or have reason to know that the advisor is not independent." He stated that the IRS "will not accept reliance on an opinion from a non-independent tax adviser as proof of reasonable cause and good faith on the part of the taxpayer."

At the same time the IRS issued the new penalty policy, the IRS proposed new professional standards for tax advisers in connection with "tax shelters," which were defined broadly. Under proposed revisions to Circular 230, tax advisers must disclose to their clients any referral agreements or financial interests in the promotion of tax shelters. In addition, a marketed tax shelter opinion must state explicitly that taxpayers should seek advice on their individual circumstances from their own, and presumably independent, tax advisers. Once these new requirements are finalized, a tax adviser's independence should be easier to determine. (17)

Significance of New Regulations and Policy

The new penalty regulations and policy complete the carrot-and-stick effort by the IRS to encourage taxpayers to disclose their transactions. In December 2001, the IRS agreed to waive any related accuracy-related penalties if taxpayers disclosed questionable transactions before April 23, 2002. (18) When the IRS announced this penalty waiver, the agency threatened to "consider the assertion of [accuracy-related] penalties" to "create a compliance incentive" for disclosure. (19) The new penalty regulations and policy complete that initiative.

In effect, the new penalty regulations will operate to enforce taxpayers' obligations to disclose reportable transactions. As previously stated, no statutory penalties currently exist for failure to disclose a reportable transaction. In issuing the proposed penalty regulations in 2002, however, the IRS stressed that "the early identification of potentially abusive tax avoidance transactions is a high priority" for the IRS. (20) The IRS also emphasized that "taxpayers have improperly relied" on professional advice relating to reportable transactions to establish reasonable cause and good faith to avoid the accuracy-related penalty when they "should have, but did not, disclose" the transactions. By increasing the incidence of penalties for undisclosed reportable transactions, the IRS intends to raise the stakes for taxpayers that conceal those transactions.

In addition, the new regulations focus more subjectively on the taxpayer. An educated, sophisticated, and experienced taxpayer must meet a higher standard to demonstrate reasonable and good faith reliance on tax advice than a less savvy taxpayer. As a result, the IRS may challenge more aggressively taxpayers (especially those that ought to know better) that claim to rely exclusively on their adviser, without independently assessing the credibility of the advice.

As a complement, the new penalty policy shifts more accountability to taxpayers for their tax advice. Historically, taxpayers obtained their opinions from independent advisers and paid hourly fees for tax services. In the late 1990s, however, promoters undertook to persuade taxpayers to enter into the tax-shelter transaction by arranging for more-likely-than-not opinions from "reputable" tax advisers. Many taxpayers started to buy these cookie-cutter opinion letters, without investigating the adviser carefully. In fact, the tax advisers often helped design the tax shelters for which they wrote opinions and, occasionally, received a share of the promoter's fees (or a referral fee). The new policy now puts taxpayers on notice that they must confirm the independence of their tax advisers in order to rely on advisers' opinions.

The new disclosure requirements on tax advisers under Circular 230 could help, but may also hurt, taxpayers that seek to rely on tax advice. On the one hand, advisers' disclosures under Circular 230 will make easier taxpayers' efforts to determine whether or not their advisers are independent. In issuing the new penalty policy, Commissioner Everson stressed that these new disclosures from advisers "will provide taxpayers with critical information to evaluate the quality and reliability of the advice they receive." (21) On the other hand, the IRS may hold taxpayers to a high standard of due diligence to investigate their advisers. As Commissioner Everson also stated, disclosures from advisers will "put taxpayers on notice that they should seek independent advice." Therefore, the IRS will expect taxpayers to know of the relationships with promoters that tax advisers disclose and to seek independent advice.

Prospect for Further Changes

Taxpayers that wish to rely on tax advice for penalty protection will face an even more hostile environment in the event Congress enacts new penalty legislation. Both the House and Senate are primed to codify nearly identical legislation that is much more stringent than the final regulations and new penalty policy. These provisions have been included in "The American Jobs Creation Act," H.R. 2896, and "The Jumpstart Our Business Strength Act," S. 1637 (the "House and Senate Bills'), which have been approved by the respective tax-writing committees.

First, the House and Senate Bills would replace the rules that apply to tax shelters with a new accuracy-related penalty. There generally is a "strengthened reasonable cause exception" for these penalties. (22) If a taxpayer does not disclose the transaction, however, the strengthened reasonable cause exception is not available; in other words, a strict-liability penalty applies.

Moreover, the House and Senate Bills would markedly increase penalties. Thus, the bills would impose a hefty additional penalty above and beyond the accuracy-related penalty if a taxpayer fails to disclose a reportable transaction. Under both bills, a corporate taxpayer must pay up to $200,000 in penalties for failure to disclose a reportable transaction. In addition, under the bills, taxpayers that do not disclose listed transactions or reportable transactions with a significant tax avoidance purpose would be subject to a 30-percent penalty, as opposed to the current 20-percent penalty, on underpayments attributable to such transactions. Given the broad support in Congress, these provisions are likely to be enacted.

Conclusion

Tax opinions may still prevent penalties, but only if taxpayers choose their advice and advisers carefully. To avoid penalties going forward, taxpayers may need to disclose liberally any reportable transactions, for the IRS may view failure to do so as a "strong indication" of a lack of good faith. Taxpayers must also exercise more due diligence to ascertain whether or not their advisers are independent from promoters. Such due diligence is especially important because the IRS will hold taxpayers to a highly subjective standard of reasonableness and good faith based upon taxpayers' education, sophistication and business experience. Once the IRS finalizes revisions to Circular 230, taxpayers must scrutinize their tax opinions to identify any financially relationship between their adviser and a promoter. In the future, tax penalties will be larger, and easier to trip.

(1) I.R.C. [section] 662. Taxpayers are subject to two types of penalties for understatements--the accuracy-related penalty under section 6662 and the fraud penalty under section 6663. The accuracy-related penalty is 20 percent of the understatement, compared with the fraud penalty, which is 75 percent of the understatement. This article does hot discuss the fraud penalty, which the new rules do not implicate.

(2) I.R.C. [section] 6662(b). A substantial valuation overstatement, a substantial overstatement of pension liabilities, and a substantial estate or gift tax valuation understatement also trigger the accuracy-related penalty. Id.

(3) For corporations, the reasonable cause and good faith exception is the only way to avoid a penalty from a substantial understatement of tax liability for a tax shelter, which is broadly defined to include arrangements in which "a significant purpose ... is the avoidance or evasion of Federal income tax." I.R.C. [section] 662(d).

(4) Internal Revenue Manual [section] 20.1.1.3.1.2.

(5) Treas. Reg. [section] 1.6664-4(b) and (c).

(6) See, e.g., Rybak v. Commissioner, 91 T.C. 524 (1988) (holding that a taxpayer that relied on the advice of accountants and financial planners who received a fee from the promoter could not avoid penalties); Belle v. Commissioner, 81 T.C.M. (CCH) 1271 (2001) (holding that a taxpayer that relied on the advice of an accountant who had been arranged by the promoter could hot avoid penalties).

(7) Treas. Reg. [section] 1.6011-4(a). (8) Treas. Reg. [section] 1.6011-4(b)(1).

(9) See 2003 TNT 249-3 (Dec. 29, 2003) (adding language to Treas. Reg. [section] 1.6664-4(c) and adding new Treas. Reg. [section] 1.6664-4(d)).

(10) Id.

(11) See Memorandum from Commissioner Everson entitled "Penalty Policy Statement of the Internal Revenue Service," 2003 TNT 249-9 (Dec. 29, 2003).

(12) The regulations also provide that a taxpayer cannot rely on professional advice that a regulation is invalid to satisfy the reasonable cause exception if the taxpayer did net disclose the position that the regulation was invalid. Sec note 9.

(13) 2003 TNT 249-9 (Dec. 29, 2003). Proposed regulations issued a year earlier precluded the use of a tax opinion to satisfy the reasonable cause exception in the case of an undiselosed reportable transaction. See Preamble, 67 Fed. Reg. 79,894 (Dec. 31, 2002). In issuing the final regulations, the IRS acknowledged "there may be circumstances in which a taxpayer does net lack good faith in failing to disclose a reportable transaction." See Preamble, 68 Fed. Reg. 75,126 (Dec. 30, 2003). Commentators had urged the IRS to change the standard because, in seine circumstances, taxpayers might reasonably believe that a transaction need net be disclosed. Id.

(14) See Preamble, 68 Fed. Reg. 75,126 (Dec. 30, 2003).

(15) Treasury Release on Proposed Regulations Regarding Penalty Defenses, 2002 TNT 251-12 (Dec. 30, 2002).

(16) Emphasis added. The legal authority for this statement is unclear. Presumably, the statement reflects the case law, though the independence of the adviser is seemingly only one factor to determine reasonable cause and good faith of the taxpayer. See note 6.

(17) The rules win be effective on the date that final regulations are published in the Federal Register. See 2003 TNT 249-4 (Dec. 29, 2003).

(18) See Announcement 2002-2, 2002-2 I.R.B. 304 (Jan. 14, 2002).

(19) See 2001 TNT 247-9 (Dec. 21, 2001).

(21) See Preamble, 67 Fed. Reg. 79,894 (Dec. 31, 2002).

(21) See Notice from Treasury Department, 2003 TNT 249-4 (Dec. 29, 2003).

(22) Under the strengthened reasonable cause exception, a taxpayer must show that (1) the facts affecting the transaction have been adequately disclosed in accordance with the regulations under section 6011, (2) there is or was substantial authority for such treatment, and (3) the taxpayer reasonably believed that such treatment was more likely than net the proper treatment.

RELATED ARTICLE: Routine commercial transactions are not tax shelters.

At the end of last year, the IRS and Treasury revised the fax shelter disclosure regulations to permit taxpayers to protect commercial information in transactions in which there is no proprietary "fax strategy." See T.D. 9108 (Dec. 29, 2003) (amending Treas. Reg. [section] 1.6011-4). The disclosure regulations require taxpayers who have participated in a "confidential transaction" (one of the six categories of so-called reportable transactions) to disclose these transactions by attaching a disclosure statement to their tax return.

The original disclosure regulations defined "confidential transaction" broadly to include virtually any transaction that restricted the taxpayer's ability to reveal any fact that may have been relevant to understanding the transaction's fax treatment. See former Treas. Reg. [section] 1.6011-4(b)(3)(i), (c)(9) (Feb. 28, 2003). Many taxpayers (as well as groups such as Tax Executives Institute) expressed concern that routine business transactions preventing parties from revealing sensitive information (such as the identity of the parties and the quantity, delivery and pricing terms for a product) might be reached by the regulations. The original regulations provided a safe harbor for taxpayers who waived confidentiality, but many taxpayers were reluctant to use the regulations' waiver language because it did not protect sensitive business information.

Under revised regulations, the IRS and Treasury will treat transactions as confidential only if a highly-paid adviser imposes confidentiality to protect his or her own fax strategies. The revised disclosure regulations thus define "confidential transaction" to cover only transactions for which an advisor is paid a minimum fee ($250,000 if the taxpayer is a corporation) and the advisor imposes confidentiality on the taxpayer to protect the advisor's fax strategies. See Treas. Reg. [section] 1.6011-4(b) (Dec. 29, 2003). The narrower definition should ensure that most routine business transactions with confidentiality restrictions will not be subject to disclosure as "confidential transactions" (although the transactions might still fall within a different category of reportable transaction).

The revised regulations may apply to any transaction entered this year. Thus, many taxpayers need not disclose routine business transactions as confidential transactions when they file their 2003 fax return.

STEVEN M. ROSENTHAL and KATARINA O. SAVINO are lawyers with Miller & Chevalier Chartered. Mr. Rosenthal joined the firm as a member in March 2001. He is co-chair of the Taxation Section of the District of Columbia Bar. Ms. Savino joined the firm as an associate in 2002 after receiving her law degree from Harvard Law School.