Administrative Guidance, Ethical Standards, and Tax Return Positions: In-house tax professionals must traverse a difficult course.
Although many tax executives prefer to operate within the comfort zone of "should," the major new rules added by the TCJA make that difficult. Indeed, when most corporations filed their 2017 tax returns, there was little or no binding guidance other than the language of the Internal Revenue Code itself, which was fraught with numerous ambiguities. Yes, at the time there were some nonbinding proposed regulations--also known as suggestions for comment--but not final or temporary regulations, which are currently entitled to Chevron deference. Likewise, the Internal Revenue Service had issued several notices related to Section 965 prior to the due date for 2017 returns. But again, sub-regulatory guidance, such as a notice, is not binding authority and is given deference only commensurate with its "ability to persuade."
More and more proposed regulations have been issued since 2017 returns were filed. What will the regulations look like when finalized, perhaps after technical corrections to the TCJA? Although this answer is far from certain, if the proposed regulations are finalized within eighteen months of the TCJA's enactment, under Section 7805 they may be retroactive and apply to the 2017 tax year. Thus, many return positions that were relatively certain when 2017 tax returns were filed may suddenly become uncertain due to subsequently issued regulations. In these situations, tax executives did not have the option to plan for or to avoid the uncertainty altogether.
Is Chevron Deference Itself Uncertain?
Will taxpayers and the courts have to defer to the final regulations once issued? Perhaps, but the U.S. Supreme Court is likely to revisit Chevron deference in the next few years. Justice Anthony Kennedy, who served as the Supreme Court's swing vote for many years prior to his retirement in July, wrote in April 2018 in Pereira v. Sessions, 138 S. Ct. 2105, 2120-21 (2018) (Kennedy, J. concurring):
The type of reflexive deference exhibited in some of these cases is troubling.... [I]t seems necessary and appropriate to reconsider, in an appropriate case, the premises that underlie Chevron and how courts have implemented that decision. The proper rules for interpreting statutes and determining agency jurisdiction and substantive agency powers should accord with constitutional separation-of-powers principles and the function and province of the Judiciary.
Given its current makeup now that Justice Kennedy has retired, the Supreme Court seems likely to revisit Chevron and at least "tighten" it to some degree.
Finally, to the extent the regulations themselves are ambiguous, courts will struggle with the question of whether they should defer to the IRS' interpretation of its own ambiguous regulations or, as did the Tax Court in Gottesman & Co. v. Commissioner, 77 T.C. 1149 (1981), rule in favor of a taxpayer's reasonable interpretation when faced with regulatory ambiguity.
Charting the Levels of (Un)Certainty
It may be helpful to step back and review the overall picture. The chart on the next two pages shows the range of (un)certainty that is not only legal but also ethically permissible. This chart can also serve as an important communication tool for discussions with nontax executives regarding the tax risks a corporation may face.
As the chart shows, the overall legal and ethical structure recognizes that significant uncertainty may be the norm, not the exception.
Tax Reserves, IRS Audits, and Disclosures
It is very likely that a corporation's financial auditors, not the IRS, will first identify a significant tax risk. In response, the financial auditors may or may not require the corporation to establish a reserve. This obviously may influence whether a corporation must file a Schedule UTP for uncertain tax positions, which functions the same way Forms 8275 and 8275-R do for noncorporate taxpayers. This schedule and these forms may highlight issues for the IRS to audit, but they also generally provide additional protection against penalties, as do Revenue Procedure 94-69 disclosures.
For a disclosure to provide penalty protection, however, it must be adequate. Schedule UTP serves as adequate disclosure for corporate taxpayers and is generally required for (1) tax positions for which a reserve has been recorded and (2) tax positions where no reserves are recorded because of an expectation to litigate the issue when the taxpayer believes (a) the probability of settling the issue is less than fifty percent and (b) the taxpayer is more likely than not to prevail in litigation.
Normally, there is no requirement to file a Schedule UTP in later years unless the uncertain position affects more than one year. For example, if a Schedule UTP was filed for the 2017 tax year for a tax position that generates a carryover, generally no Schedule UTP is required to be filed for 2018. In contrast, a corporation may need to file a Schedule UTP if an uncertain tax position in 2017 creates basis that is utilized in 2018.
A caveat also exists for changed circumstances. For example, if a corporation takes a position on its 2017 return for which no reserve was recorded because the corporation determined that the position was correct, but circumstances change and in 2018 the corporation determines that the tax position is uncertain but does not record a reserve because it expects to litigate, the corporation must still file a Schedule UTP with the 2018 return for the 2017 position. (See Example 5 of the Schedule UTP instructions.) Many corporations adversely impacted by subsequently issued regulations may find themselves in this situation.
In fact, a number of corporations have taken return positions that they believed correct when they filed their 2017 tax returns, so no tax reserves were established or Schedule UTP filed for the position. Subsequently, proposed regulations have been issued that would adversely impact the return position once finalized. In response to the proposed regulations, some corporations have attempted to establish tax reserves, but financial auditors have refused to let them do so because proposed regulations are not binding authority. But, once finalized, the retroactive regulations may cause an uncertainty to spring to life and require a tax reserve as well as a Schedule UTP. (See Examples 2 and 5 of the Schedule UTP instructions.)
In the absence of a Schedule UTP, and in the case of an item or position other than one that is contrary to a regulation, disclosure must be made on Form 8275. If the position is contrary to a regulation, disclosure must be made on Form 8275-R. If neither Schedule UTP nor the forms are required, tax executives should carefully consider the strategic use of Revenue Procedure 94-69 disclosures at the commencement of an IRS audit.
Levels of (Un)Certainty for Tax Return Positions Assumes IRS audits merits of return position Not Frivolous 5%-10% Brief Description of This standard is Standards satisfied if the position is not patently improper. A position that is "merely arguable" or "merely a colorable claim" is likely frivolous. Internal Revenue Taxpayers may be Code [section] 6662 penalized under Taxpayer Penalty [section] 6702 Civil accuracy-related for filing penalty of 20% for a frivolous substantial valuation returns. misstatement or 40% for a gross valuation misstatement. Internal Revenue For tax returns due on Code [section] 6694 Tax or before Dec. 31,2007, Return Preparer a preparer may avoid Penalty penalties if the position Civil return is disclosed (except preparer penalty for for tax shelters and understatement of reportable positions), taxpayer's liability, unless the position for greater of was frivolous. $1,000 or 50% of income. IRS Circular 230 A practitioner may not Applies to attorneys advise a client to take and CPAs representing a position on a document, taxpayers before affidavit, or other paper the IRS submitted to the IRS (or advise to submit it) unless the position is not frivolous. AICPA SSTS No. 1 A practitioner should Applies to CPAs not recommend a position that he or she knows "serves as a mere arguing position advanced solely to obtain leverage in a negotiation." ABA Opinions Formal Op. 85-352 Applies to (1985) requires a lawyers nonfrivolous basis for a lawyer to "bring or defend a proceeding, or assert or controvert an issue therein." See also ABA Model Rule 3.3. Effect of Disclosure Does not absolve (to the IRS) civil penalty. Even if disclosure is not technically necessary, it may be utilized strategically to provide additional penalty protection without raising a reasonable cause defense, which may waive privilege. Internal Revenue Code Even without a [section] 6664 reasonable basis, Reasonable Cause the [section] 6662 Defense to Civil penalty and the Penalties [section] 6694 penalty can be avoided with a reasonable cause and good faith defense. Reasonable Basis 10%-15% Brief Description of This standard is satisfied if Standards the position is reasonably based on one or more authorities, taking into account the relevance and persuasiveness of each. Although the reasonable basis standard demands less than substantial authority, how much less is not entirely clear. There is some support for the proposition that a position with a 10%-15% likelihood of prevailing is sufficient. Internal Revenue In the case of non-shelter Code [section] 6662 items, a taxpayer can Taxpayer Penalty avoid the substantial Civil accuracy-related understatement penalty of penalty of 20% for a [section] 6662(b)(2), the substantial valuation disregard of rules or misstatement or 40% regulations under for a gross valuation [section] 6662(b)(1), misstatement. and the civil penalty for an excessive claim for refund under [section] 6676(a), with a position that has a reasonable basis, if it is adequately disclosed. A position is not considered negligent if there is a "reasonable basis" for the position. Internal Revenue For tax returns due after Code [section] 6694 Tax Dec. 31,2007, a preparer Return Preparer may avoid penalties if a Penalty reasonable basis for a Civil return position exists and the preparer penalty for position is disclosed, understatement of except for tax shelters taxpayer's liability, and reportable positions. for greater of $1,000 or 50% of income. IRS Circular 230 A practitioner may not Applies to attorneys willfully, recklessly, and CPAs representing or through gross taxpayers before incompetence sign a tax the IRS return (or refund claim) if he or she knows it contains a position that lacks a reasonable basis. AICPA SSTS No. 1 A practitioner Applies to CPAs cannot prepare or sign a return unless he or she concludes the position has a reasonable basis and it is adequately disclosed. A practitioner should not recommend a tax position unless there is a reasonable basis for the position and the practitioner advises the taxpayer to disclose the position. ABA Opinions Formal Op. 314 (1965) Applies to provides that, in lawyers advising a client in the course of preparation of returns, the lawyer may freely urge positions most favorable to the client as long as there is a reasonable basis for the position taken (revised by Op. 85-352). Effect of Disclosure Disclosure is necessary (to the IRS) to absolve the penalties Even if disclosure for substantial is not technically understatement under necessary, it may be [section] 6662(b)(2), utilized strategically the disregard of rules to provide additional or regulations under penalty protection [section] 6662(b)(1), without raising a and for an excessive reasonable cause claim for refund or defense, which may credit under [section] waive privilege. 6676(a). Disclosure is necessary under SSTS No. l and will absolve the [section] 6694 penalty. Internal Revenue Code The defense is applicable [section] 6664 to [section] 6662 and Reasonable Cause [section] 6694 penalties, Defense to Civil but a taxpayer may not Penalties rely on advice that a regulation is invalid to establish reasonable cause and good faith unless the taxpayer adequately disclosed the position that the regulation is invalid. Realistic Possibility of Success 33% Brief Description of Asa general rule, a Standards "realistic possibility of success" requires a likelihood of success approaching 33%. This standard was intended to elevate, not merely restate, the reasonable basis standard. Although a 10% likelihood of prevailing will not satisfy the standard, a position need not be supported by substantial authority. Internal Revenue In the case of non- Code [section] 6662 shelter items other than Taxpayer Penalty reportable transactions, Civil accuracy-related the penalty for disregard penalty of 20% for a of a rule with substantial valuation respect to a revenue misstatement or 40% ruling or notice under for a gross valuation [section] 6662(b)(1) misstatement. will not apply if the position has at least a realistic possibility of success. Internal Revenue For tax returns due on Code [section] 6694 Tax or before Dec. 31,2007, Return Preparer no [section] 6694(a) Penalty penalty is imposed Civil return if there was a preparer penalty for realistic possibility of understatement of success for the position. taxpayer's liability, for greater of $1,000 or 50% of income. IRS Circular 230 Applies to attorneys and CPAs representing taxpayers before the IRS AICPA SSTS No. 1 A practitioner should Applies to CPAs not recommend a position or prepare a return unless he or she has a good-faith belief that the position has at least a realistic possibility of being sustained on the merits. ABA Opinions This is the threshold Applies to for advising on a lawyers reporting position under Op. 85-352. The lawyer must believe in good faith that the position is warranted in law or can be supported by a good faith argument. Effect of Disclosure Disclosure is not (to the IRS) necessary under Even if disclosure this standard. is not technically necessary, it may be utilized strategically to provide additional penalty protection without raising a reasonable cause defense, which may waive privilege. Internal Revenue Code The defense is [section] 6664 applicable. Reasonable Cause Defense to Civil Penalties Substantial Authority 40%-45% Brief Description of This objective standard Standards is satisfied if the weight of the authorities supporting the position is substantial compared to those supporting contrary treatment. It is stricter than "reasonable basis" but less stringent than "more likely than not." The IRS Penalty Study places the required degree of success at 45%. Internal Revenue In the case of Code [section] 6662 non-shelter items, Taxpayer Penalty taxpayers may escape Civil accuracy-related the substantial understatement penalty of 20% for a penalty of [section]6662 if a substantial valuation position is supported by misstatement or 40% substantial authority. Please for a gross valuation see Treasury Regulation misstatement. section 1.6662-4(d)(3)(iii) for a detailed listing of relevant authorities. It includes, among other items, statutes; proposed, temporary, and final regulations; revenue rulings and procedures; and congressional intent. Internal Revenue For tax returns due Code [section] 6694 Tax after Dec. 31,2007, no Return Preparer [section] 6694(a) penalty is Penalty imposed if there was Civil return substantial authority for preparer penalty for the position. understatement of taxpayer's liability, for greater of $1,000 or 50% of income. IRS Circular 230 Applies to attorneys and CPAs representing taxpayers before the IRS AICPA SSTS No. 1 Applies to CPAs ABA Opinions Applies to lawyers Effect of Disclosure Disclosure is not (to the IRS) necessary under Even if disclosure this standard. is not technically necessary, it may be utilized strategically to provide additional penalty protection without raising a reasonable cause defense, which may waive privilege. Internal Revenue Code The defense is [section] 6664 applicable. Reasonable Cause Defense to Civil Penalties More Likely Than Not >50% Brief Description of This standard requires Standards a likelihood of success that is greater than 50%. Internal Revenue This subjective Code [section] 6662 standard AND the Taxpayer Penalty objective substantial Civil accuracy-related authority standard must penalty of 20% for a be satisfied by a substantial valuation noncorporate taxpayer misstatement or 40% to avoid the substantial for a gross valuation understatement penalty misstatement. for tax shelter items. Thus, there must be a subjective (and reasonable) belief that it will more likely than not prevail on the merits if challenged, and the position must be supported by substantial authority. Also, [section] 6662A penalties apply for reportable transaction understatements. Internal Revenue No [section] 6694 penalty Code [section] 6694 Tax imposed for tax Return Preparer shelters and reportable Penalty transactions if it was Civil return reasonable to believe preparer penalty for that the position understatement of would more likely than not be taxpayer's liability, sustained on its merits. for greater of $1,000 or 50% of income. IRS Circular 230 Applies to attorneys and CPAs representing taxpayers before the IRS AICPA SSTS No. 1 Applies to CPAs ABA Opinions Formal Op. 346 (Revised) Applies to (1982) requires a tax lawyers lawyer, in making an overall evaluation of realization of tax benefit, to state whether the benefits "probably will be realized." Effect of Disclosure Disclosure is not (to the IRS) necessary under this Even if disclosure standard (except with is not technically respect to penalties necessary, it may be under [section] 6662A). utilized strategically to provide additional penalty protection without raising a reasonable cause defense, which may waive privilege. Internal Revenue Code The defense is [section] 6664 applicable. To Reasonable Cause absolve the Defense to Civil [section] 6662A Penalties penalty for reportable (but not listed) transactions, the taxpayer must establish a reasonable basis, must have disclosed the transaction, and must meet this more likely than not standard. "Should" Prevail 70%-85% Brief Description of A "should" opinion Standards has a 70%-80% chance of success on the merits and is materially higher than that of a "more likely than not" opinion. Some practitioners imply that a "should" opinion implies that the IRS has no reasonable basis to oppose it. Internal Revenue Code [section] 6662 Taxpayer Penalty Civil accuracy-related penalty of 20% for a substantial valuation misstatement or 40% for a gross valuation misstatement. Internal Revenue Code [section] 6694 Tax Return Preparer Penalty Civil return preparer penalty for understatement of taxpayer's liability, for greater of $1,000 or 50% of income. IRS Circular 230 Applies to attorneys and CPAs representing taxpayers before the IRS AICPA SSTS No. 1 Applies to CPAs ABA Opinions Applies to lawyers Effect of Disclosure Disclosure is not (to the IRS) necessary under Even if disclosure this standard. is not technically necessary, it may be utilized strategically to provide additional penalty protection without raising a reasonable cause defense, which may waive privilege. Internal Revenue Code The defense is [section] 6664 applicable. Reasonable Cause Defense to Civil Penalties
How Long Will Uncertainty Last?
Historically, the rule of thumb was that the normal three-year statute of limitations created an eighteen- to twenty-four-month window from the date a tax return was filed for the IRS to start most audits--and if it did not, it was unlikely that the IRS would audit the tax return. Under the TCJA that window may have increased significantly. A six-year limitations period applies to an assessment of net tax liability due to pre-2018 accumulated deferred foreign income, omissions of Subpart F income or income from the new GILTI tax, or adjustments related to the transition tax. Even in the absence of extensions of the statute of limitations, six years is a long time. And, for some issues, this may be just the beginning. Keep in mind, and by way of example, that the ongoing Altera case is a challenge to the 2003 amendments to the cost-sharing regulations. As much as tax executives might hope that the TCJA uncertainties now on the table will not take fifteen years to resolve, that is nonetheless a possibility.
Tax executives facing high-value tax uncertainty clearly see choppy waters and potential storms on the horizon. Thorough evaluation and effective communication of these risks are critical to successfully navigating these waters. These are shared challenges best confronted together.
Todd Welty is a partner at McDermott Will & Emery and chair of its tax controversy practice. Lowell Yoder is a partner at McDermott Will & Emery, focusing on cross-border mergers and acquisitions, global tax planning, and international tax controversies.
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|Author:||Welty, Todd; Yoder, Lowell|
|Article Type:||Cover story|
|Date:||Jan 1, 2019|
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