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Administrative Guidance, Ethical Standards, and Tax Return Positions: In-house tax professionals must traverse a difficult course.

Many corporations currently face tremendous high-value tax uncertainty as a result of the 2017 Tax Cuts and Jobs Act (TCJA), not to mention other longstanding tax risks such as transfer pricing. For some tax executives, these risks constitute familiar waters. For other tax executives, however, navigating these risks is less routine and may seem more challenging, especially if the corporation generally favors certainty and earnings quality over a few percentage points of effective tax rate.

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
Publication:Tax Executive
Article Type:Cover story
Date:Jan 1, 2019
Words:3362
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