“Although I may marry others, and marry often,” says the heroine, bosom heaving, to her one true love, “nothing can alter my eternal devotion to you.”
Which makes perfect sense if you are a tax advisor. Consider the following:
Gwendolen and Cecily consult Algernon, a tax expert, about deferring recognition of more than $10 million in gain on the sale of real estate through the use of a Section 1031 like-kind exchange. (Algernon, Gwendolen and Cecily and are characters in “The Importance of Being Earnest,” a play written by 19th century author Oscar Wilde. Wilde, a celebrated wit, once observed that “it is only by not paying one’s bills that one can hope to live in the memory of the commercial class.” We shall honor Wilde for his keen insight into the business mind by adapting his characters to a modern business case study.) In addition to the standard Section 1031 issues, they need reassurance that the property being sold was ‘held for investment,’ as they had not held the land very long before they undertook to subdivide it into lots for the purpose of selling them in bulk to a homebuilder. In addition, Gwendolen wants to reinvest her share of the sales proceeds in replacement investment property, while Cecily wants to purchase an expensive retirement spread where she can try her hand at breeding racehorses.
In his initial meeting with Gwendolen and Cecily, Algernon discusses the possible difficulty in qualifying the property as held for investment, owing to the short holding period and the subdivision into building lots. In addition, he outlines several improvised and, Algernon notes, uncertain structuring techniques available to deal with the problem of having less than all partners in a partnership electing to reinvest under the like kind exchange rules. He also describes to Cecily, in general terms, the rules relating to hobby losses.
As the meeting concludes, Algernon recaps the issues discussed and recites for his clients his follow-up ‘to-do’ items. First, he notes that although Gwendolen and Cecily may have a problem meeting the “held for investment” requirement with respect to the relinquished property, he is pretty sure there is at least substantial authority for that position, and he promises a short memo containing a discussion of helpful caselaw. Mindful of his clients’ dislike for large professional fees, he promises to keep the time spent on that memo to a minimum, just enough, that is, to protect Gwendolen and Cecily from an accuracy-related penalty.
With respect to the differing reinvestment plans, Algernon suggests redeeming Cecily with a note just prior to closing on the relinquished property. He explains that while no consensus has formed among tax practitioners as to one best, customary commercial practice in this difficult area, his gut tells him that, more likely than not, the presale redemption structure will work for tax purposes. He promises to discuss his assessment with a colleague and then confirm it with Gwendolen and Cecily in a quick e-mail. Gwendolen mentions that, with Algernon’s permission, she might forward his email to a real estate colleague wrestling with the same problem.
Finally, with respect to the horse farm, Algernon tells Cecily that there is a large body of the case law on the hobby loss issue, and that the right answer in any given case is fact-sensitive. He agrees to send Cecily copies of some sample cases. Cecily would then report back to Algernon how she plans to conduct her horse breeding business. Implicit in this conversation, which is conducted with a wink and a nod, is that Algernon will coach Cecily to provide him with the “right facts,” without regard to what Cecily’s horse breeding plans actually are. Whatever the real facts, Algernon thinks to himself, there is little likelihood of an audit. Algernon plans to avoid written advice to the client on this issue.
As the meeting breaks up, Algernon summons his secretary to make copies of his notes for each of Gwendolen and Cicely.
Cut! Tell me what’s missing from this script?
“Not much,” you sniff. “It’s utterly trivial and pedestrian. Gwendolen and Cecily, as real estate developers, display a characteristic sense of entitlement to an exemption from income taxes. Algernon, ever the servant of justice — and aware that Gwendolen and Cecily know every other CPA and tax advisor in town — eagerly serves up the appropriate, if aggressive, strategy for accomplishing that result.”
True, but irrelevant. What’s really missing is an appreciation of how recently imposed practice obligations on tax advisors — accountants and lawyers — as well as recent changes in the reporting obligations, have rendered that scene dangerous to the pocketbooks of Gwendolen and Cecily and a threat to the professional good standing of Algernon. A radical shift is underway in the expected role of tax advisors in the fair administration of Federal tax law. As this article will show, Oscar Wilde’s love smitten protagonist’s claim that “nothing can alter my eternal devotion to you” notwithstanding, Algernon’s indiscriminate willingness to serve up every tax dodge demanded by Gwendolen and Cecily’s is a conceit of the past — less quaint, but as out of date as the names Wilde chose for the characters in his plays.
Enactment of New Circular 230
Although Treasury Department regulation of tax practitioners, known as Circular 230, dates back many decades, the most recent version of that regulatory scheme became effective on June 20, 2005. It includes the following noteworthy enhancements and additions: best practices; covered opinions (both the definition and when the requirement for issuing a covered opinion arises); procedures to ensure compliance with the covered opinion rules; and rules relating to other written tax advice.
Best practices are aspirational rather than mandatory. The best practices section, Section 10.33, recites a list of practice values akin to those appearing in the Rules of Professional Conduct. The regulations provide that best practices include “advising the client regarding the import of the conclusions reached, including, for example, whether a taxpayer may avoid accuracy-related penalties…if the taxpayer acts in reliance on the advice.” So far, so good. Aggressive tax planning necessarily involves, either explicitly or implicitly, a judgment about whether a position can be taken on a return without exposing either the taxpayer or the preparer to penalties.
Circular 230 imposes best practices obligations on law firms and accounting firms. These are discussed in the Respondeat Superior section of this essay.
A character in a well known play (not Wilde’s) expressed surprise at the discovery that he had been speaking “prose” all his life. With the advent of the new Circular 230, only the meekest of tax advisors will confidently assume that they are not issuing “covered opinions” in the every day course of their practice. Under Section 10.35 of Circular 230, all but the mice among us must cope with the challenge of either complying with or taking conscious steps to avoid having to comply with the covered opinion rules. The covered opinions rules, therefore, complex and cumbersome though they are, bear careful consideration.
A covered opinion consists of written advice (electronic communications constitute written advice) concerning one or more “Federal tax issues,” provided that the Federal tax issue or issues arise from an enumerated list of categories, as follows: (i) a listed transaction (see, as of the date of this writing, Notice 2004-67); (ii) a marketed opinion; (iii) an entity, plan or arrangement the principal purpose of which is to avoid or evade taxes (a “principal purpose transaction”); or (iv) an entity plan or arrangement which has as a significant purpose to avoid or evade taxes (a “significant purpose transaction”).
For the covered opinion rules to apply, moreover, a Federal tax issue must be “significant,” meaning that the IRS must have a “reasonable basis” for successfully challenging a taxpayer’s position, and the resolution of the controversy would have a “significant impact” on the overall tax treatment of the transaction. (That’s three uses of the word significant to keep straight: significant purpose transactions, significant Federal tax issue and a significant impact on the tax treatment of a transaction.)
Issuing a covered opinion is a lot of work and creates a lot of expense for clients, so many if not most tax advisors will attempt to deliver competent, responsible tax advice without triggering the covered opinion rules. Principal purpose transactions always trigger the requirement for a covered opinion. Significant purpose transactions, in contrast, may or may not call for the issuance of a covered opinion. As discussed below, the “significant purpose” test is a wobbly, uncertain gear in the Circular 230 regulatory scheme.
Significant Purpose versus Principal Purpose
Complying with the intricate new rules of Circular 230 is not only impossible, it is also extremely difficult. The rules are a challenge to understand, and it is impossible to know for sure if you really do understand them. Nowhere is that difficulty more evident than in the linedrawing required to determine if a transaction is a principal purpose transaction or a significant purpose transaction.
As recited above, written advice concerning a principal purpose transaction is per se required to be given in the form of a covered opinion. Written advice concerning a plan or transaction having tax avoidance as merely one of its significant purposes, however, need be given in the form of a covered opinion only if the written advice is in a “suspect category” (my terminology, not that of Circular 230). A suspect category is one or more of the following: a reliance opinion; a marketed opinion; advice subject to conditions of confidentiality; or advice subject to contractual protection.
The Circular 230 regulations define principal purpose transactions as those with respect to which the tax avoidance or evasion purpose exceeds all other purposes in importance. In contrast to that bland but commonsense definition of principal purpose transactions, Circular 230 does not define significant purpose transactions. Regulations promulgated under the tax shelter rules of Section 6111 provide that a significant purpose transaction is a transaction “structured to produce tax benefits that constitute an important part of the intended results of the arrangement” (emphasis added). Those regulations provide, however, that transactions which are (i) entered into in the “ordinary course of business” consistent with “customary commercial practice” and (ii) with respect to which there is a “generally accepted understanding that the tax benefits are properly allowable for substantially similar transactions” are not “significant purpose” transactions.
A for what it’s worth summary of the foregoing is that there are three levels. The first is the ‘ordinary course/generally accepted understanding level,’ which means no principal purpose, no significant purpose and no covered opinion burdens. The second is the ‘important but not most important’ motive, which places the practitioner in the wobbly ‘significant purpose’ zone. The third is the ‘primus inter pares/exceeds all other in importance’ level, which triggers the mandatory covered opinion rules.
Where would a judicial finding of ‘form over substance’ or ‘step transaction’ leave the tax practitioner in the context of Circular 230? Would such a finding kick the deal into principal purpose status? Orphaned tax shelter regulations under Section 6662 (Treas. Reg. §1.6662-4(g)(2)(i)) refer to “mischaracterization of the substance of the transaction” as an indicator of a principal purpose to avoid taxes. The regulations, however, also provide that principal purpose transactions are those which reflect “little or no motive for the realization of economic gain,” so even a structure which runs afoul of the step transaction doctrine should be able to qualify as significant purpose transaction as long as there is some motive for economic gain. If not, the tax advisor on the deal who failed to issue a covered opinion would be exposed to sanctions under Circular 230.
One might hope that this plays out so that a business purpose always saves a deal from slipping from significant purpose to principal purpose. Can, for example, a taxpayer say “I sold my business using this structure rather than that one, because the taxes were lower; consequently, no matter how aggressive the structuring, the principal purpose was to sell the business”?
The answer is that anything short of a truly nonstandard structure for selling a business will likely (dare I say more likely than not) qualify as, at worst, a significant purpose rather than a principal purpose transaction. Recall that the Section 6662 regulations define principal purpose transactions as transactions structured with little or no motive for the realization of economic gain. This includes transactions that utilize the mismatching of income and deductions, overvalued assets or assets with values subject to substantial uncertainty, financing techniques that do not conform to standard commercial business practices, and the mischaracterization of the substance of the transaction. Although that regulation needs to be amended to conform to recent changes in Section 6662, the provisions described above remain an excellent interpretive source. As such, they reinforce the conclusion that the structure in question is not a principal purpose transaction.
Furthermore, the detour into Section 6662 leads to a practical insight that has been overlooked amidst the anguish over the principal purpose/significant purpose linedrawing problem. The reason new Circular 230 is so tough is that the Department of the Treasury is seething mad at the inappropriate sale of penalty protection by tax practitioners. This means that even if a transaction is aggressive, if it satisfies the penalty threshold — substantial authority, for example, or reasonable basis plus disclosure — the Treasury Department will tend not to have an interest in sanctions against the advisor even if the advisor made the wrong choice between principal purpose and significant purpose. In other words, if the IRS doesn’t assert penalties against the taxpayer, how likely is it that it will second guess your Circular 230 analysis? Indeed, consistent with that read, a Treasury Department official participating in a panel discussion on Circular 230 has stated that the government will concern itself only with willful or gross misconduct.
Think of Circular 230 as a trapping mechanism: the more worried you are that your client might face penalties, the more worried the IRS wants you to be that you might face penalties. The less you think your client has to worry about, the less you have to worry about yourself.
Of the four suspect categories of written advice concerning a significant purpose transaction, the reliance opinion element is of broadest interest. A reliance opinion is one that both the advisor and client expect will insulate the taxpayer from penalties. It is defined as an opinion which concludes that a Federal tax issue will “more likely than not” be resolved in the taxpayer’s favor. The advisor can elect out of reliance opinion status by simply engaging in the awkward, client alienating, confidence reducing act of “prominently” disclosing, in a separate section of the written advice, in typeface equal to the predominant typeface in the written advice, that the opinion was “not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.”
Marketed opinions are of some interest as well. Marketed opinions are opinions which the practitioner knows or has reason to know will be used or referred to by a person other than the practitioner in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayers. The use of disturbingly general words like “recommended” and “used or referred to,” casts a wider net than salesman-driven tax scams. I can “recommend” my tax strategy to an affiliate of my client, and I can “refer to” the structure proposed by opposing tax counsel. Is either instance really supposed to fall into this heightened category of scrutiny? A partial answer to the question is that an opinion that would otherwise qualify as a marketed opinion will not be treated as one if (i) the opinion expressly disclaims an intent to serve as a marketed opinion; and (ii) the subject matter of the opinion does not involve either a listed or principal purpose transaction. Restated, if the opinion relates to matters other than principal purpose or listed transactions, you can opt out. This does not, as a practical matter, help when the opinion becomes a marketed opinion by inadvertence, that is, because it is informally “recommended” or “referred to,” as discussed above. Marketed opinions must conclude to a more likely than not confidence level with respect to each significant Federal tax issue, so marketed opinion status is highly undesirable.
Steering Clear of Covered Opinions
Let’s summarize. Issuing a covered opinion puts you in a high scrutiny zone. All things being equal, therefore, you don’t want to be issuing covered opinions. You could be in that zone, however, by, among other means, either issuing written advice on an entity, plan or transaction the “principal purpose” of which is tax avoidance or evasion (in which case it’s the end of the inquiry: no opting out), or issuing written advice where tax avoidance or evasion is a “significant” but not the sole purpose. In that latter case, opting out may save you. (Remember, for the umpteenth time, that you can’t opt out of giving a covered opinion if you opine on a principal purpose transaction, and remember that even a covered opinion on a principal purpose transaction doesn’t give penalty protection unless it concludes at a more likely than not or better confidence level.)
In addition to escaping the obligation to issue a covered option by concluding that the transaction is merely a significant purpose transaction, other paths lead out of the covered opinion zone. These include (i) advice concerning the qualification of a qualified plan, (ii) advice from an in-house advisor, (iii) preliminary advice if the advisor reasonably expects to be asked to provide follow-up advice, (iv) advice on a State or local bond issue, (v) restricting written communications to deal documents and/or deal memos containing no explicit tax advice, (vi) advice not to enter into the proposed transaction and (vii) advice contained in documents required to be filed with the SEC.
Here’s the most important path clear of covered opinions. A taxpayer does get penalty protection from an opinion which concludes that there is substantial authority for the position even if the confidence level is less than fifty percent, provided the deal is a significant purpose transaction. It’s the most important path because will, if competently rendered, protect the client from penalties.
Significant Federal Tax Issue
Consider the following sentence: “Algernon has come up with a tax planning strategy (i) which has tax avoidance as one of its significant purposes, (ii) a significant purpose [of which] is the avoidance of Federal income tax and (iii) which involves a significant Federal tax issue.” Oscar Wilde would gag on a sentence as inelegant and imprecise as that. We are tax experts, however, so we see precision where the likes of Oscar Wilde, unlettered in the language of tax law, could not. While the sentence contains three confusingly similar ideas, each has its own definition under either Circular 230 or the tax shelter rules.
The first defined phrase, has tax avoidance as one of its significant purposes, is familiar from the earlier discussion of how the covered opinion rules apply differently to principal purpose and to significant purpose transactions. The second defined phrase, regarding a transaction a significant purpose [of which] is the avoidance of Federal income tax, is found in newly enacted anti-tax shelter provision, Section 6662A. If a transaction has a significant tax avoidance purpose under Section 6662A, the tax practitioner must determine whether certain extraordinary compliance and reporting rules apply. Insofar as the second defined phrase is employed as a defined term, the phrase should concern you only if you have clients who are very large and who have an appetite for aggressive tax planning.
The third phrase, significant Federal tax issue, describes the threshold under which tax advice can be given without having to worry about covered opinions. A significant Federal tax issue is a question concerning the Federal tax treatment of income, gain, etc. (or question concerning the value of property) with respect to which the IRS has a “reasonable basis for a successful challenge.” In addition, to qualify as a significant Federal tax issue, the resolution of the issue must have a significant impact, beneficial or adverse, on the overall Federal tax treatment of the transaction or matter in question.
The word “significant,” therefore, in this context means both something that’s important in terms of magnitude — that is, a lot of money versus a little bit of money — but also in terms of the IRS’ likely interest in the question. If the IRS has a “reasonable basis” for successfully challenging a position, then the IRS is likely to have an interest and therefore the issue is, in that sense, significant as well.
And why, pray tell, do you care? You care because when traveling in the dread land of Circular 230, the covered opinion rules do not apply if the tax advice does not concern a significant Federal tax issue. More precisely, if the IRS does not have a reasonable basis for a successful challenge, then the tax practitioner need not concern him or herself with the puzzle palace of covered opinions, substantial purpose and more likely than not formulations.
Covered Opinion Rules
The issuer of a covered opinion is on inquiry notice as to facts. That’s the first rule.
Rule number two is that it must consider all relevant facts. (What’s notable about rules one and two is that they apply to all written tax advice, whether pertaining to a principal purpose transaction, a significant purpose transaction or a transaction that slips under the substantial Federal tax issue threshold.)
Rule number three is that a covered opinion must consider all significant Federal tax issues.
Rule number four is that it must reach an opinion as to each such issue as well as to the overall transaction.
The last rule is that a covered opinion must either (i) reach a more likely than not conclusion, or (ii) contain a ‘no penalty protection’ disclaimer.
Clients won’t like rule number four, the requirement to consider all significant Federal tax issues, because it will cost them a lot of money. Accountants won’t like the last rule, because it forces them either to put themselves in the line of fire by reaching a more likely than not conclusion or, by disclaiming, give the appearance of putting their own interests before those of the client.
Limited Scope Opinions.
Advisors may provide a limited scope opinion, which is an opinion that considers less than all of the significant Federal tax issues, provided the advisor and the taxpayer agree that the opinion cannot be relied on for purposes of avoiding penalties other than with respect to issues addressed in the opinion. No limited scope opinions are allowed for listed transactions or principal purpose transactions. Marketed opinions can’t be limited scope opinions.
Written Advice Other than a Covered Opinion
Even if a written opinion is not a covered opinion, the practitioner must satisfy some of the same requirements applicable to covered opinions. The opinion may not be based on unreasonable factual or legal assumptions. The practitioner may not unreasonably rely on representations or findings of the taxpayer or any other person. Further, the practitioner must consider all relevant facts which are either known or which should be known. Finally, the practitioner may not, in the written advice, take into account the possibility of an audit, that an issue will be raised on audit or that an issue will be resolved through settlement if raised.
Tax advisors who are responsible for overseeing a firm’s tax practice “should take reasonable steps to insure that the firm’s procedures for all members, associates and employees are consistent with the best practices.” This means that the firm as a whole has a direct rather than a merely indirect stake in being able to claim that it took the Circular 230 best practices exhortations to heart. Here’s some advice which, more likely than not, you would feel stupid not following: make sure your firm has a written policy on Circular 230 compliance.
Compliance with Circular 230 bears on malpractice exposure as well. “Morality is that attitude we adopt towards people we dislike,” said our Victorian quipmeister. In a similar spirit, a malpractice claim is the attitude unhappy clients adopt towards tax advisors whose advice exposes them to accuracy-related penalties without fair warning. In other words, if your client is at risk for an accuracy-related penalty, make sure you say so, so the client rather than you or your malpractice carrier coughs up the cash to pay it.
Effect of Circular 230 on Estates and Trusts Planning Advice.
The substantial understatement penalty under Section 6662 does not apply to transfer taxes. Instead, the predominant sanctions for overly aggressive transfer tax positions are the negligence and the substantial valuation understatement penalties. A taxpayer need not have a more likely than not opinion in hand to avoid the negligence penalty. Rather, a position which the taxpayer had a reasonable cause for taking, as well as a position with respect to which there is a realistic possibility of success, is each by definition not subject to the negligence penalty.2 Legal opinions, moreover, are likely to be irrelevant to substantial valuation understatements. Since a covered opinion only provides penalty protection if the giver of the opinion provides a more likely than not assessment, the practice standards applicable to tax advisors is more stringent in this area than the standard of care imposed on taxpayers. Also note that the courts have concluded that tax avoidance motives are irrelevant for transfer tax purposes.3
The Importance of Being Zealous (continued)
Let’s return to Algernon’s meeting with Gwendolin and Cecily and consider whether Algernon has created problems for himself, and perhaps for his clients, under new Circular 230.
The first of the three issues discussed was whether the subdivided real estate was held for investment under Section 1031. The threshold Circular 230 question is does it involve a significant Federal tax issue? Recall that a Federal tax issue is significant if the IRS has a reasonable basis for challenging the taxpayer’s position, that is, a more than merely arguable shot. The ‘held for’ issue appears to meet that threshold. This is consistent with informal statements from Treasury officials that if the application of the law to the facts is problematic, the issue is a significant Federal tax issue.
We might also ask if the arrangement is “consistent with the statute and Congressional purpose.” If it is consistent, it’s not a principal purpose transaction. That’s a difficult call, since the analysis turns on bad facts rather than aggressive structuring. Perhaps we can back into concluding this is not a principal purpose transaction by virtue of Algernon’s belief that he has substantial authority for the position. Note that an arrangement can be consistent with the statute and Congressional purpose and yet still be a significant purpose transaction. The ‘consistent with the statute and Congressional purpose’ exception allows an escape from principal purpose status but not from significant purpose status.
If we are right so far, we have a possible covered opinion problem, because it’s a substantial Federal tax issue. We can deal with it, however, as a lower cost, lower risk substantial purpose matter. Does that mean a substantial purpose “reliance opinion?” If so, avoiding principal purpose status is not much of a consolation, as either way the clients bear the cost of a covered opinion. But Algernon can help his clients short of a covered opinion, reliance or otherwise. He can opine that there is substantial authority for this position and nothing more, and with that, Cecily and Gwendolin are likely to be protected from accuracy related penalties on that issue. Since it is not a more likely than not opinion, moreover, Algernon doesn’t have to worry about whether or not he should include penalty disclaimer language.
There is a temptation to take a better-safe-than-sorry approach and include the disclaimer language anyway. Algernon will weigh this temptation against the cost of conveying subliminally the message that he and his clients are not on the same side.
Regarding the second issue, Cecily’s plan to separately reinvest her share of the sales proceeds, we begin with the same inquiry, does it involve a significant Federal tax issue? Algernon’s idea, a presale redemption of Cecily’s interest in the owning entity, is almost certainly a structure that the IRS would have a reasonable basis for challenging, if only based on the step transaction doctrine. Consequently, it is surely a significant Federal tax issue, and we have to consider whether or not to issue a covered opinion.
Are we at least under the threshold for principal purpose transactions? Recall that a transaction which is consistent with the statute and Congressional purpose is not a principal purpose transaction. Is a partner redemption in anticipation of a 1031 exchange consistent with Section 1031 and Congressional purpose? Likely not. Are we then stuck with the principal purpose transaction, and all the attendant extra work and risk to the tax practitioner attendant upon that status?
Probably not. Consider that tax shelter regulations under Section 6111 provide that transactions which are consistent with “customary commercial practice” and with respect to which there is a “generally accepted understanding that the tax benefits are property allowable for substantially similar transactions” are not significant purpose transactions under the tax shelter rules. While Circular 230 does not explicitly incorporate definitions found in the tax shelter regulations, transactions which satisfy the “consistent with customary commercial practice” found in the tax shelter regulations are, it is fair to surmise, not high scrutiny transactions under Circular 230. Since the structure involving a redemption just prior to the sale of relinquished property has been widely discussed in tax publications, one could reasonably conclude that this transaction satisfies that standard and is therefore neither a significant purpose transaction under the tax shelter rules nor a principal purpose transaction under Circular 230.
On the other hand, Algernon may feel that using language in the tax shelter regulations to bootstrap the deal out of even the significant purpose requirements violates the too good to be true rule. He may also reason that, while there is a generally accepted understanding that the tax benefit of deferral is properly allowable under his proposed structure, there is no single, best customary commercial practice for achieving deferral, so he hasn’t even formulated a threshold case for relying on the language in the tax shelter regulations. Finally, he may wisely conclude that the definitions under the tax shelter regulations which predate new Circular 230 are not necessarily controlling under Circular 230.
Algernon will likely decide therefore either to treat it as a principal purpose transaction or to split the difference between principal purpose and the less-than-substantial-purpose status suggested by the tax shelter regulations and treat it as a substantial purpose transaction. If he treats as a principal purpose transaction, he can give Cecily and Gwendolin penalty protection, because, as the facts recite, he believes they will more likely than not prevail in the event of an IRS challenge. (You can give a covered opinion for a principal purpose transaction without coming to a more likely that not conclusion; however the opinion won’t protect your clients from imposition of penalties.)
His promise to confirm that conclusion with his clients in a “quick e-mail,” however, is a mistake. If he wants to opine about a principal purpose transaction, and intends, moreover, for that opinion to provide penalty protection, he needs to comply with the burdensome covered opinion requirements rather than conveying his conclusion in a quick e-mail. (Note here that his problem with a short e-mail response is noncompliance with Circular 230, while his clients’ problem is losing penalty protection.) The quickest, least expensive solution may be to skip the opinion altogether and just prepare an outline of the structure (with no discussion of the tax motive behind any of the steps) and do the documents. Neither the outline nor the documents constitute written advice for purposes of Circular 230.
As to Gwendolen sharing whatever writing Algernon produces with her colleague, that might void the accountant client privilege and it could possibly turn the writing into a marketed opinion. A marketed opinion is a high scrutiny category of written advice, and Algernon wants earnestly to avoid it. Algernon, therefore, has both malpractice and Circular 230 reasons for not consenting to Gwendolen forwarding the advice.
Regarding the third issue, the horse farm, an IRS agent capable of reading minds would know that Algernon did not believe that Cecily’s new spread was being purchased for the purpose of operating a business at a profit. Since Circular 230 requires Algernon to evaluate the reasonableness of client representations, he would appear to be in violation of Circular 230. Further, his unreasonable reliance is a violation whether or not his advice is in the form of a covered opinion, a non-reliance substantial purpose opinion, other written advice, or, indeed, even if it was conveyed verbally.
For purposes of this exercise, however, let’s not impart mind reading powers to the IRS. Let’s assume that Algernon reasonably relied on the facts presented by his client. Does this involve a significant Federal tax issue; that is, would the IRS have a reasonable basis for challenging the operated for profit status? As presented, the facts suggest some vulnerability to an audit adjustment, so let’s assume the answer is yes. Does it, on the other hand, qualify for the highly undesirable status of principal purpose transaction? If Cecily attempts to operate the horse farm at a profit, then the arrangement is consistent with the statute and Congressional purpose, and it is therefore not a principal purpose transaction. Restated, if operating a business is the principal reason for buying the farm, which it is, then operating the farm in a way that avoids application of the hobby loss rules can’t also be the principal purpose. It is, therefore, at worst, a significant purpose transaction.
How about the tax shelter language about customary commercial practice and a generally accepted understanding that the tax benefits would be allowable for substantially similar transactions? Can Cecily use that language to escape even significant purpose status? No. Given the volume of caselaw on this issue, the fact specific nature of the tax issue and Cecily’s announced desire to slow down, Algernon should fashion his tax advice relating to the horse breeding arrangement on the assumption that it is a significant purpose transaction.
What about Algernon’s consideration of the likelihood of an audit? If you think he’s okay as long as he doesn’t discuss the likelihood of an audit in a written opinion, you would be wrong. Circular 230 provides, even in the requirements for “other written advice,” that the practitioner may not, in evaluating a federal tax issue, take into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be resolved through settlement.
Does this mean that you can’t mention these things to your client? Surely not! It means that you can’t use those considerations in deciding whether you’ve reached a relevant opinion threshold, such as more likely than not or reasonable basis. Remember, however, that a verbal opinion is neither covered by Circular 230 nor of any use to the client in avoiding the imposition of a penalty.
Algernon has some other problems as well. Insofar as he concludes that one, but less than all of the transactions, plans and arrangements that he discussed in connection with the sale and reinvestment require a covered opinion, it is possible that all the transactions discussed are part of that transaction, plan or arrangement. In that case, the burdensome covered opinion rules would apply to all aspects of every part. A determined Office of Professional Responsibility could certainly make a good case for grouping the core like-kind exchange transaction with the structuring intended to allow Cecily and Gwendolyn to reinvest in different properties.
If that possibility concerned Algernon, he might elect to issue a limited scope opinion, which is allowed for significant purpose (but not principal purpose) transactions. He should also worry, however, about whether a non-reliance opinion on a significant purpose transaction can be issued side by side with a limited scope opinion. In other words, do you violate the limited scope opinion rules by delivering a limited scope opinion on one significant purpose transaction and non-covered opinion tax advice on a related transaction? (Probably not. Since each should be a significant purpose transaction, however, Algernon should just issue non-reliance opinions on both of them, thereby sidestepping the covered opinion rules entirely.)
Algernon has created another problem for himself by handing his clients a copy of his meeting notes. His meeting notes may constitute written advice, and all written advice has to be tested against the covered opinion rules of Circular 230. His defense would be that the covered opinion rules do not cover preliminary advice if the advisor “reasonably expects” to be asked to provide follow-up advice. The problem is that Algernon wasn’t planning to give Cecily any written tax advice on the hobby loss issue.
The fact that he did not plan to give written advice about the horse farm is a problem in its own right, because the same factors relevant to the hobby loss issue might have led Algernon to recommend that Cecily try to qualify the farm as like kind property under the original transaction. Algernon probably doesn’t deserve it, but he may have malpractice exposure if he misses this issue, an ethics problem if he doesn’t identify where the interests of his joint clients diverge and a compliance issue under Circular 230 if he issues a covered opinion on the like kind exchange without identifying it as a significant Federal tax issue. (I think the second and third items, especially the third, are stretches.)
Although Congress probably didn’t intend it, Algernon may also want to give some thought to the tax shelter rules. There is a large body of tax shelter regulations currently in effect which predate both new Circular 230 and stricter tax shelter rules ushered in with the 2004 American Jobs Protection Act. Overlapping and inconsistent terminology, manifest in the many uses of the word ‘substantial’ discussed above, leave this area of the law in an incoherent knot.
Last but, in dollar terms and regulatory burden, certainly not least, consider that the proposed like-kind exchange involves a book-tax difference of more than $10 million. If the clients satisfy certain other requirements (for example, either $250 million in gross book value assets or publicly traded stock), the like-kind exchange proposed by Cecily and Gwendolen may constitute a reportable transaction. Reportable transaction status under Treas. Reg §1.6011-4 triggers unpleasant additional reporting and record keeping obligations for both taxpayers and their tax advisors.
It’s a new day for tax practitioners. The interests of practitioners, never fully aligned with their clients, has been thrown further out of alignment by Circular 230. Taken together with recently enacted tax shelter reporting obligations, the language of new Circular 230 reflects a trend towards turning tax planners into gate keepers for the IRS, albeit uncomfortable ones. This is, of course, a departure from the ethos of zealous representation which is inculcated in school and reinforced by the typical professional culture.
As it happens, Oscar Wilde anticipated this trend: “It is perfectly monstrous,” complains Lord Illington in ‘A Woman of No Importance,’ “the way people go about nowadays, saying things about one behind one’s back that are absolutely, entirely true.”
1Treas. Reg. §301.6112-2.
2Treas. Reg. §1.6662-3(a). Note, however, that the reasonable cause defense routes the inquiry back, as a practical matter, to the matter of opinions of counsel.
3Christoffani v. Commissioner, 97 T.C. 74 (1991); Gulig v. Commissioner, 293 F. 3d 279 (2002) and Knight v. Commissioner, 115 T.C. 506 (2000)