stephanie simmons ray [email protected] 206-223-7401© 2008 lane powell pc written federal tax...

Stephanie Simmons Ray [email protected] 206-223-7401© 2008 Lane Powell PC

Written Federal Tax Advice – Regulation and Risks

___________Selected Topics

Oregon/Washington Tax InstituteMay 2, 2008

Neil D. Kimmelfield


Introduction


Topics● Section 6662 penalty protection● FIN 48● Circular 230● Disciplinary rules● Section 6694 preparer penalties● Malpractice risk● Tax shelter promoter penalties● Criminal penalties for false statements● Confidentiality of tax advice● Comfort levels


What Can Happen to You if You Mess Up?

● Sanction by the IRS?● Tax penalties?● Malpractice claim by client?● Discipline by the bar?● Securities law exposure?● Criminal penalties?


What Can Happen to Your Client if You Mess Up?

● Unexpected taxes plus interest● Tax penalties● Losses from a dumb investment


What Is “Messing Up?”

● Giving a wrong answer● Giving a really wrong answer● Warning the client, but not warning

enough● Insufficient due diligence● Lying about the tax consequences● Giving too weak an opinion


What Is the Setting for Your Advice?

● Planning a transaction – hypothetical tax advice

● Evaluating a prospective transaction – assumed facts

● Return preparation advice (ordinary)● Return preparation advice (tax shelter)● Assisting with a marketed transaction● Assisting with FIN 48 computations


Common Terms● More likely than not (MLTN)● Substantial authority● Reasonable basis● Reasonable belief● Reasonable cause● Comfort level● Penalty protection● Significant tax-avoidance purpose


Penalty Protection Advice


Protecting Client From Accuracy-Related Penalties

● The Code sections 6662 (substantial understatement) 6662A (reportable transactions) 6664 (reasonable cause)


Protecting Client From Accuracy-Related Penalties (cont’d)

● Section 6662 basics Penalty based on amount of

understatement Supporting authority for a losing position

can reduce the penalty Penalty is reduced by the tax attributable to

a position with adequate support (a “Supportable Position”)



● Non-tax shelter Supportable Positions Objectively, there is SUBSTANTIAL AUTHORITY

OR Objectively, there is a REASONABLE BASIS, and

the facts are disclosed on the return

OR Objectively, the position is just a loser, BUT:

The taxpayer acted in GOOD FAITH with REASONABLE CAUSE



● Tax shelter Supportable Positions Objective substantial authority doesn’t

help Objective reasonable basis doesn’t help,

even with disclosure

HOWEVER The penalty may be avoided to the extent

the taxpayer acted in GOOD FAITH with REASONABLE CAUSE



● What is a “tax shelter?” Any “entity” or “arrangement” if a

“significant purpose” of the plan or arrangement is the avoidance of Federal income tax

“Significant purpose” is not defined anywhere. (See outline page 14.)



● How can written advice provide “reasonable cause?” Reg. § 1.6664-4(b)(1): “Reliance on . . .

professional advice . . . constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.”



● Reasonable Cause: Minimum standards for advice (Reg. § 1.6664-4(c))

Must be based on all pertinent facts and circumstances and related law

May not be based on unreasonable factual or legal assumptions

May not unreasonably rely on representations



● Reasonable Cause: What advice does the taxpayer need?

Reg. § 1.6664-4(c)(2): Advice includes an opinion “on which the taxpayer relies . . . with respect to the imposition of the Code section 6662 accuracy-related penalty.”



● Reasonable Cause: What advice does the taxpayer need?

Does a “Substantial Authority” (or “Reasonable Basis”) opinion provide “reasonable cause?”

Does a stronger opinion put the taxpayer in a better position?



● Reasonable Cause for “tax shelter” items Section 6664 regulations require belief in

“MLTN” sustainability for corporate tax shelter items. See Reg. § 1.6664-4(f).

Section 6662 regulations require belief in “MLTN” sustainability for non-corporate tax shelter items. See Reg. § 1.6662-4(g).

Are these regulations obsolete?



● Reasonable Cause and Circular 230 disclaimers Typical disclaimer language: This advice “was not

written to be used and cannot be used for the purpose of avoiding penalties.”

12/17/04 Circular 230 Preamble: Section 6664 regulations will be amended to prohibit reliance on advice with disclaimer.

Is it “reasonable” to rely on advice with the disclaimer?



● Reasonable Cause for “Reportable Transactions” See section 6662A Special rule in section 6664(d)

Taxpayer must “reasonably believe” return treatment is MLTN proper

Reasonable belief cannot be based on opinion from “material advisor”

Reasonable belief cannot be based on opinion that does not satisfy due-diligence standards



● Practical points: Is a “tax shelter” involved?

If so, taxpayer must have MLTN reasonable belief – probably based on your advice

Is your client relying on your analysis or your advice?

If relying on advice, must satisfy due-diligence standards

Watch out for Circular 230 disclaimers Consider “substantial authority” opinion

without disclaimer


FIN 48 Advice


FIN 48 Advice

● Basic FIN 48 rules To report the benefit of a tax position on a

company’s financial statement, the company must determine that it is MLTN that the position will be sustained, based on the technical merits of the position, if the taxing authority examines the position.

The benefit to be recorded is the largest amount that is MLTN to be realized, taking into account the possibility of compromise.


FIN 48 Advice (cont’d)

● Functions of written advice An unsophisticated company may need

help making MLTN judgment about the merits of a position

Even a sophisticated company may have to demonstrate MLTN determination to auditors

Any company may need help predicting settlement scenarios


FIN 48 Advice (cont’d)

● Contents of FIN 48 opinion Not necessarily a Circular 230 “covered

opinion” (Reg. § 10.35(b)(2)(ii)(C)) Use “disclaimer” language if return has not yet

been filed

Find out what the auditors will need Consider “roadmap” issues


Circular 230


Circular 230

● Sanctions Applied only to violations committed “recklessly

or through gross incompetence” Censure, suspension, or disbarment from practice

before the IRS (Reg. § 10.50(a)) Monetary penalty, not exceeding “the gross

income derived (or to be derived) from the conduct giving rise to the penalty” (Reg. § 10.50(c))


Circular 230 (cont’d)

● What is “written advice” Letters and memos Includes “electronic communications”

E-mails Intranet postings? Bulletin board postings? Voice mail?



● Standards for all written advice (Reg. § 10.37(a)) No unreasonable factual or legal assumptions No unreasonable reliance on representations Must consider all relevant facts the advisor

“knows or should know” May not take audit risk into account



● “Covered opinions” are subject to additional rules

● What is a “covered opinion?” Opinions on “listed transactions” Opinions on “principal purpose” transactions Certain opinions on “significant purpose”

transactions



● When do opinions on “significant purpose” transactions become “covered opinions?” Reliance opinions Marketed opinions Confidential opinions Money-back opinions


Circular 230 (cont’d)● What is a “reliance” opinion?

Concludes it is MLTN that at least one “significant Federal tax issue” will be resolved in taxpayer’s favor

● “Reliance opinion” status can be avoided with disclaimer language “This opinion was not intended to be used,

and it cannot be used, to avoid penalties that may be imposed on the taxpayer.”


Circular 230 (cont’d)● What is a “marketed” opinion?

Practitioner has reason to know the opinion will be used in “promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayer(s).”

● “Marketed opinion” status can be avoided with adequate disclosures Opinion cannot be relied on for penalty avoidance Opinion was written to support promotion of the

arrangement Taxpayer should get independent tax advice


Circular 230 (cont’d)● When can a “limited scope” opinion

avoid being a “covered opinion?” Can’t relate to a “listed” transaction Can’t relate to a “principal purpose”

transaction Can’t be a “marketed” opinion Must contain required disclosures (see

next slide) Taxpayer must agree that its ability to rely

is limited


Circular 230 (cont’d)● Required disclosures for “limited

scope” opinions (Reg. § 10.35(e)(3)) The scope of the opinion is limited There are issues that could affect the

overall Federal tax treatment that are not addressed

The opinion can’t be used to avoid penalties with respect to issues outside the scope of the opinion


Circular 230 (cont’d)● Requirements for “covered opinions”

(Reg. 10.35(c)) Must identify all factual assumptions in a

separate section Must identify all factual representations in

a separate section



(cont’d) Must consider all “significant federal tax

issues” and must evaluate likelihood of prevailing on each

Must provide “overall conclusion as to the likelihood that the Federal tax treatment of the transaction or matter that is the subject of the opinion is the proper treatment”



(cont’d) If a marketed opinion, must say so and

must recommend getting independent tax advice

Must disclose any compensation arrangement between the advisor and a person other than the client


ABA Guidance on Tax Opinions


Disciplinary Rules – ABA Opinions

● Both Oregon and Washington have adopted Rules of Professional Conduct based on the ABA Model Rules

● Neither State has issued guidance regarding tax opinions

● ABA Opinions could be given weight by the courts


Disciplinary Rules – ABA Opinions (cont’d)

● ABA Opinion 314 (1965) Attorney is advocate for taxpayer; no duty to

disclose weakness to IRS

● ABA Opinion 85-352 (1985) Attorney may advise taking a position only if there

is a “realistic possibility of success” in litigation No definition of this standard No due-diligence requirement


Disciplinary Rules – ABA Opinions (cont’d)

● ABA Opinion 346 (1982) Addresses only marketed tax shelter

opinions Provides due diligence, good faith, and full-

disclosure guidelines similar to those in Circular 230 for covered opinions


Section 6694(a) – Return Preparer Penalty


Section 6694(a) Return Preparer Penalty

● Overview An advisor can be treated as a return preparer A return preparer may be subject to penalty if the

return has an understatement due to an “unreasonable position”

If a position is undisclosed, it must pass a MLTN test to avoid the penalty

The penalty can be as much as 50% of the preparer’s fee

IRS gave temporary relief from the MLTN standard in Notice 2008-13

Congress may fix this


Section 6694(a) Return Preparer Penalty (cont’d)

● When is an advisor a preparer? When giving advice that is “directly

relevant” to a determination relating to an entry on a return

IF

The entry is considered to be a “substantial portion” of the return



● When is advice “directly relevant” to a return item? Pre-transaction planning does not count Advice regarding GAAP tax reserves does

not count Other advice may be considered “directly

relevant” to a return item



● When is a return entry a “substantial portion” of the return? Reg. § 301.7701-15(b)(1): Determined by

“comparing the length and complexity of, and the tax liability or refund involved in, that [entry] to the length and complexity of, and tax liability or refund involved in, the return or claim for refund as a whole.”

How does advisor know whether this applies???



● When is a return entry a “substantial portion” of the return? (cont’d) Notice 2008-13: An entry that “could result in a

deficiency determination (or disallowance of refund claim) that the preparer knows or reasonably should know is a significant portion of the tax liability reported on the tax return . . . .”

Not much comfort if little or no tax is reported!



● Avoiding the penalty [Assume there is an erroneous position

resulting in an understatement] Was the position disclosed? If it was, no penalty if there was a

“reasonable basis” for the position If it was not, you must have had

“reasonable belief” it would MLTN be sustained



● What is “disclosure” under sec. 6694? Under the Code: “Relevant facts affecting

the item's tax treatment are adequately disclosed in the return or in a statement attached to the return.”

Problem: The taxpayer won’t want to do this if there is substantial authority



● “Disclosure” under Notice 2008-13 Advice to taxpayer: “the advice … includes a

statement informing the taxpayer of any opportunity to avoid penalties under section 6662 that could apply to the position as a result of disclosure, if relevant, and of the requirements for disclosure.”

Advice to return preparer: “the advice to the tax return preparer includes a statement that disclosure under section 6694(a) may be required.”

This is easy! Do it!



● No disclosure: Must apply the MLTN test Preparer must have a “reasonable

belief” the position would MLTN be sustained on its merits

Must have MLTN belief Belief must be reasonable



● Requirements for MLTN belief Must be based on analysis of pertinent facts and

authorities (like “substantial authority” analysis) Must conclude MLTN to be sustained “if

challenged by the IRS” May rely on information provided by taxpayer May not rely on information that “appears to be

incorrect or incomplete” May “rely in good faith and without verification

upon information furnished by another advisor”



● Bottom line for advisors Know when you are a “return preparer” Take advantage of the Notice 2008-13

disclosure safe harbors



● Possible amendment by Congress (Rangel bill – H.R. 5719) Most positions would be subject to

“substantial authority” standard Disclosed positions: “Reasonable basis”

standard Tax shelters: Reasonable belief/MLTN

standard


Malpractice Risk


Malpractice Risk

● Can you be held liable for giving bad tax advice?

● Yes!


Malpractice Risk (cont’d)

● To whom do you owe a duty? Your client Third parties you had reason to know

would rely on the advice

● Make sure you opinion specifies who may rely on it



● Possible damages Losses must be caused by the negligent

advice Causation is not always clear



● Possible damages (cont’d) Unexpected tax liability

Would it have been incurred anyway?

Deficiency interest Did taxpayer benefit from deferred payment of

tax?



● Possible damages (cont’d) Penalties

Would taxpayer have taken the position without the opinion?

Transaction/investment losses Would taxpayer have done the deal anyway?



● Standard of care Specialists are held to standard of care

appropriate for attorneys practicing in the specialty

There is a higher standard of care for tax specialists

There may be an even higher standard for sub-specialties



● Malpractice avoidance Specify who may rely on your advice Don’t give an opinion in an area you don’t

know Don’t oversell your expertise If you’re a tax generalist giving very

technical advice, suggest to your client that you consult a specialist

Don’t give a stronger opinion than necessary


Section 6700 – Tax Shelter Promoter Penalty


Tax Shelter Promoter Penalties● Federal penalty – Code section 6700

Elements Assists in organizing, or assists in selling, an

entity, plan, or arrangement

AND Knowingly makes a false statement about a

material matter About a tax benefit in connection with the

entity, plan, or arrangement


Tax Shelter Promoter Penalties● Federal penalty – Code section 6700

Penalty = 50% of gross income to be derived from the activity

This penalty has been imposed on attorneys actively involved in promotion

Query: How much involvement in promotion is necessary?


Tax Shelter Promoter Penalties (cont’d)

● Oregon penalty – ORS 314.406 (2007) Penalty applies if Code section 6700

applies Applies only to “a person who promotes a

tax shelter” with Oregon contacts Penalty is 100% of the gross income

derived in promoting the shelter Query: Is “promoting” narrower than the

scope of section 6700?


Section 7206(2) – Criminal Liability For False Statements


Criminal Penalty for False Statements – Section 7206(2)

● “Any person who . . . [w]illfully aids or assists in . . . or advises the preparation . . . under. . . the internal revenue laws, of [any] document, which is fraudulent or is false as to any material matter . . . shall be guilty of a felony . . . .”

● Penalty: Up to a $100,000 fine and 3 years’ imprisonment


Criminal Penalty for False Statements – Section 7206(2) (cont’d)

● What may cause a tax opinion to be criminally false? A false conclusion due to reliance on

material facts known to be untrue

OR A false conclusion due to legal analysis

known to be incorrect (?)


Criminal Penalty for False Statements – Section 7206(2) (cont’d)

● Justice Department letter to court in KPMG case: “[W]hile the opinions state that certain tax treatments of certain facts (falsely) described in the opinion letter are more likely than not to survive IRS challenge, the Government alleges that conspirators did not, in truth, believe that to be so.”


Confidentiality of Tax Opinions


Confidentiality of Tax Advice● Concern

You need to disclose risks to your client Circular 230 may require you to discuss adverse

authority Section 6664 “reasonable cause” opinions must

consider “contrary” authorities Client’s auditors may insist on full analysis in FIN

48 opinionsBUT…..

You don’t want to give the IRS a “roadmap”


Confidentiality of Tax Advice (cont’d)

● IRS summons authority Code section 7602: “For the purpose of . . .

determining the liability of any person for any internal revenue tax . . . the Secretary is authorized – (1) To examine any books, papers, records, or other data which may be relevant or material to such inquiry ….”



● IRS summons authority (cont’d) United States v. Arthur Young & Co., 465

U.S. 805 (1984): “The language ‘may be’ reflects Congress' express intention to allow the IRS to obtain items of even potential relevance to an ongoing investigation, without reference to its admissibility.”



● IRS policy of restraint for “tax accrual workpapers” (TAWs”) TAWs are defined as: “audit workpapers, whether

prepared by the taxpayer, the taxpayer's accountant, or the independent auditor, that relate to the tax reserve for current, deferred and potential or contingent tax liabilities . . . .”

IRM 4.10.20.3.1(1): “Audit or tax accrual workpapers should be requested with discretion and not as a matter of standard examining procedure.”



● IRS policy of restraint for “tax accrual workpapers” Under IRM 4.10.20.3.1(2)a., IRS will not request tax

accrual workpapers unless: “A specific issue has been identified by the examiner for which there exists a need for additional facts.”

I.e., workpapers should not be sought in a fishing expedition



● Legal opinions Should be subject to IRS summons

authority unless privileged “Policy of restraint” should apply to FIN 48

opinions



● Protections for legal opinions Attorney-client privilege Work-product doctrine



● Elements of attorney-client privilege Communication made in confidence To an attorney In connection with legal services In an attorney-client relationship

● Attorney communications that contain client information are covered



● Required expectation of confidentiality An opinion is not protected by the attorney-client

privilege if it is intended to be disclosed to a third party.

Thus, a penalty-protection opinion may not be privileged.

See Long-Term Capital Holdings, et al. v. United States, 90 AFTR2d 2002-7446 (D. Conn. 2002).



● Waiver of privilege through disclosure A privileged opinion may lose protection if

it is actually disclosed to third parties, such as the taxpayer’s auditors.

See United States v. Textron, Inc., 507 F. Supp 2d 138 (D. R.I. 2007).



● Work-product doctrine FRCP Rule 26(b)(3) limits the discovery of

documents “prepared in anticipation of litigation or for trial.”

May be obtained only by showing “substantial need.”

Special protection given to “mental conclusions, opinions, or legal theories of an attorney”



● Work-product doctrine (cont’d) Disclosure to third parties does not

automatically waive work-product protection

Key is maintaining confidentiality from litigation adversaries



● Application of protections to legal opinions Transaction-planning opinions: Generally should

be protected by attorney-client privilege Tax-return assistance opinions:

May be protected by attorney-client privilege if the client prepares its return “in house”

Little chance of protection if the client is expected to provide the opinion to an outside return preparer



● Application of protections to legal opinions (cont’d) Section 6662 penalty-protection opinions: Little

chance of attorney-client privilege protection; difficult to show expectation of confidentiality

FIN 48 opinions: Good chance of attorney-client privilege protection if

client does not disclose opinion to outside auditors No attorney-client privilege protection if opinion is

disclosed to auditors Possible work-product protection even if opinion is

disclosed to auditors, if client can demonstrate that opinion would not have been obtained but for the client’s anticipation of litigation – see Textron decision


“Comfort Levels”


Comfort Levels

● Crude hierarchy Will Should MLTN Substantial authority Reasonable basis


Comfort Levels (cont’d)

● MLTN formulations in the law MLTN the proper treatment (section 6664(d)

(2)) Under Regs, MLTN that treatment “will be

upheld if challenged by the Internal Revenue Service.”

MLTN that the position would be sustained on its merits (section 6694)



● MLTN formulations in the law (cont’d) MLTN that an issue would be resolved in

the taxpayer’s favor (Reg. § 10.35(b)(4)) MLTN that the tax treatment will be upheld

if the IRS challenges it (Prop. Reg. § 10.34(e)(1))

MLTN that the position will be sustained if the taxing authority examines the position (FIN 48)

I think this is the clearest and best.



● Examples of various formulations Will be deductible Will be allowed as a deduction Will be allowed if examined in a well-reasoned

decision Will be “x” and should be so treated

● Query: Does “MLTN is examined in a well-reasoned decision” give penalty protection?



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