The Ethics of Tax Opinions: Do They Really Help? 61 st Tulane Tax Institute October 31, 2012 William P. Bowers, Partner Fulbright & Jaworski L.L.P.

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1 The Ethics of Tax Opinions: Do They Really Help? 61 st Tulane Tax Institute October 31, 2012 William P. Bowers, Partner Fulbright & Jaworski L.L.P.

2 Standards of Care For Tax Opinions Regarding Federal Income Taxes Standard of care required of a return preparer under Section 6694 of the Code Standard of care required of the professional under Circular 230 Standard of care under applicable federal and state ethical and disciplinary rules Standards of care required of taxpayer for penalty protection under Section 6664(c) Standard of care imposed on the professional to avoid malpractice claims 2

3 What Is A Tax Opinion Advice from a lawyer or accountant to a taxpayer regarding the treatment of a tax item that will be reported on the taxpayer s tax return. Normally, the opinion expresses the professional s judgment regarding the likelihood of the position being sustained if challenged by the IRS. Opinions may be communicated in several forms: Formal written opinion Informal memorandum or containing advice Oral advice 3

4 Three Case Studies For Tax Opinion (None Are Tax Shelters) Oral advice provided prior to closing of transaction Written advice with Circular 230 legend delivered in an prior to closing of transaction Formal written opinion required as a closing condition of transaction 4

5 Section 6662 Accuracy Related Penalty ( ARP ) Section 6662 (b)(1) negligence or disregard for rules Section 6662 (d)(1) substantial understatement 1. Exception to ARP a. Reasonable basis with disclosure on tax return (Section 6662(d)(2)(B)(ii)) b. Substantial authority (Section 6662(d)(2)(B)(i)) 2. Special rules for tax shelters and corporations a. Tax shelters (Section 6662(d)(2)(C)) b. Multiparty financing transaction for corporate taxpayer that fails to clearly reflect income (Section 6662(d)(2)(B)) 5

6 Section 6694 Return Preparer Penalties Signing tax return preparer ( STRP ) (Treas. Reg. Sec (b)(1)) Non-signing tax return preparer ( NSTRP ) (Treas. Reg. Sec (b)(2)) Penalty for unreasonable position; position unreasonable unless: (Treas. Reg. Sec (a)(1)(ii)) 1. Substantial authority 2. Reasonable basis with disclosure 3. Tax shelters (Notice ): substantial authority and speech regarding penalty Documenting advice (Treas. Reg. Sec (d)(3)(iii)) Due diligence (Treas. Reg. Sec (e)) Exception: if reasonable cause for understatement and act in good faith (Section 6694(a)(3)) 6

7 Three Case Studies and Section 6694 Oral advice prior to transaction: Not a NSTRP 1. Advice post transaction may change answer 2. Example of post transaction advice 3. Safer to assume NSTRP; substantial authority or reasonable basis and disclosure advice prior to transaction: Not a NSTRP 1. Advice post transaction may change answer 2. Example of post transaction advice 3. Safer to assume NSTRP; substantial authority or reasonable basis and disclosure Formal written opinion: Not a NSTRP 1. Advice post transaction may change answer 2. Example of post transaction advice 3. Safer to assume NSTRP; substantial authority or reasonable basis and disclosure Formal written opinion presents less risk to NSTRP 7

8 Circular 230 Who is subject (Section 10.2(a)(4)) Due diligence (Section 10.22) Best practices (Section 10.33) Advice on potential penalties for taxpayer (Section 10.34)(see change in Section in 2011 Regulations conforming penalty disclosure and ARP) Covered opinions for significant purpose transaction (Section 10.35) 1. Reliance opinion with confidence level of MLTN (Section 10.35(b)(4)) 2. Marketed opinion (Section 10.35(b)(5)) 3. Recite all facts, representations and assumptions/no unreasonable representations or assumptions (Section 10.35(c)(1)) Exceptions for: 1. No reasonable basis for successful challenge 2. Opinions filed with SEC 3. Circular 230 legend, no reliance for penalty protection Reliance opinion at MLTN is not standard for ARP 8

9 Other written advice (Section 10.37) Circular 230 (cont d) Proposed changes to covered opinion (NPRM REG ) 1. Remove covered opinion in Section One standard for all written advice under Section Eliminate need for Circular 230 legend 4. Is there more to the proposed changes than eliminating covered opinions and ubiquitous Circular 230 legend? a. Expand Section b. Broaden scope of procedures to ensure compliance under Section for those overseeing a firm s tax practice c. Proposed [Section] 10.37, unlike current [Section] 10.35, does not require that the practitioner describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, and the practitioner s conclusion with respect to the law and the facts. Rather, the scope of the engagement and the type and specificity of the advice sought by the client,.are factors in determining the extent that the relevant facts, application of the law to those facts, and the practitioner s conclusions with respect to the law and the facts must be set forth in the written advice. Preamble of NPRM REG

10 Three Case Studies and Circular 230 Oral advice subject to Section penalty disclosure advice: 1. Circular 230 legend exception to covered opinion 2. Subject to Section penalty disclosure 3. Subject to Section written advice Formal written opinion subject to covered opinion Section Formal written opinion subject to Proposed Regulation Section

11 ABA Formal Opinion For Lawyers May advise reporting position if good faith belief position is warranted and realistic possibility of success on merits, even if no substantial authority or disclosure But must advise on all potential penalties 1. Is there substantial authority? 2. Need for disclosure in absence of substantial authority 11

12 Three Case Studies and ABA Formal Opinion Lawyer subject to Formal Opinion in all three cases 12

13 Taxpayer Reliance On Advice For Penalty Protection Under Section 6664(c) Taxpayer had reasonable cause for position and acted in good faith Most important fact is effort of taxpayer to assess taxpayer s tax liability Education of taxpayer a factor; Professional s advice may establish good faith and reasonable cause but does not necessarily get taxpayer off the hook; advice cannot be too good to be true 1. Taxpayer disclose all facts relevant 2. No unreasonable assumptions or representations 3. No particular form required 4. Professional advised of Section 6694 and Circular 230 standards of care 13

14 Taxpayer Reliance On Advice For Penalty Protection Under Section 6664(c) (cont d) Cases have added factors for promoted/marketed tax shelters 1. Canal 1 : PWC delivered should level opinion in leveraged partnership transaction a. PWC not independent: flat fee contingent on closing; participated in structuring transaction b. Draft opinion only c. Draft opinion littered with typos d. Faulty logic e. Reliance on unreasonable assumptions/representations f. Court s analysis focused on PWC rather than the taxpayer (compare Gerdau MacSteel and Southgate) 2. Long Term Capital Holdings 2 : King & Spalding delivered opinion in tax advantaged transaction a. Oral opinion delivered prior to filing of tax return but written opinion delivered after filing of tax return b. Taxpayer failed to read cases relied on in the opinion c. Opinion failed to provide legal analysis but rather relied on quotes from cases d. Opinion relied on unreasonable representation that transaction entered into for a business purpose with expectation of material pre-tax profit/no support for those representations 14

15 Taxpayer Reliance On Advice For Penalty Protection Under Section 6664(c) (cont d) 3. Gerdau MacSteel 3 : D & T delivered opinion in tax shelter transaction a. Only draft opinion issued prior to filing of tax return b. D & T not independent: flat fee contingent on closing, otherwise hourly rate; participated in structuring transaction and promoted transaction c. Opinion relied on unreasonable representation regarding business purpose d. Taxpayer s in house tax department failed to review opinion or make an independent assessment of the transaction 4. Southgate 4 : Opinions of lawyer and accountant in tax advantaged transaction but not a tax shelter transaction a. Neither professional had conflict of interest b. Neither professional had any on-going relationship with client c. Lawyer participated in structuring the transaction d. No representations or assumptions that the taxpayer knew or should have known were incorrect e. Expert testified opinions met standards for covered opinions 15

16 Three Case Studies and Section 6664(c) Oral advice theoretically could count as advice on which taxpayer could rely for reasonable cause and good faith exception; advice does not have to take any particular form Treas. Reg. Sec (c)(2); but problem of proof (e.g., Long Term Capital Holding) theoretically could count as advice on which taxpayer could rely but for the Circular 230 legend. Will Circular 230 legend negate good faith reliance of taxpayer? Under Proposed Regulations need for legend eliminated. Will written advice change if Proposed Regulations adopted? 16

17 Three Case Studies and Section 6664(c) (cont d) Covered opinion should count as advice on which the general and limited partner may rely but tax shelter cases raise questions: a. Tax Court might conclude professional had impermissible conflict of interest because the professional participated in structuring the transaction on which the opinion was rendered; fee conditioned other than on hourly rate; no long-standing relationship with limited partner b. In any event, make sure final opinion delivered as closing condition c. Make sure the recipients treat the opinion with appropriate care, including having the professionals vet the opinion with the recipient, including a review of analyses, representations and assumptions d. Provide all supporting materials on which the opinion is based; this given case law, together with Code and Regulations and Rules on which the opinion is based e. Taxpayer should be an active participant in the opinion process 17

18 Malpractice Claims Claim may be either tort of negligence or breach of contract; Bernard Wolfman et. al., Standards of Tax Practice Section (5th ed. 1999) Standard of care generally same under either theory: what a reasonably careful lawyer practicing in same or similar locality would do or not do, (i.e., customary practices ); Sections 51 and 52 of the Restatement of Torts There is a presumption that if the professional complies with Circular 230 and the applicable ethical rules the professional will have met the customary practice standard; Lipton v. Boesky 5 ; Martinson Bros. v. Hjellum 6 Professional is not liable for mere error in judgment ; J. Todres, Malpractice And The Tax Practitioner: An Analysis Of The Areas In Which Malpractice Occurs, 48 Emory L.J. 547 (1999) Advice is not a guaranty of result but advisor in rendering advice on unsettled issues has a duty to advise the client so that the client may understand and assess the risk and where alternatives are available, that is, advise the client in a manner that permits the client to make an educated decision. Id. at

19 Three Case Studies and Malpractice Claims Oral advice could be the subject of a malpractice claim; but more likely the source of client discontent; problem of proof for both the professional and the client; a. Did professional comply with return preparer duty under Section 6694 and Section of Circular 230; b. Professional should document the file with a memorandum explaining the scope of the engagement and the advice rendered; c. Certain transactions/advice should not be left to oral advice; it s asking for trouble; client may have difficulty relying on advice for reasonable cause and good faith exception under Section 6664(c); d. Was advice mere error in judgment? advice could be the subject of a malpractice claim; same caveats as above; 19

20 Three Case Studies and Malpractice Claim (cont d) Written opinion could be the subject of malpractice claim a. Professional is not liable for mere error in judgment; professional is not guarantor of results; MLTN opinion reflects risks; IRS may win in a challenge; b. Did opinion satisfy covered opinion requirements of Section of Circular 230? c. Be particularly careful with representations and assumptions; simply assuming business purpose and profit motive is not enough; d. Was Limited Partner advised that professional may be viewed as having a conflict of interest that would preclude Limited Partner from relying on the opinion for reasonable cause and good faith exception to Section 6664(c)? 20

21 Footnotes: 1. Canal Corporation, 135 TC 199 (2010) 2. Long-Term Capital Holdings, 94 AFTR 2d (DC Conn, 2003) aff d 96 AFTR 2d (CA-2, 2005) 3. Gerdau MacSteel Inc., 139 TC No. 5 (2012) 4. SouthGate, 104 AFTR 2d (DC ND Tex 2009), aff d 108 AFTR 2d (CA-5, 2011) 5. Lipton v Boesky, 110 Mich. App. 589, 313 N.W. 2nd 163 (1961) 6. Martinson Bros. v. Hjellum, 395 N.W. 2nd, 865, 872 (N.D. 1985) 21