Electronic copy available at: http://ssrn.com/abstract=2370183

CHAPMAN UNIVERSITY SCHOOL

OF LAW

LEGAL STUDIES RESEARCH PAPER SERIES

PAPER NO. 13-16

CAN THE IRS EFFECTIVELY REGULATE TAX PLANNING

ADVICE?

Michael B. Lang

This paper can be downloaded without charge at: The Social Science

Research Network Electronic Paper Collection:

http://ssrn.com/abstract=2370183

Electronic copy available at: http://ssrn.com/abstract=2370183

Can the IRS Effectively Regulate Tax Planning Advice?1

Michael B. Lang

Tax practitioners provide advice to clients with regard to the planning and

implementation of transactions or execution of documents (as, for example, in estate planning),

the preparation and filing of returns, the representation of clients before the IRS or in judicial

proceedings, and the preparation of required financial statements subject to requirements such as

those under FIN 48.2 In many of these roles the advice provided will at least come to the

attention of, or result in something that is viewed by, a third party in addition to the client, such

as a judge, IRS employee or investor. This provides some external check, whether intended or

not, on the quality of the advice. This is less true of advice about entries on (or the preparation

of) returns, for which the audit rate is low to say the least, and pre-transaction tax planning

advice,3

1 © Michael B. Lang, Professor of Law, Chapman University Dale E. Fowler School of Law. The author appreciates comments received on earlier versions of this article from Michael Desmond, Linda Galler, participants in the University of Washington Law School’s Symposium on Duties to the Tax System, and members of the Bloomberg BNA Tax Management Income Tax Advisory Board. The author also thanks Christina Wang for her research assistance.

which will rarely see the light of day unless the tax consequences of the transaction

involved are disputed by the IRS.

2 Not all tax practitioners may provide all categories of tax advice. Tax lawyers may provide advice in all of these categories, while return preparers (whether ultimately subject to the regulatory jurisdiction of the IRS Office of Professional Responsibility or not), are severely limited in the tax advice they can provide. CPAs may give tax advice more generally by virtue of 5 U.S.C. § 500(c), but may not generally represent taxpayers in judicial proceedings (except in the United States Tax Court, if admitted by examination). Enrolled agents, actuaries, appraisers and retirement plan agents are all limited in providing tax advice to the authority granted them by the IRS under the provisions of Circular 230. 3 This article focuses on planning advice provided before a transaction is implemented. Post-transaction tax advice about the how the transaction is to be reported on a return will usually be subject to the return preparer accuracy standards. When tax planning advice is referred to, the reference is generally to pre-transaction tax planning advice even if not so specified.

Electronic copy available at: http://ssrn.com/abstract=2370183

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Although the IRS rarely audits filed tax returns4 and perhaps even less frequently has a

chance to learn of tax planning advice, the Service nonetheless has a significant stake in the

accuracy of both return preparation advice and tax planning advice. The difficulty of monitoring

the quality of such advice, however, has plagued the tax system for many years. The net result

of this history is a fairly straightforward structure for penalizing purveyors of substandard return

preparation advice, complete with definitions of what constitutes an “unreasonable position” on a

return, juxtaposed against a history of costly, unsatisfactory efforts to address the quality of tax

planning advice. The latest proposals to amend Circular 230 would in fact abandon the only

current qualitative accuracy standard applicable to pre-transaction tax planning advice.5 This is

perhaps no surprise. A review of all reported disciplinary actions reported on the IRS Office of

Professional Responsibility (OPR) website turned up no successful disciplinary action based on a

practitioner’s substandard tax planning advice,6

4 For each of fiscal years 2009, 2010 and 2011, the average audit rate for individual federal income tax returns was a little over 1 percent, although the rate was much higher for those with adjusted gross incomes of more than $200,000. See http://www.taxdebthelp.com/tax-problems/tax-audit/irs-audit-statistics.

and OPR Director Karen Hawkins has

publically stated many times that OPR has not used the covered opinion rules of current Circular

5 Current Circular 230 § 10.35 requires advice on so-called covered opinions (referring to opinions on various categories of tax-motivated transactions) to be provided at a “more likely than not” level of confidence for the practitioner to indicate to the taxpayer that the advice meets the standards of Circular 230. This standard is at odds with the standards applicable to many return positions under IRC §§ 6662 and 6694 and Circular 230 § 10.34. Proposed § 10.35 would require such advice to be “competent,” but neither this standard nor § 10.37 would include an accuracy standard. 6 On the contrary, in the one reported case of any significance, the administrative law judge dismissed a complaint charging one of the lawyers responsible for opinions related to the infamous Long-Term Capital Holdings tax shelter transaction with failing to exercise due diligence in connection with the opinions. See Director, Office of Professional Responsibility v. John M. Sykes, III, Complaint No. 2006-1 (Jan. 29, 2009). It is not even clear that OPR had the authority to file the complaint, since at the time the opinions were provided OPR’s authority to regulate written tax shelter opinions was unclear. See infra. Interestingly, one case found that certain opinions on tax shelter transactions, which were probably return preparation advice, met the covered opinion standards which it described as “even more strict than the standards that were in effect when the opinions … were drafted.” Southgate Master Fund, LLC v. U.S., 651 F. Supp. 596, 636 (N.D. Tex. 2009), aff’d, 659 F. 3d 466 (5th Cir. 2011).

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230 in a single case.7

In light of this history, this article attempts to determine whether tax planning advice can

ever be effectively regulated by the Service. The article first explores whether tax advice

generally, and tax planning advice specifically, differs in kind from other forms of legal advice.

Secondly, it looks at the clear regulatory distinction between the treatment of return preparation

advice and the treatment of tax planning advice, taking into account possible historical anomalies

and asking if the difference in treatment is justified or misguided. The article then reviews

efforts to regulate planning advice directly, including earlier attempts to address tax shelter

opinions in Circular 230, the current covered opinion rules and written advice rules, and the

proposed changes in these sections of Circular 230, asking whether these approaches are useful.

Less direct approaches such as flagging certain transactions with tax shelter potential for

particular focus through rules about listed and other reportable transactions are noted along with

their limitations as is the possible role of oral tax planning advice, which the IRS has really not

made a serious attempt to address.

More recently, at a meeting of the Standards of Tax Practice Committee of

the ABA Section of Taxation Director Hawkins acknowledged that Circular 230’s § 10.37

written advice rules have also not been used to pursue any disciplinary actions.

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7 Sanctions may be imposed on practitioners who have provided false opinions without recourse to the covered opinion or written advice rules. See, e.g., IRS Newswire IR-2010-057 (announcing practitioner consent to suspension for knowingly giving false opinion on tax-exempt status of bonds in violation of Circular 230 § 10.51(j) and failing to exercise due diligence in violation of section 10.22).

Finally, the article discusses how combining more than one

approach (such as retaining the accuracy standard of the covered opinion rules, UTP filing

requirements, and competency testing) might be useful in regulating the quality of tax planning

advice, but concludes that a magic IRS bullet for monitoring and regulating the quality of tax

8 If taxpayers feel they can’t rely on oral advice for penalty protection, the regulation of oral advice may be less important. Whether taxpayers can rely on oral advice is discussed infra, although the cases on the subject generally involve taxpayers seeking to avoid taxpayer accuracy penalties under IRC § 6662 (for return understatements) and the cases often fail to indicate whether the advice involved was return preparation advice or pre-transaction tax planning advice. It is unclear how prevalent oral tax planning advice is.

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planning advice has yet to be invented. However, reducing the ability of taxpayers to rely on the

advice of tax advisors to avoid penalties might force taxpayers to hold their advisors to account

to a degree that the Service will never be able to do. The discussion will mostly focus on tax

lawyers, although it is generally applicable to advice provided by other Circular 230 practitioners

who provide tax planning advice, particularly CPAs.

Tax Advice vs. Legal Advice

All lawyers are subject to the ethical rules of their state of licensure. These ethical rules

include standards regarding subjects such as competence, diligence and communicating with the

client.9 The rules and related comments generally provide little guidance with regard to the

quality or accuracy of tax planning advice. In the context of advocacy, the ethical rules typically

require that the lawyer not bring or defend a proceeding or assert or controvert an issue unless

“there is a basis in law and fact for doing so that is not frivolous, which includes a good faith

argument for an extension, modification or reversal of existing law.”10

9 Model Rules of Prof’l Conduct (MRPC) 1.1 (competence), 1.2 (diligence), and 1.4 (communication). The concept of diligence envisioned in Rule 1.2 is different from the “due diligence” referred to in Circular 230 § 10.22. CPAs are subject to similar standards promulgated by the AICPA. See AICPA Rules of Prof’l Conduct ET § 201 General Standards. CPAs, however, may be subject to disciplinary activity not only by their state accounting regulatory body, but also by the AICPA itself.

This standard, however,

presumes the presence of at least two sides in the dispute before an impartial tribunal. Planning

advice in a nontax context often involves negotiations over the terms of a transaction in which

any advice that is unfavorably viewed by another party to the transaction may lead to a

negotiated agreement about how the transaction is structured. Making sure that the transaction‘s

consequences reflect both parties’ expectations imposes a natural check on the viability of the

10 MRPC 3.1.

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planning advice.11

Non-tax planning advice also differs from return preparation advice and tax planning

advice because there is often no strong public interest in how a typical transaction is negotiated

between the parties. It is a private transaction with modest ancillary effects on the public. While

a transaction may have a substantial impact on the public interest that calls for direct public

intervention of some kind if, for example, the transaction may result in violations of antitrust

laws or environmental laws, the public acting though its duly elected government has no such

direct interest in examining all or even many such private transactions.

In this respect, tax advice to a taxpayer in connection with the audit of a tax

return or in litigation resembles non-tax planning advice because a third party (representing the

IRS) is a participant in the process, thus serving as a check on the viability of the advice, but this

is not true of either return preparation advice or tax planning advice.

Tax return preparation advice and tax planning advice, including estate planning, are very

different. There is no immediate third party check on the advice. Often the only other party with

a stake in the accuracy of the advice is the Treasury because of the public interest in raising

revenue. Yet the advice and the transactions impacted by the advice often receive no scrutiny.

Any audit occurs at least months, and usually years, later. Indeed, the transactions that result

from the advice may not trigger tax consequences until many years later, particularly in the case

of estate planning. Even then, statutes of limitation may preclude not only the IRS from

11 This situation may also arise with respect to some tax planning advice, where favorable tax consequences for one party (for example, payments following a divorce qualifying as deductible alimony) may depend on unfavorable tax treatment of the other party (inclusion of alimony payments in income). Much pre-transaction tax planning advice does not involve such a tradeoff.

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pursuing the advisor,12 but also unhappy clients.13 For these reasons among others,

commentators have long taken the view that tax lawyers have a duty to the system that is broader

and more complex than the duty of other lawyers. In representing clients, tax lawyers not only

have a duty to the legal system as a whole, they also have a duty to the system of tax

administration as such.14

Return Preparation Advice vs. Tax Planning Advice

Because the system relies on “voluntary” filing of tax returns, tax

lawyers and others who prepare or advise on the preparation of returns have a duty to assure that

the returns are accurate to the extent of the level of confidence for the return positions required

by law. This has produced two sometimes parallel series of steps designed to protect the public

interest, one involving statutory and regulatory standards for return preparer advice and the other

more wide-ranging disciplinary rules enforced by OPR, which largely parallel the statutory

return preparer standards with respect to return preparation advice, but have also in recent years

reflected a halting attempt to address written tax planning advice. To understand this situation,

it is helpful to look at how these rules developed.

The tax advice rules and standards, statutory and regulatory as well as disciplinary, were

initially derived from the ethical rules of the legal profession. The ABA first addressed the

12 See 28 U.S.C. § 2462 (five-year statute of limitations applies to enforcement of any federal civil fine, penalty or forfeiture) , held applicable to OPR disciplinary proceeding for suspension from practice because penal, as opposed to remedial, in Director, Office of Professional Responsibility v. Luis R. Hernandez, Complaint No. 2010-09 ( May 26, 2011) (willful failure to timely file federal income tax returns and willful failure to file). This 5-year statute of limitations would also apply to imposition of penalties under IRC § 6694, but it is unclear if it would apply to discipline resulting from conduct with respect to taxpayers in violation of Circular 230 as opposed to practitioner compliance violations.

13 For statutes of limitations in tax malpractice actions, see Michael B. Lang, Tax Malpractice: Issues and Avoidance, 54 BNA TAX MANAGEMENT MEMO. 19, 25-28 (2013), at http://ssrn.com/abstract=2235912.

14 See Linda Galler & Michael B. Lang, REGULATION OF TAX PRACTICE 3-5 (2010) (quoting and citing various authorities).

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appropriate ethical standard for lawyers providing tax advice in ABA Formal Opinion 65-314.15

Opinion 65-314 concluded that under the Canons of Ethics a lawyer providing tax return

preparation advice “may freely urge the statement of positions most favorable to the client just as

long as there is a reasonable basis for those positions.” Some twenty years later, the ABA

revisited this issue in light of the Model Rules of Professional Conduct, noting that the

reasonable basis standard had been “construed by many lawyers to support the use of any

colorable claim on the tax return to justify exploitation of the lottery of the tax return audit

selection process.”16 Opinion 85-352, like the 1965 opinion, relied on the concept that the

lawyer is entitled to advise her client to take a return position that might not be more likely than

not to prevail because of her duty to represent the interest of the client zealously and loyally

within the bounds of the law.17 But the 1985 opinion noted that the lawyer must also

“realistically anticipate” that the return filing may be “the first step in a process that may result in

an adversary relationship between the client and the IRS.”18 With this in mind the Opinion drew

on Model Rule 3.1, addressing the degree of merit required in the case of claims or contentions

of an advocate, as an appropriate if not perfect analogy to the return-filing situation in which an

adversary relationship with the IRS might be anticipated.19

Model Rule 3.1 at the time required that a claim have “a basis that is not frivolous, which

includes a good faith argument for an extension, modification or reversal of existing law.”

Opinion 85-352 expanded on this standard, stating that a lawyer may advise reporting a position

on a return if the “lawyer in good faith believes the position is warranted in existing law or can

15 Apr. 27, 1965. 16 ABA Formal Op. 85-352, July 7, 1986, text accompanying note 1. 17 Id. at text accompanying note 4. 18 Id. at text following note 2. 19 Whatever the likelihood of an audit of a tax return may be, tax planning advice is even less likely to see the light of day, but at this point the ABA was not thinking of tax planning advice.

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be supported by a good faith argument for an extension, modification or reversal of existing

law,” provided there is some realistic possibility of success if the matter is litigated.20 However,

the ethics opinion also stated that the lawyer should advise the client whether there is or was

substantial authority for the position and, if not, the penalty that the taxpayer might suffer and

how the penalty might be avoided by adequate return disclosure.21 This reflected a conflict at

the time between the statutory taxpayer tax return accuracy standards (requiring that an

undisclosed position be supported by substantial authority) and the then return preparer accuracy

standards.22 In 1989, however, after a number of earlier steps, Congress revised the earlier return

preparer accuracy standards in section 6694 of Internal Revenue Code to reflect the ABA and

AICPA realistic possibility of success standards.23 With respect to undisclosed return filing

positions, in 2007 and 2008 the realistic possibility of success standard was abandoned by

Congress to reflect for the most part the taxpayer accuracy standards in IRC § 6662.24 At the

same time, Congress enacted a new definition of “tax return preparer” in section 7701(a)(36),

which Treasury amplified in regulations.25

One notable aspect of the regulatory elaboration of IRC §§ 6694 and 7701(a)(36)

is a definition of two categories of tax return preparers, signing tax return preparers and

nonsigning tax return preparers. A signing tax return preparer is “the individual tax return

20ABA Formal Op. 85-352, text accompanying note 4, adding subsequently that the lawyer, “in his role as advisor,” “should refer to the potential penalties and other legal consequences should the client take the position advised.” The AICPA replaced its earlier return preparer standard with a similar realistic possibility standard in 1988. 21 ABA Formal Op. 85-352. 22 See Michael B. Lang, Commentary on Return Preparer Obligations, 3 FLA. TAX REV. 128 (1996). 23 See Bryan Camp, ‘Loving’ Return Preparer Regulation, 140 TAX NOTES 457, 457-461 (2013), which includes some useful earlier Circular 230 history, but which mistakenly (in text accompanying note 18) states that 31 U.S.C. §330(d) was added in 1984, as opposed to 2004. 24 Small Business and Work Opportunity Tax Act of 2007, Pub. L. 110-28, 121 Stat. 190; Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Div. C of Pub. L. 110-343, 122 Stat. 3765. 25 Treas. Reg. 301.7701-15, published at TD 9436, 73 FR 78463, Dec. 22, 2008, as amended by T.D. 9436, 74 FR 5107, Jan. 29, 2009.

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preparer who has the primary responsibility for the overall substantive accuracy” of the

preparation of the return or claim for refund.26 A nonsigning tax return preparer is someone who

is not a signing tax return preparer, “but who prepares all or a substantial portion of a return or

claim for refund … with respect to events that have occurred at the time of the advice.”27 This

definition basically exempts pre-transaction tax planning advice from the return preparer

standards. The exemption is protected by a safe harbor rule permitting tax planners to give a

modest amount of post-transaction advice without being treated as return preparers.28

Furthermore, even if the planner fails to satisfy the safe harbor rules, any applicable section 6694

penalty would be based only on the compensation attributable to the post-transaction advice.29

The “tax return preparer” definition dates back to the original enactment of a definition of

“income tax return preparer” in IRC § 7701(a)(36) by the 1976 Tax Reform Act as part of

Congress’s effort to deal with problems encountered by the IRS with improper return preparation

and abusive practices by return preparers.

Thus, tax return preparers, signing and nonsigning, must adhere to the section 6694 accuracy

standards, but those providing pre-transaction tax planning advice are off the hook. How did this

happen?

30 Congress intended to aid the IRS in detecting

incorrectly prepared returns and deterring income tax return preparers’ improper conduct.31

26 Treas. Reg. § 301.7701-15(b)(1).

The

27 Treas. Reg. § 301.7701-15(b)(2). 28 Ibid., 2d sentence. 29 See Treas. Reg. § 1.6694-1(f)(2)(ii). 30 Pub. L. 94-455, 90 Stat. 1520; see S. Rep. No. 94-938, 94th Cong., 2d Sess. 349-359 (1976). The later change in the term to “tax return preparer” reflected the extension of the return preparer accuracy standards to preparers of returns other than income tax returns.

31 Id. at 350-351.

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signing and nonsigning preparer definitions then appeared in the final regulations issued under

the 1976 Tax Reform Act in November 1977.32

Treasury’s action was explained in 2008, when the regulations were amended, as follows:

The November 1977 final regulations applied the tax return preparer

penalty provisions to persons who did not sign the return or claim for

refund, or make or control the entries on the return or claim for refund,

including tax professionals who rendered advice that was directly related

to the determination of the existence, characterization, or amount, of an

entry on a return or claim for refund. By including a broad definition of

tax return preparer, the Treasury Department and the IRS intended the

regulations to increase advisor care and to monitor careless or deceptive

members of the profession. The November 1977 final regulations

reflected the considered view that excluding nonsigning tax professionals

from the reach of section 6694 could result in a lack of accountability for

positions taken on a return, as taxpayers could escape penalty liability

because they employed tax return preparers, tax return preparers could

escape liability because they relied on nonsigning tax professionals'

opinions, and nonsigning tax professionals could escape liability because

they would not be considered tax return preparers.33

32 TD 7519, 42 FR 17452.

33 73 FR 34560, 34561-34562, Proposed Rules, Tax Return Preparer Penalties Under Sections 6694 and 6695 (June 17, 2008).

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A few points are notable about this explanation. First, the 1977 version of the regulations

might well have been viewed as covering pre-transaction tax planning advice “directly related”

to an entry on the return. Second, Treasury does not seem to have envisioned this in 1977 and in

2008 moved the regulations defining signing and nonsigning “tax return preparers” in the other

direction, as previously discussed. Third, it seems likely that a taxpayer (or a tax return

preparer) under current law might escape penalty liability by relying on pre-transaction tax

planning advice from an advisor who was not a return preparer and would not be subject to the

return preparer accuracy penalty, no matter how unreasonable the advisor’s advice is. The third

point is fully confirmed by a review of numerous cases of taxpayers asserting a section 6664

reasonable cause, good faith defense to a taxpayer accuracy penalty imposed under section

6662.34

The exemption of tax planning advice from the return preparer accuracy standards is

perhaps best understood by looking at the history of OPR’s disciplinary authority in this area.

Bryan Camp has explained in a recent article the expansion of the disciplinary authority of OPR,

beginning with the enabling statute, 31 U.S.C. § 330, which originally authorized the Treasury

Department to “regulate the practice of representative of persons before the Department of the

Treasury.”

This issue is addressed more fully later in this article.

35 As explained by Professor Camp, the focus of such regulation for years was not on

return preparation at all, but rather on representing persons in a dispute before the IRS.36

34 See David T. Moldenhauer, Penalty Protection Opinions and Advisor Conflicts of Interest (4/25/11),

As

noted earlier, the return preparer accuracy standards were enacted in 1976 to deal with the

http://ssrn.com/absstratc=1822386. Moldenhauer focuses on cases where the IRS argued that the advisor had a conflict of interest, but his collection of these cases is comprehensive. 35Bryan Camp, ‘Loving’ Return Preparer Regulation, 140 TAX NOTES 457 (2013). 36Ibid. at 459. Camp notes that the 1966 version of Circular 230 specifically excluded return preparation from the definition of practice before the IRS. Ibid. at 459-460. See 31 FR 10773, 10774 (Aug. 13, 1966).

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perceived problems of incorrect return preparation and return preparer abusive practices.37 In

1984, a sentence in Circular 230 § 10.2(a) excluding return preparation from the definition of

practice was removed from Circular 230, while an initial attempt was made to apply written

standards to Tax Shelter Opinions in a new section 10.33.38 While the 1984 tax shelter opinion

standards reflected Treasury’s ambition more than a real enforcement goal,39 bringing return

preparation by Circular 230 practitioners40

So, by the 1980s, return preparation was being regulated by both a penalty system under

IRC § 6694 and through discipline of Circular 230 practitioners.

within the jurisdiction of Circular 230 and OPR’s

predecessor was consistent with the movement toward subjecting return preparation to statutory

accuracy standards.

41 These systems were more

fully coordinated when then new section 10.34(a) of Circular 230 was promulgated in 1994.42

The goal originally was to regulate return preparers, but if return preparers are subject to return

preparer accuracy standards only when they actually prepare and sign returns, the standards are

readily avoided, as the Treasury realized in 1977 in proposing the original regulations under

section 6694.43

37 See S. Rep. No. 94-938, 94th Cong., 2d Sess. 349-359 (1976).

The return preparers could simply advise the taxpayers how to prepare their

returns on their own and avoid the standards applicable to those who prepare returns. With more

recent legislation and conforming changes to Circular 230, return preparation and advising on

38 49 FR 6719 (Feb. 23, 1984). 39 It would not be until after the 2004 change to 31 U.S.C. § 330(d) that Treasury would feel confident of its authority to regulate written tax planning advice. 40 Basically, this included return preparation by attorneys, CPAs and enrolled agents. 41 Of course, only Circular 230 practitioners were subject to the disciplinary rules of Circular 230. 42 59 FR 31523 (June 20, 1994). 43 See 73 FR 34561-34562.

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return positions are now subject to penalty standards and disciplinary standards that are generally

consistent with each other.44

Pre-transaction tax planning advice, however, has been left largely unregulated. Early

efforts to address tax shelter opinions in the 1984 version of Circular 230 § 10.33 went nowhere

because the IRS was uncertain that its authority to regulate written advice was authorized by then

31 U.S.C. § 330. Return preparers have been subject to stricter rules with respect to items

attributable to tax shelters or reportable transactions, but these rules only apply to their return

preparation or advice on return positions.

45 It is perhaps instructive as to the difficulty of

regulating pre-transaction tax planning advice that the ABA has not addressed the issue in recent

years. In fact, the ABA has yet to revisit its 1985 Opinion about advising positions on a return.46

44 There is one major difference between the penalty standards of IRC § 6694 and the disciplinary standards in Circular 230 § 10.34. The penalty standard is more like a no fault or modest fault rule imposing a fine for a mistake. Disciplinary sanctions may only be imposed if the standards of Circular 230 are violated willfully, recklessly or through gross incompetence. Circular 230 § 10.52(a). A “pattern of conduct“ may be a factor in determining whether the practitioner’s acts constitute gross incompetence. See Circular 230 §§ 1034(a)(2) and 10.51(a)(13). To put this in layman’s terms, the penalty provision’s application is analogous to receiving a speeding ticket for driving a car at 10 miles per hour over the speed limit. The disciplinary provision’s application is analogous to having a driver’s license suspended for either reckless driving or for receiving five speeding tickets within a few months.

The ABA Opinion’s continued presence might suggest that, absent some statutory or regulatory

standard for tax planning advice, it could be viewed as a default ethical standard for tax planning

advice. However, tax planning advice is far removed from return preparation advice, represents

a greater danger to the fisc, particularly in the form of tax shelter planning and aggressive estate

planning, and is more difficult for the IRS to investigate. It is difficult to see any good reason to

retain this lower ethical standard for tax planning advice. In any event, expecting state bar

45 AICPA Statement on Standards for Tax Services No.1 (SSTS No. 1), Interpretation No. 1-2, Tax Planning (2011) clearly draws this distinction in ¶ 5, discussed infra. 46 Perhaps the ABA feels the Opinion is still valid for positions on state income tax returns.

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authorities or state attorney general offices to enforce ethical standards applicable to tax planning

advice is unrealistic.

The AICPA has been more active on this front. In 2011 it revised its Statement on

Standards for Tax Services (SSTS) No. 1, Tax Return Positions to reflect the 2007 and 2008

amendments to IRC § 6694. The revised SSTS No. 1, however, retains the AICPA version of the

realistic possibility standard (first adopted by the AICPA in 1988) for return positions advised by

CPAs that are not subject to a different rule by statute, such as positions taken on state tax

returns for which there is no established state return preparer accuracy standard.47 A revised

Interpretation 1-2, Tax Planning, addresses tax planning advice in light of the 2007 and 2008

legislation and the current Circular 230 rules. The Interpretation divides tax planning into two

categories: (1) Tax planning for completed transactions as to which the CPA “may be

considered” a nonsigning tax return preparer with respect to items “for which the tax planning is

undertaken that subsequently are reflected on the taxpayer’s tax return;”48 and (2) Tax planning

with respect to prospective transactions, as to which the implication is that only the standards for

providing written advice (which would currently include the covered opinion rules) apply.49

Covered Opinions and Written Advice

In 2004 Congress added paragraph (d) to 31 U.S.C. § 330, the authorizing legislation for

the Treasury to regulate those who practice before the IRS.50

47 See SSTS No.1, Interpretation No.1-1, Reporting and Disclosure Standards (2011).

Section 330(d) reads: “Nothing in

this section… shall be construed to limit the authority of the Secretary of the Treasury to impose

standards applicable to the rendering of written advice with respect to any entity, transaction,

48 SSTS No. 1, Interpretation 1-2, Tax Planning ¶ 5. 49 Id. ¶¶ 4 and 5. See also Illustrations 12 and 13, which do not refer to any accuracy standard. 50 American Jobs Creation Act of 2004, Pub. L. 108-357, 118 Stat. 1418.

15

plan or arrangement, or other plan or arrangement, which is of a type which the Secretary

determines as having a potential for tax avoidance or evasion.” This awkward language was

intended to clarify the Treasury’s authority, through what is now the IRS Office of Professional

Responsibility, to regulate Circular 230 practitioners who provide tax shelter opinions.51 The

Treasury, having had a provision in Circular 230 addressing tax shelter opinions as early as 1984

and having been in the process of amending this aspect of Circular 230 when the 2004 legislation

was enacted, reacted quickly and later in 2004 adopted the so-called covered opinion rules

(current section 10.35 of Circular 230), as well as a relatively vague provision addressing other

written advice (current section 10.37).52

It would be an understatement to say that these changes did not effectively regulate tax

planning advice. The covered opinion rules mandate a detailed process, structure and substance

for opinions on several defined categories of transactions deemed to present a danger of tax

avoidance or evasion. Although satisfaction of all these requirements does not necessarily mean

the taxpayer can rely on the opinion for penalty protection,

53

51 See H. Rep. No. 108-755, 108th Cong., 2d Sess. 616 (2004).

the practitioner who provides an

opinion that both fails to satisfy these detailed requirements and also fails to include an

appropriately conspicuous disclaimer could be subject to discipline under Circular 230.

Interestingly, however, it is not at all clear that such an opinion could not be relied upon by a

52 TD 9165, 69 FR 75839 (Dec. 20, 2004). Section 10.35 was subsequently amended in minor respects, but these amendments are not important to this discussion. More details on this history can be found in the Supplementary Information section of the Proposed Amendments to Circular 230 published on September 17, 2012, 77 FR 57055, 57056. Given Treasury’s reluctance to enforce the earlier standards for tax shelter opinions, it is curious that it added section 10.37 to Circular 230, since the advice covered by this provision, while written, does not necessarily have a “potential for tax avoidance or evasion,” within the meaning of 31 U.S.C. § 330(d). Of course, since section 10.37 has not been the subject of any enforcement activity, this point may be moot. 53 See Circular 230 § 10.35(f)(1), stating that even if an opinion satisfies the covered opinion rules, “the persuasiveness of the opinion with regard to the tax issues in question and the taxpayer’s good faith reliance on the opinion will be determined separately under applicable provisions of the law and regulations.” One wonders how often authors of covered opinions have called this caveat to their clients’ attention.

16

taxpayer under I.R.C. § 6664 to support a reasonable cause, good faith defense to imposition of a

taxpayer accuracy penalty.54

In any event, the response to this sledgehammer covered opinion regulation was that

every major law firm and CPA firm (and most smaller ones) with a tax practice simply added a

suitable disclaimer to all emails and most other written communications.

55

Significant progress has been made in combating abusive tax

shelters and schemes, and preventing unscrupulous individuals from

promoting those arrangements. In recent years, heightened awareness

of the ethical standards governing tax advice contributed to this

improved state and has benefited practitioners, taxpayers, and the

government. At the same time, there is no direct evidence to suggest

that the overly-technical and detailed requirements of current § 10.35

were responsible for, or particularly effective at, curtailing the

The number of tax

shelter opinions written dropped precipitously. Nobody really knows all the causes, but when

the Treasury in 2012 proposed repealing the covered opinion rules, it stated:

54 The regulations call for determining whether a taxpayer has acted with reasonable cause and in good faith to be made on the basis of all the facts and circumstances. It is quite possible that whether the opinion at issue actually satisfied the covered opinion rules might not even be a relevant fact or circumstance in some cases, while it might not be decisive in others. See Treas. Reg. § 1.6664-4. 55 The disclaimers were perceived as necessary to avoid having any “written advice,” broadly construed, treated as a reliance opinion. The disclaimer had to “prominently” disclose that the written advice “was not intended or written by the practitioner to be used, and … cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” Circular 230 § 10.35(b)(4)(ii). Prominent disclosure was defined in a way that resembles the worst of state bar ethical rules governing advertising and solicitation by lawyers: “At a minimum, to be prominently disclosed an item must be set forth in a separate section (and not in a footnote) in a typeface that is the same size or larger than the typeface of any discussion of the facts or law in the written advice.” Id. § 10.35(b)(8). The viability of such requirements should not be underestimated. See Hunter v. Va. State Bar, 744 S.E.2d 611 (Va. 2013), cert. denied, 133 S. Ct. 2871 (2013)(First Amendment challenge to Bar regulation of advertising on lawyer’s blog rejected; Bar rule disclaimer requirements upheld including those as to formatting and presentation, rejecting less demanding substitute of lower court).

17

behavior of individuals attempting to profit from promoting frivolous

transactions or transactions without a reasonable basis.56

This probably underestimates the impact of the covered opinion rules, especially in conjunction

with the codification of the economic substance doctrine in 2010 in IRC § 7701(o).

57 It was not

uncommon for earlier tax shelter opinions to ignore this doctrine, even if the firms offering the

opinions had done extensive research on the subject.58

Of perhaps greater importance were the problems with the provision:

With codification of the doctrine, the

detailed requirements of the covered opinion rules make it impossible to ignore the economic

substance doctrine in a tax shelter opinion.

Practitioners overwhelmingly conclude that the rules are overbroad,

difficult to apply, and do not necessarily produce higher quality tax

advice. Many practitioners have stated that the rules unduly interfere

with their client relationships and are not an ethical standard that

everyone, including clients, can comprehend easily. Some

practitioners have also opined that these rules may reduce, rather than

enhance, tax compliance due to the perception that a covered opinion

takes more time to produce and is more expensive for the client than

other tax advice. In this same regard, it has been suggested that the

rules increase the likelihood that practitioners will provide oral advice

56 77 FR at 57057. Although criminal indictments and, in some cases, convictions of those involved in promoting and providing opinions on frivolous tax shelters have been small in number, the in terrorem effect of these actions has probably deterred others thinking of promoting tax frivolous tax shelters. 57 The Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, § 1409. 58 See, e.g., Director, Office of Professional Responsibility v. John M. Sykes, III, Complaint No. 2006-1 (Jan. 29, 2009).

18

to their clients when written advice is more appropriate because

current § 10.35 does not govern oral advice.

Another concern that the government has heard from practitioners

relates to the unrestrained use of disclaimers on nearly every

practitioner communication regardless of whether the communication

contains tax advice. Practitioners have stated that this practice

discourages compliance with the ethical requirements because some

practitioners have concluded that, if they include a disclaimer, they

are free to disregard the standards in current § 10.35 regarding written

tax advice. The disclaimers also lead to confusion for clients because

clients often do not understand why the disclaimer is present and its

consequences. In addition, practitioners have complained that the

disclaimer's widespread overuse causes clients to ignore the

disclaimers altogether, and may render their use in some

circumstances irrelevant.59

Much of the detail in Section 10.35 is surely counterproductive, but there is one aspect of

the provision that is important - the more likely than not standard. For an opinion to be of any

59 77 FR at 57057. The proposed amendments to Circular 230 do nothing to counteract the incentive that section 10.35 provides for practitioners to give oral advice instead of written advice. This is not surprising since it is unclear whether OPR has the authority to regulate oral tax planning advice at all. The 2004 amendment to 31 U.S.C. § 330(d) only mentioned “written advice.” It is also worth noting that repeal of the covered opinion rules will not necessarily lead to disappearance of the disclaimers. Dropping disclaimers may lead some clients to think that they can rely on all the written communications they receive from their lawyers. This would not appear to be an unreasonable reaction and on some facts might lead to a malpractice suit against the lawyer who dropped the disclaimers, resulting from her client’s reliance on some snippet of advice that wasn’t properly vetted before being passed on to the client in an email. The author’s informal survey of tax litigators with either litigation or expert witness experience in the malpractice area indicated that most of them were not inclined to drop the disclaimers.

19

value to the taxpayer for penalty protection purposes with respect to any particular “significant

Federal tax issue”60 the opinion has to reach a conclusion at a confidence level of at least more

likely than not with respect to the issue.61 This standard doe not state that the more likely than

not conclusion has to be correct as of the then existing governing law or that the conclusion is a

competent one, or even that the practitioner reasonably believes that the more likely than not

conclusion is correct, although the Service could presumably read such a reasonable belief

limitation into the provision and, indeed, such a limitation should appear in the provision.

Leaving this drafting error aside,62

deletion of this accuracy standard upon repeal of the covered

opinion rules will leave no accuracy standard for pre-transaction tax planning advice.

Section 10.37, even with amendments similar to those proposed in 2012, will only focus

on the process followed by the practitioner in preparing the opinion rather than the quality of the

final result. There are three problems with this approach to regulating tax planning advice: (1) It

is inconsistent with the rationale and specifics of the taxpayer and return preparer accuracy

standards and reasonable cause, good faith defense provisions; (2) A process is no substitute for

good advice, although it may help reach a good result; and (3) It is costly.

Section 6664(c) of the Internal Revenue Code permits the taxpayer to avoid taxpayer

accuracy and fraud penalties imposed under section 6662 or 6663 with “respect to any portion of

60 Circular 230 § 10.35(b)(3) defines “significant” federal tax issue as one as to which the IRS has a reasonable basis for a successful challenge and the resolution of which could have a significant impact on the overall federal tax treatment of the transaction(s) or matter(s) addressed in the opinion. 61 See, e.g., Circular 230 § 10.35(e)(4). 62 Maybe it is not a drafting error. The “error” is consistent with the idea that it is the process that matters, not whether it reaches a sound result. This is a misguided concept of the value of a good process. A good process should help achieve a sound result, but following a good process and getting the wrong result because of poor judgment is not satisfactory. In this context, the rules should require both a process that encourages practitioners to reach a sound result and a sound result.

20

an underpayment if it is shown that there was a reasonable cause for such portion and that the

taxpayer acted in good faith with respect to such portion.”63 The regulations clearly provide that

reasonable reliance on a professional tax advisor may support a reasonable cause, good faith

defense under section 6664.64 While the regulations go on at some length about the facts and

circumstances that are relevant in determining whether the reliance on professional advice is

reasonable and in good faith,65 there is no requirement that the advice be provided from an

individual who is a return preparer subject to the return preparer accuracy standards of section

6694. There is a crossreference to rules applicable to advisors,66 but this crossreference, while

out of date,67

does not seem to limit the source of such advice to return preparers. One could

readily infer that pre-transaction tax planning advice can be relied up to support a reasonable

cause, good faith defense to the taxpayer accuracy penalty, even if such advice is not subject

itself to any accuracy standard.

In fact, a review of cases involving taxpayer assertion of a reasonable cause, good faith

defense to taxpayer accuracy penalties indicates that taxpayers rely on whatever tax advice is

received, whether it is pre-transaction tax planning advice, such as a tax shelter opinion provided

before or at the closing of the transaction, similar advice provided later (but previously

promised), or advice at the time of or in connection with the return filing. Taxpayers also rely on

written and/or oral advice. The courts do not appear to draw any distinction based on whether

63 Successful assertion of this defense is subject to additional requirements in some circumstances, such as when a reportable transaction is involved, but these variations are not relevant at this point in the discussion. 64 Treas. Reg. § 1.6664-4(c). 65 Id. Factors include the taxpayer’s education, sophistication and business experience, all pertinent facts and circumstances, whether the advice is based on unreasonable assumptions or unreasonably relies on representations, statements, findings or agreements of the taxpayer or others, etc. 66 Treas. Reg. § 1.6664-4(c)(3). 67 It refers to the pre-2004 Circular 230 § 10.33 tax shelter opinion rule!

21

the advice relied upon by the taxpayer was pre-transaction planning advice or instead advice

subject to the return preparer standards.68 Often any pre-transaction planning advice received by

the taxpayer is then passed along by the taxpayer to whoever is providing return preparation

advice and the degree to which the return preparer has relied on the pre-transaction planning

advice is unclear. It is perhaps even more surprising that the government in litigation does not

seem to argue that the difference between the two kinds of advice is relevant in weighing

whether reliance is reasonable. If the advice is not specific as to the taxpayer’s transaction but is

more generic in nature, the taxpayer cannot reasonably rely on it. Nor can the taxpayer rely on

such generic advice indirectly by relying on an advisor (such as a return preparer) who relied on

the generic advice that did not directly address the taxpayer’s actual transaction.69 In fact, it is

not always clear in the cases whether the advice involved would be treated as tax planning advice

or return preparer advice. Sometimes, it isn’t even clear whether advice was provided orally or

in writing. What is clear is that a taxpayer may be able to rely on either oral or written tax

planning advice to avoid a taxpayer accuracy penalty.70

A parallel reasonable cause, good faith defense is available to tax return preparers

otherwise subject to a penalty under IRC section 6694(a) for an understatement due to an

68 Even where the facts indicate opinions were provided after the transaction in connection with the taxpayer’s preparation of the return, the courts don’t necessarily point this out. See, e.g., Southgate Master Fund, LLC v. U.S., 651 F. Supp. 596 (N.D. Tex. 2009), aff’d, 659 F. 3d 466 (5th Cir. 2011). This is consistent with the regulations which do not indicate that the advice relied upon by the taxpayer must be in one category or the other. 69 SAS Investment Partners v. Commissioner, T.C. Memo. 2012-159 (reliance on oral advice of tax advisor that was based on advisor’s review of redacted opinion letter that contained no reference to facts of taxpayer’s transaction, held not reasonable). 70 See, e.g., Allison III v. United States, 80 Fed. Cl. 568 (2008) (reasonable for taxpayer Dorsey to rely on informal oral advice of his tax advisor who reviewed tax opinion and memorandum and confirmed that they were technically correct).

22

“unreasonable position.”71 The regulations state that the return preparer may demonstrate

reasonable cause and good faith through reliance in good faith without verification “upon

information and advice furnished by another advisor, another tax return preparer or other

party.”72 This is subject to the usual caveats to the effect that the preparer may not ignore the

implications of information furnished to, or actually known to, the preparer and must make

reasonable inquiries if the furnished information appears incorrect or incomplete.73

However, no

distinction is drawn between advice provided to the return preparer by another tax return

preparer and advice provided to the return preparer by an advisor who is not a tax return

preparer, but provided tax planning advice, perhaps months or even years earlier.

Thus, tax return preparers, like taxpayers, may rely on pre-transaction tax planning

advice to avoid accuracy penalties. This is true in both cases despite the fact that the tax

planning advice may not have been subject to any federal accuracy standard and will definitely

not be subject to any federal accuracy standard if the proposed amendments to Circular 230 are

adopted. Although CPAs and lawyers providing pre-transaction tax planning advice are still

subject to the standards of their respective professions as explained earlier, these standards at this

time are lax to the extent they are defined at all and unlikely to be enforced. The current contrast

between the treatment of pre-transaction tax planning advice and the treatment of return

preparation advice has the bizarre effect of applying clearly defined accuracy standards to those

practitioners least likely to be able to assess the accuracy of their advice (return preparers) and

little regulation at all to those who should be better able to assess the accuracy of their advice

71 IRC § 6694(a)(3) (no penalty “if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith”). 72 Treas. Reg. §§ 1.6694-1(e)(1) and -2(e)(5). 73 Treas. Reg. § 1.6694-1(e)(1), 4th and 5th sentences..

23

(mostly CPAS and lawyers).74 Furthermore, the lax treatment of tax planning advice undercuts

the rationale discussed above for subjecting nonsigning tax return preparers to the return preparer

accuracy standards.75

If nonsigning preparers need regulation to prevent their use to circumvent

the rules applied to signing preparers, then tax planning advice also needs to be brought into the

regulatory scheme to preclude taxpayer and tax return preparer reliance on tax planning advice

that is unregulated.

It is worth noting that the return preparer accuracy regulations do caution that the tax

return preparer is not considered to have relied in good faith on another advisor’s advice if, inter

alia, “[t]he tax return preparer knew or should have known (given the nature of the tax return

preparer’s practice), at the time the return or claim for refund was prepared, that the advice or

information was no longer reliable due to developments in the law since the time the advice was

given.”76

74 Obviously, CPAs and tax lawyers often provide return preparation advice, but the tax return preparer group as a whole is on average much less equipped by education and experience to assess the quality of the advice provided than the CPA and tax lawyer group as a whole.

This is, of course, clear recognition that the tax return preparer may, unless this caveat

applies, rely on tax planning advice. This also suggests that tax planning advice should include

caveats that: (1) if action addressed in the planning advice is not immediately taken, the advice

should be revisited to determine whether its conclusions are still valid before taking action; and

(2) despite receipt of favorable planning advice, before the consequences of any transaction

implemented in reliance on the tax planning advice are reported for tax purposes, the advice

should be reevaluated to assure that it is still valid. Such caveats should also be included in tax

planning advice provided directly to a taxpayer.

75 See 73 FR 34560, 34561-34562, Proposed Rules, Tax Return Preparer Penalties Under Sections 6694 and 6695 (June 17, 2008). 76 Treas. Reg. § 1.6694-2(e)(5)(iii).

24

The second problem with the elimination of the accuracy standard for planning advice in

Circular 230’s covered opinion rules in favor of an enhanced standard for written advice

generally under Circular 230 § 10.37 is that it moves from what at least appears to be an

accuracy standard (is the advice correct?)77 to a wholly process standard (did the preparer follow

the correct steps in providing the advice?). The Sykes decision amply demonstrates the folly of

regulating process in lieu of accuracy.78

Sykes undertook all the steps one would have expected

the author of a major tax shelter opinion to take, even if these steps were not reflected in the

short form opinion he provided. The Service’s real problem with his opinion was not the lack of

due diligence with which he was charged or, for that matter, his failure to take the steps that

would be required under the current or the proposed version of Circular 230 § 10.37’s written

advice rules. The real problem was that his judgment produced a conclusion that the Service

regarded as wrong, and as wrong enough to merit a disciplinary sanction. An accuracy standard

makes it possible for the Service to take disciplinary action against practitioners whose advice

fails to meet the accuracy standard. Indeed, with an accuracy standard the Service may often be

able to determine if enforcement action is appropriate without an extensive investigation

requiring access to privileged information.

Evaluating the practitioner’s process is far more difficult. The practitioner’s process may

appear fine, but, as has been true of groups of practitioners focused on aggressive tax planning in

areas as diverse as using interest-free loans for estate planning, various leasing transactions, son-

77 As mentioned above, the current covered opinion rules should be read as requiring that a more likely than not conclusion be one that the practitioner reasonably believes to be correct, even if it is not in fact correct, in order to comply with the rules. 78 Director, Office of Professional Responsibility v. John M. Sykes, III, Complaint No. 2006-1 (Jan. 29, 2009).

25

of-Boss transactions and sales of streams of lottery payments, the practitioner’s analysis may be

infected by groupthink. This groupthink results when groups of practitioners pursue the same

aggressive planning technique, sometimes supported by articles, as well as CLE and financial

institution presentations, about how wonderful the technique is for the right kind of clients.

Often, very few, if any practitioners who are not actively using the technique even address the

issues, so those using the technique convince themselves that it works. In the interest-free loan

area, this process went on for years, even decades.79

The Service should require practitioners

engaged in tax planning to provide sound advice, not just go through the motions. Indeed, the

practical difficulty of using the written advice standards of Circular 230 to regulate tax planning

advice is probably part of the reason section 10.37 has never been used in an enforcement action.

Finally, process regulation is costly. The extent of investigation and time spent on the

hearing in the Sykes case should be instructive. This is often how malpractice litigation proceeds

and it is costly in time and money. The proposed amendments to Circular 230 that would expand

section 10.36 would expand the process orientation of OPR enforcement, making it possible for

OPR to focus on a firm’s institutional and management problems that trigger Circular 230

violations, but the litigation of particular cases would nonetheless continue to be costly and

complex.

Other Obstacles to Regulating Tax Planning Advice

79 In the interest-free loan area, there were dozens, if not hundreds of articles in tax and estate planning periodicals as well as state bar journals and other publications, with only one or two (generally by academics) questioning the viability of the technique.

26

Even with an accuracy standard applicable to practitioners who provide pre-transaction

tax planning advice, regulating the quality of such advice will not be easy for a number of

reasons. First of all, it is not clear that the IRS can regulate pre-transaction oral tax planning

advice at all. Nonetheless, it is clear that taxpayers may rely on oral advice to support an IRC §

section 6664 reasonable cause, good faith defense to imposition of a penalty under section

6662.80 It is also clear that tax return preparers may rely on oral advice from another advisor in

preparing a return or advising a taxpayer about a return position.81 In addition, the regulations

under section 6694 seem to apply to the provision of oral advice in as much as they require in

several places that the tax return preparer “contemporaneously document” certain advice in the

tax return preparer’s files,82 a requirement that would seem to be unnecessary if the advice is

provided in writing. It seems likely that Circular 230 § 10.34 is intended to apply to oral tax

return preparation advice as well, although the recent Loving decision83

80 Treas. Reg. § 1.6664-4(c)(2) (advice is ”any communication” “setting forth the analysis or conclusion of a person” provided to the taxpayer “on which the taxpayer relies”; “[a]dvice does not have to be in any particular form”). See, e.g., Southgate Master Fund, LLC v. U.S., 651 F. Supp. 596, 636 (N.D. Tex. 2009) (reliance on oral and written advice precluded penalty), aff’d, 659 F. 3d 466 (5th Cir. 2011) (only written opinions are mentioned); Olszonicki v. U.S., 867 F. Supp. 610 (N.D. Ohio 1993) (taxpayers of advanced age and poor health with limited education relied on long-time accountant that no return was due for income taxed in Germany; held, reasonable cause).

might suggest a narrow

reading of 31 U.S.C. §330(d) that would preclude the Service from regulating oral return

preparation advice through OPR disciplinary proceedings. There does not, however, appear to

be any authority for the Service to regulate oral pre-transaction tax planning advice. The 2004

amendment to 31 U.S.C. § 330 (d) conspicuously limits the authority granted therein to “written

advice with respect to any entity, transaction plan or arrangement, or other plan or arrangement,

81 Treas. Reg. § 1.6694-2(e)(5), 3rd sentence. 82 See Treas. Reg. §§ 1.6694-2(d)(3)((i)((C), -2(d)(3)(ii)(A) and (B), - 2(d)(3)(iii) (advice “must be particular to the taxpayer and tailored to the taxpayer’s facts and circumstances”). 83 Loving v. U.S, 917 F. Supp. 2d 67 (D.D.C. 2013) (enjoining IRS initiative to bring return preparers fully within jurisdiction of OPR through registration, competency testing, required continuing education and full application of Circular 230 on ground that unauthorized by 31 U.S.C. § 330) , modified, 920 F. Supp. 2d 108 (D.D.C. 2013), on appeal to D.C. Circuit Court of Appeals.

27

which is of a type which the Secretary determines as having a potential for tax avoidance or

evasion.” While there may be some written advice that does not fall within this grant of

authority because it does not have a potential for tax avoidance or evasion, oral advice is clearly

not covered.

As a result, the Service cannot now directly regulate the quality of oral tax planning

advice. Furthermore, as noted above, the covered opinion rules may provide an incentive for tax

practitioners to provide oral tax planning advice instead of written advice.84 In fact, any

regulation of written tax planning advice (including the proposed enhancement of Circular 230 §

10.37) that does not apply to oral advice will have this effect. Nonetheless, although taxpayers

seek to rely on oral tax planning advice to some extent as a defense against penalties, these

defenses are often rejected for a variety of reasons, such as lack of proof,85 the taxpayer’s failure

to provide the advisor necessary information86 or the like. Indeed, the same lack of

sophistication that makes judges willing to accept a claimed reliance on oral advice as a defense

in some cases may undermine the taxpayer’s claim in other cases. If both oral advice and written

advice are involved, the quality of the written advice is likely to be controlling.87

84 See 77 FR at 57057.

By contrast, if

the oral advice is based on defective written advice, the oral advice is likely to be found lacking

as well.

85 See, e.g., Blum v. C.I.R., T.C. Memo 2012-16 (2012) (no evidence of claimed oral advice); Kierstead v. C.I.R., 330 Fed. Appx. 126 (9th Cir. 2009) (lack of proof). See also SAS Inv. Partners v. C.I.R., T.C. Memo 2012-159 (2012) (reliance on oral advice from advisor after advisor reviewed redacted opinion letter that did not provide any facts allowing determination of whether bona fide transaction existed unreasonable for taxpayer with “as much business acumen” as tax matters partner of purported partnership). 86 See, e.g., Kerman v. C.I.R., T.C. Memo 2011-54, aff’d, 713 F.3d 849 (6th Cir. 2013) (oral advice of accountant could not be relied upon because taxpayer did not provide accountant necessary and accurate information; same as to tax opinions and documents from others with inherent and obvious conflicts of interest, whom court also did not believe taxpayer relied on), cert. filed, Sept. 23, 2013; SAS Inv. Partners v. C.I.R., supra. 87 Cf. Southgate Master Fund, LLC v. U.S., 651 F. Supp. 596, 636 (N.D. Tex. 2009) (reliance on oral and written advice precluded penalty), aff’d, 659 F. 3d 466 (5th Cir. 2011) (only written opinions are mentioned).

28

One approach to the problem of oral pre-transaction tax planning advice might be to limit

reliance on such oral tax planning advice to support a reasonable cause, good faith defense to

underpayment situations involving less than a fixed amount, perhaps $50,000 or $100,000, but

there are apparently many taxpayers with substantial amounts at stake who lack the

sophistication to realize that they should probably be getting their advice in writing.

Furthermore, members of the judiciary seem to be fairly sympathetic to taxpayers who honestly

appear to have relied on professional advice, whether oral or written.88

The Service does have the authority to regulated written tax planning advice under

Circular 230, although again a narrow construction of 31 U.S.C. §330(d) might limit that

authority to advice with respect to a plan or arrangement et cetera having a “potential for tax

avoidance or evasion,” whatever that may mean. Arguably, any written tax planning advice that

the Service seeks to regulate meets this standard because even simply wrong or negligent advice,

if it leads to less revenue for the Service, has resulted in some tax avoidance. Assuming any

written tax planning advice is subject to regulation under Circular 230 and that some accuracy

standards are mandated for such advice, as under the covered opinion rules, there are still serious

obstacles to effective enforcement of such standards.

88 See, e.g., Olszonicki v. U.S., 867 F. Supp. 610 (N.D. Ohio 1993) (taxpayers of advanced age and poor health with limited education relied on long-time accountant that no return was due for income taxed in Germany; held, reasonable cause); Rawls Trading LP v. C.I.R, T.C. Memo. 2012-340 (2012) (accomplished engineer who was unsophisticated on financial and tax matters, but persuaded court that he wanted to provide CPA all relevant information and comply with law; held, reliance on CPA was reasonable and in good faith with respect to son-of-Boss transaction).

29

Tax planning advice is not always immediately visible to the Service. First, the taxpayer

must implement whatever the advice calls for.89 This will always take place after the advice has

been provided, at times long after the advice is provided. For example, this might be the case for

estate planning that involves an annual gift program. After the plan is implemented, some facts

about the plan will generally need to be reflected on a tax return before the Service even has a

clue that advice was provided. Even then, the Service must actually audit the return to discover a

problem on the return, trace the problem back to the advice, attempt to evaluate the advice and, if

there is to be some sort of discipline and/or penalty, initiate appropriate action. By then, the

imposition of a penalty (such as a monetary sanction imposed by OPR or a return preparer

penalty under IRC § 6694) might well be foreclosed by the five-year statute of limitations in 28

U.S.C. §2462.90

Some disciplinary actions may fare better. Section 2462 has been held to apply to

various OPR disciplinary actions for the practitioner’s noncompliance with his own filing

obligations on the theory that they are penal rather than remedial.91 However, discipline based

on providing substandard written tax planning advice might well be characterized as remedial in

nature, in which case section 2462 may not apply and there may be no statute of limitations.92

89 Written advice advising a taxpayer not to pursue an aggressive tax planning technique will rarely, if ever, be visible to the Service. However, the Service’s interest in preventing such advice is limited since there is no real cost to the fisc of having taxpayers fail to take advantage of aggressive tax planning techniques. Taxpayers can be justifiably left on their own to deal with tax advisors who are providing overly conservative planning advice.

As

a practical matter, however, any effort to get serious about regulating written tax planning advice

should be accompanied by a change in the applicable statute of limitations for resulting

90 In one recent case, the Tax Court noted that the transaction began six years before its reporting took place. Gaggero v. C.I.R., T.C. Memo 2012-331 (2012). 91 See, e.g., Director, OPR v. Luis R. Hernandez, Complaint No. 2010-09 (May 26, 2011)(willful failure to timely file and willful failure to file own tax returns). 92 See, e.g., Coghlan v. NTSB, 470 F.3d 1300, 1306 (11th Cir. 2006) (revocation of airline transport pilot certificate; held, remedial because implicated air safety; section 2462 not applicable).

30

disciplinary actions and penalties, either tolling the statute until the Service is aware (or should

be aware) of the problem on the tax return93

or extending the statutory period for actions

involving discipline with respect to written tax planning advice. The tolling alternative is more

directly targeted at solving the problem for the Service and seems the preferable alternative in

this context.

Even with a solution to the statute of limitations problem, the Service is still likely to

have problems ferreting out deficient written tax planning advice. So, while the public may have

a greater stake in the accuracy and quality of tax planning advice than in much return preparation

advice, the Service is likely to find it difficult to monitor such planning advice and take

appropriate action with respect to the advisors when justified. Written tax planning advice is

surely easier to regulate if the Service can find out about it in a timely manner. Two aids in this

process are reportable transaction filings and UTP (Uncertain Tax Positions) Schedules filed

with Form 1120 by corporations. The reportable transactions filings for listed transactions94

93 This approach would be consistent with statutes of limitations in many jurisdictions where the statute does not start to run in a torts action until the plaintiff has discovered or should have discovered the negligent act of the defendant.

and

UTP schedule filings have the advantage of incorporating some concept of an accuracy standard

into the requirement for filing. In the listed transactions category, the Service has in effect

indicated by identifying such transactions through published guidance that the hoped for tax

treatment of the transactions involved does not, in its view, satisfy the taxpayer accuracy

standards that should apply to the tax treatment of such transactions. Recall that the crucial issue

in regulating pre-transaction tax planning advice is applying an accuracy standard rather than

94 Listed transactions are transactions that are the same as or substantially similar to transactions already identified by the Service through guidance as tax avoidance transactions. Treas. Reg. § 1.6011-4(b)(2).

31

looking at the tax advisor’s process. As a result, written advice provided about listed

transactions is an obvious subject for examination, assuming privilege claims can be overcome.

UTP schedules are less informative, but still indicate that the taxpayer may be uncertain

about whether the positions involved are consistent with the taxpayer accuracy standards.

Apparently, the taxpayer’s tax liability reserves also include items for which the taxpayer

believes its position is more likely than not to prevail because some amount must be reported

because of the uncertainty.95

In these situations, far more investigation may be necessary to

determine if improper advice has been provided by a tax advisor, but at least the UTP filings

provide clues in the UTP schedules as to the possibility that some positions are uncertain and

may reflect written opinions that would be of interest to the IRS.

Reportable transactions other than listed transactions are somewhat different in that they

instead have characteristics (e.g., confidentiality agreements)96

(referred to by some as

“markers”) that the Service has found associated with aggressive tax planning, but these markers

themselves are not necessarily evidence of a problem with the taxpayer accuracy standards. As

such, the required disclosure statements are less likely to lead to problematic written advice, but

they are worthy of review in the enforcement process, particularly if the taxpayer’s returns are

otherwise under audit.

95 See Jeremiah Coder, Lower Tax Reserves Hint at Possible Effects of UTP Reporting, 136 TAX NOTES 11371 (Sept. 17, 2012), quoting George A. Hani of Miller & Chevalier as saying that for a “good number of companies, the prospect of submitting a Schedule UTP caused them to take steps to eliminate uncertainty and therefore reduce the reserve number.” 96 For reportable transactions and the required disclosure statements for such transactions, see Treas. Reg. § 1.6011-4.

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Examining UTP schedules and filings about listed and other reportable transactions,

however, even if helpful, will not even offer an entree into the written tax planning advice given

to many individuals, small businesses and other taxpayers. One is tempted to suggest in this

regard that CPAs and lawyers providing tax advice be required to pass a competency test that

includes a rigorous unit on practice standards and Circular 230 more generally.97 In view of the

fact that many states already have a certification process for lawyers who wish to qualify as tax

experts, it seems unlikely that the tax bar would be willing to accept competency testing by the

IRS, even if those already certified as tax experts at the state level were exempt, although this

would no doubt make acceptance easier. CPAs would probably react similarly. Nonetheless,

competency testing, particularly for tax lawyers, may be worth considering. After all, most law

schools do not require students to take any tax courses.98

Even where there is a requirement, few

students take more than one or two tax courses in law school. Furthermore, many, if not most,

states do not test tax law on the bar exam at all.

If the Service cannot effectively regulate the quality of written tax planning advice

provided to individuals and other taxpayers, these taxpayers will need to protect themselves. In

at least one respect, this makes sense. The taxpayer selects his tax advisor. If the advisor does a

poor job, perhaps it should be the taxpayer who holds the advisor accountable through a

malpractice action. In a malpractice action, the taxpayer may recover a variety of damages,

97 One wonders how many tax lawyers could pass the test that enrolled agents must pass. Proposed § 10.35 would add a competency test to Circular 230 for the first time, but OPR Director Karen Hawkins has indicated that she would not be likely to rely on this provision by itself, if it is adopted, in disciplinary enforcement proceedings, but would instead assert violation of the competence standard in conjunction with asserted violations of other provisions. 98 In California, for example, only 3 or 4 out of more than 20 ABA accredited law schools require all students to take at least one tax course.

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including any penalty paid to the IRS as a result of the advisor’s malpractice.99

This seems

appropriate. Unfortunately, however, if the taxpayer avoids a penalty on reasonable cause, good

faith grounds by relying on the incompetent advisor’s advice, there is no penalty to recover from

the advisor. The advisor may escape any penalty or discipline if the statute of limitations on

Service action has expired. Depending on the context, there may be other items of damages, but

none that will have the net effect of penalizing the advisor instead of the taxpayer.

The possibility of a malpractice action also depends on the jurisdiction in which the

taxpayer can file the action. In some jurisdictions a malpractice action is likely to be precluded

by the statute of limitations. New York, for example, has a statute of limitations that favors

defendants in legal malpractice cases and might well expire before many actions would be

filed.100 California, on the other hand, tolls both its statute of repose and its statute of limitations

for such actions until the plaintiff sustains “actual injury,”101

a rule that is advantageous for a

plaintiff, although its exact application in various contexts is uncertain. Malpractice actions

against CPAs are often subject to a statute of limitations that differs from that applicable to

actions against lawyers.

Conclusion

99 See generally Michael B. Lang, Tax Malpractice: Issues and Avoidance, 54 BNA TAX MANAGEMENT MEMO. 19, 23-25 (2013), at http://ssrn.com/abstract=2235912; Jacob L. Todres, Tax Malpractice Damages: A Comprehensive Review of the Elements and the Issues, 61 TAX. LAW. 705 (2008). 100 See Jacob L. Todres, Investment in a Bad Tax Shelter: Malpractice Recovery is No Slam-Dunk, 107 TAX NOTES 217 (2005). 101 Calif. Civ. Proc. Code § 340.6(a)(1).

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There is no magic bullet that will allow the IRS to regulate the quality of tax planning

advice easily and effectively. It can improve its prospects for success by taking several steps.

First, it should retain a tax practitioner accuracy standard, not only for those kinds of advice

currently subject to the covered opinion rules, but for all written advice. This accuracy standard

should not be stated as a process rule, as is arguably the case in the covered opinion rules, but

should be stated as an objective accuracy standard. It could be incorporated into a revamped

written advice standard in section 10.37 of Circular 230.

Secondly, to the extent feasible, the Service should actively discourage taxpayers from

attempting to rely on oral tax planning advice. While it can be expected that the courts will

continue to allow unsophisticated taxpayers to rely on oral advice in some contexts, every effort

should be made to resist this when substantial transactions or tax shelters are involved.

Third, OPR should argue that 28 U.S.C. § 2462 does not apply to discipline imposed for

providing substandard written advice or, in the alternative, argue that the statute should be tolled

until the IRS knows or should know of such a violation of Circular 230.

Fourth, the IRS should make use of information available from reportable transaction

filings and Form 1120 Schedule UTPs to discover written tax opinions and advice that fail to

satisfy any practitioner accuracy standards for such advice or opinions established by Circular

230.

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Fifth, consideration should be given to competency testing for lawyers and CPAs who

provide tax planning advice. Perhaps such testing could be optional, with certification of passage

entitling the practitioner to advertise the fact and entitling her clients to a presumption of

reasonable cause, good faith reliance when acting in reliance on her advice.

Sixth, the Service should require written tax planning advice to include caveats requiring

the recipient of the advice to have the advice reviewed and updated before taking delayed action

based on the advice and before reporting an item on a tax return reflecting a transaction

implemented based on the advice.

Even if all of these steps are taken, the answer to the title question is probably: “Not very

well.” Many taxpayers will be on their own dealing with tax advisors. Taxpayers should be

reminded in IRS publications to select their tax advisors with care, be sure to provide the

advisors all important factual information and pay close attention to the advice provided,

including whether it is based on the information provided, is supported by reasonable

assumptions and seems to make sense. If the advice seems okay but nonetheless does not meet

the requisite standards and causes harm to a taxpayer, the taxpayer may have to pursue a

malpractice action on his own in order to obtain justice.