Practical Guide for Compliance with Circular 230 and the
Reportable Transaction Disclosure Framework Post-AJCA
By Susan T. Edlavitch
and Brian S. Masterson*Venable LLP, Washington, D.C.
Tax Management Memorandum Vol. 46 No. 9 May 2, 2005
[Editor’s Note: The following article was published in the May 2, 2005, issue (Vol.
46, No. 9) of Tax Management Memorandum. Accordingly, it reflects T.D. 9165, the
final Circular 230 regulations published in the December 20, 2004, Federal Register,
but does not reflect T.D. 9201, published in the May 19, 2005, Federal Register. The
latter Treasury Decision amended §10.35 of Circular 230, “Requirements for covered
opinions,” by: (1) expanding the definition of “excluded advice” in §10.35(b)(2)(ii) to
include certain advice provided after a return is filed, certain advice provided to a
practitioner’s employer, and certain negative advice; (2) modifying the definition of
“prominently disclosed” in §10.35(b)(8); and (3) modifying the definition of “the
principal purpose” in §10.35(b)(10) by adding language similar to Regs. § 1.66624(g)(2)(ii) (to the effect that tax avoidance is not the principal purpose—although tax
avoidance may be a significant purpose—if the purpose is to claim tax benefits “in a
manner consistent with the statute and Congressional purpose”). Editor’s Notes have
been added below to alert readers to significant changes made by T.D. 9201.]
Major References:
I.R.C. §§6011, 6111, 6112, 6662, 6662A, 6664, 6707, 6707A; Regs. §1.6011-4; 2004
American Jobs Creation Act, P.L. 108-357; Circular 230.
INTRODUCTION
The Treasury Department and the Internal Revenue Service (IRS) have confronted
daunting, if not insurmountable, challenges in their efforts to combat abusive tax
shelters.1 The government faces a formidable opponent—a tax shelter industry acting
in concert and, until recently, shrouded in secret.2 To date, the focus of the
government has been on enforcement action, strengthening the standards of
professional conduct, and applying stiffer sanctions.
Congress, the Securities and Exchange Commission (SEC), and the Public Company
Accounting Oversight Board (PCAOB) have stopped short of ensuring auditor
independence by separating tax consulting from the audit function. 3 Under recently
issued PCAOB proposed rules concerning auditor independence, a registered public
accounting firm would lose its independence, for audit purposes, if it engages in
providing any of the following three types of tax services to their audit clients: 4 (1)
contingent fee arrangements;5 (2) services related to tax planning or advice on certain
types of potentially abusive tax transactions;6 and (3) tax compliance and planning
services for senior officials who oversee an audit client's financial reporting. 7
Registered public accounting firms can continue to provide routine tax consulting to
audit clients, as long as the services are pre-approved by the client company's audit
committee.8
Congress also has responded by enacting legislation aimed at abusive tax avoidance
transactions and the various participants. The American Jobs Creation Act of 20049
(AJCA) includes 15 different tax shelter provisions. The new provisions generally
rewrite the old tax shelter registration and list maintenance rules of §§6111 and
611210 to bring the statutory language in line with the reportable transaction
disclosure regulations under §6011.11 In addition to providing new and increased
penalties for taxpayers and their advisors, the AJCA amended 31 USC §330 to grant
the Treasury and the IRS expanded authority to impose Circular 230 standards for
written advice and monetary penalties against practitioners who violate any provision
of Circular 230.
The new statutory and regulatory requirements and their related penalties seek to
achieve a balance between the conflicting goals of curbing abusive tax transactions
while avoiding onerous burdens on routine commerce. One theme underlying the new
rules is to create tax transparency between taxpayers and their advisors. Another
theme is to require practitioner adherence to higher standards of professional conduct
and voluntary compliance with aspirational "best practices." The final theme is to
impose stiffer penalties in order to deter taxpayers and their advisors from engaging
in misconduct.
The discussion that follows addresses these recent statutory and regulatory
developments affecting federal tax practice. To that end, this memorandum begins
with a summary of the final regulations under Circular 230, which provide "best
practices" for tax advice generally and standards for Covered Opinions and Other
Written Advice. Next, this memorandum discusses the reportable transaction
disclosure rules and the related penalty provisions affecting taxpayers and their
advisors following the AJCA. Then, this memorandum addresses the opinion
standards for protection against the accuracy-related penalties in light of revised
Circular 230 and the AJCA.
CIRCULAR 230 "BEST PRACTICES" AND WRITTEN ADVICE STANDARDS
On December 20, 2004, the Treasury Department and the IRS published final
regulations under Circular 230 in the Federal Register.12 These regulations, which
establish standards for an estimated 100,000 disclosing "practitioners" providing
Covered Opinions and Other Written Advice (as defined herein), 13 were designed
"[t]o restore, promote, and maintain the public's confidence in those individuals and
firms" providing tax advice.14 The final regulations also set forth "best practices"
applicable to all tax advice. The discussion that follows addresses these new Circular
230 rules, which apply to written advice addressing estate and gift tax issues as well
as income tax issues.15
There is a real urgency for understanding, and compliance with, the new Circular 230
practice rules, especially in light of the possibility of sanctions for their violation. 16
For the head of a firm's tax practice, the urgency is even greater, because he or she
faces special sanctions for failure to ensure compliance.17 To allow practitioners
sufficient time for compliance and to educate their clients so that expectations can be
adjusted going forward, the effective date of the final regulations was delayed until
after June 20, 2005 (six months after publication of the final regulations in the
Federal Register).18
Aspirational "Best Practices"
Section 10.33 of Circular 230 establishes "best practices" for tax advisors providing
advice to taxpayers relating to federal tax issues or submissions to the IRS. The rule
incorporates by reference all of the Circular 230 professional standards as "best
practices." The final regulations make it clear that the "best practices" are intended as
aspirational standards only. Although the Preamble underscores the need to observe
the "best practices" in order to preserve public confidence in the tax system, §10.52
specifically removes the best practices of §10.33 from those rules subject to sanction.
To render the highest quality of representation in providing tax advice and preparing
an IRS submission, tax advisors are urged to adhere to "best practices" that include
compliance with the following as well as all other Circular 230 professional
standards:19 (1) communicating clearly with the client regarding the terms of the
engagement; (2) establishing the facts by determining which facts are relevant,
evaluating the reasonableness of any assumptions or representations, relating the
applicable law (including potentially applicable judicial doctrines) to the relevant
facts, and arriving at a conclusion supported by the law and the facts; (3) advising the
client regarding the import of the conclusions reached, including whether a taxpayer
who relies on the advice may avoid accuracy-related penalties; and (4) acting fairly
and with integrity in practice before the IRS. Tax advisors with responsibility for
overseeing a firm's practice are required to take reasonable steps to ensure that the
firm's procedures for all members, associates, and employees are consistent with
these "best practices."20
Standards for Covered Opinions
Key Terms
A "Covered Opinion" is defined in §10.35(b)(2) as any written advice (including
electronic communications) by a practitioner that concerns one or more federal tax
issue(s) arising from—
a.
b.
c.
A transaction that is substantially similar to a listed transaction under Regs.
§1.6011-4(b)(2) (Listed Transaction);21
Any partnership or other entity, any investment plan or arrangement, or any
other plan or arrangement, the principal purpose of which is the avoidance or
evasion of any tax (Principal Purpose Transaction); or
Any partnership or other entity, any investment plan or arrangement, or any
other plan or arrangement, a significant purpose of which is the avoidance or
evasion of tax (Significant Purpose Transaction)
—if the opinion is a Reliance Opinion, a Marketed Opinion, is subject to conditions
of confidentiality, or is subject to contractual protection.
A "Reliance Opinion" is written advice that concludes at a confidence level of at least
"more likely than not" (a greater than 50% likelihood) that one or more significant
federal tax issues would be resolved in the taxpayer's favor.22 Although a Reliance
Opinion generally is prepared to provide protection from penalties that might be
imposed on the taxpayer, the Covered Opinion requirements are not dependent on the
offering of penalty protection, but rather are triggered by rendering a "more likely
than not" opinion intended for the taxpayer's reliance. Written advice (not involving a
Listed Transaction or Principal Purpose Transaction) with certain predominantly
disclosed opt-out language is exempt from treatment as a Reliance Opinion.
Written advice is a "Marketed Opinion" if the practitioner knows or has reason to
know that the written advice will be used or referred to by a person other than the
practitioner (or a person who is a member of, associated with, or employed by the
practitioner's firm) in promoting, marketing, or recommending a partnership or other
entity, investment plan, or arrangement to one or more taxpayer(s).23 Written advice
(not involving a Listed Transaction or Principal Purpose Transaction) with certain
predominantly disclosed opt-out language is exempt from treatment as a Marketed
Opinion.
Written advice is subject to "conditions of confidentiality" if the practitioner imposes
on one or more recipients of the written advice a limitation on disclosure of the tax
treatment or tax structure of the transaction and the limitation on disclosure protects
the confidentiality of that practitioner's tax strategies, regardless of whether the
limitation on disclosure is legally binding.24 A claim that a transaction is proprietary
or exclusive is not a limitation on disclosure if the practitioner confirms to all
recipients of the written advice that there is no limitation on disclosure of the tax
treatment or tax structure of the transaction that is the subject of the written advice. 25
Written advice is subject to "contractual protection" if the taxpayer has the right to a
full or partial refund of fees paid to the practitioner (or a person who is a member of,
associated with, or employed by the practitioner's firm) if all or a part of the intended
tax consequences from the matters addressed in the written advice are not sustained,
or if the fees paid are contingent on realization of the tax benefits from the
transaction.26
Exclusions
A Covered Opinion, by definition, exempts four categories of advice. First and most
obvious, all oral advice is excluded from the Covered Opinion requirements, since a
Covered Opinion refers only to written advice.
Second, a Covered Opinion, by definition, excludes any written advice with less than
the threshold avoidance intent evidenced by subject matter, namely, written advice
that does not concern the tax treatment of a Listed Transaction, Principal Purpose
Transaction, or Significant Purpose Transaction. Such written advice, though not a
Covered Opinion, would nevertheless be subject to the Circular 230 requirements for
Other Written Advice, discussed below.
Third, a Covered Opinion, by definition, excludes written advice (other than a
Marketed Opinion) that would otherwise be treated as a Reliance Opinion but does
not involve a "significant" federal tax issue. A federal tax issue is "significant" if the
IRS has a reasonable basis for a successful challenge and its resolution could have a
significant impact, either beneficial or adverse under any reasonably foreseeable
circumstance, on the overall federal tax treatment of the transaction(s) or matter(s)
addressed in the opinion.27 Written advice concluding that the IRS has no reasonable
basis for a successful challenge to the claimed tax treatment would not implicate a
"significant" federal tax issue. Such written advice, without satisfying the Covered
Opinion requirements, could be relied upon for penalty protection, but the opinion
would still be required to satisfy the Circular 230 requirements for Other Written
Advice.
The fourth and last category of excluded written advice also falls outside the
definition of a Reliance Opinion. A Reliance Opinion is defined in terms of written
advice concluding at a confidence level of "more likely than not" that one or more
significant federal tax issues would be resolved in the taxpayer's favor. Written
advice that concludes at a lower confidence level, such as a "substantial authority"
opinion, could escape the Covered Opinion requirements without any prominent
disclosures, assuming such written advice is not otherwise a Covered Opinion.
Section 10.35(b)(2)(ii) specifically lists the following excluded advice: (A)
preliminary advice as to which a Covered Opinion is reasonably expected to follow
and (B) written advice (other than advice pertaining to a Listed Transaction or a
Principal Purpose Transaction) that concerns the qualification of a qualified plan, is a
state or local bond opinion,28 or is included in documents filed with the SEC.29
[Editor’s Note: T.D. 9201, 70 Fed. Reg. 28824 (5/19/05), added to the list of
“excluded advice”: (C) written advice prepared for and provided to the taxpayer after
the taxpayer has filed a return reflecting the tax benefits of the transaction, unless the
practitioner knows or has reason to know that the taxpayer will rely on the written
advice to take a position on an amended return or on a subsequently filed return; (D)
written advice provided to the practitioner’s employer in the practitioner’s capacity as
an employee solely for purposes of determining the employer’s tax liability; and (E)
written advice that does not resolve a Federal tax issue favorably to the taxpayer at
any level of confidence (e.g., not frivolous), but only with respect to that issue.]
Also exempt from the Covered Opinion requirements is written advice (not
concerning a Listed Transaction or Principal Purpose Transaction) that would
otherwise constitute a Reliance Opinion or a Marketed Opinion but contains certain
prominently disclosed "opt-out" language. Language is considered "prominently
disclosed" if set forth in a separate section at the beginning of the written advice in a
bolded typeface that is larger than any other typeface used in the written advice.30
[Editor’s Note: T.D. 9201 modified the definition of “prominently displayed” to
provide somewhat greater flexibility in how the disclosure language may be
displayed. See the Editor’s Note accompanying footnote 30, below.] The "opt-out"
disclosures for avoiding Reliance and Marketed Opinions are set forth below:


Disclosure to "Opt-out" of a Reliance Opinion: This advice was not
intended or written to be used, and it cannot be used by the taxpayer, for the
purpose of avoiding penalties that may be imposed on the taxpayer.
Disclosure to "Opt-out" of a Marketed Opinion: This advice was not
intended or written to be used, and it cannot be used by any taxpayer, for the
purpose of avoiding penalties that may be imposed on the taxpayer. The
advice was written to support the promotion or marketing of the
transaction(s) or matter(s) addressed by the written advice. The taxpayer
should seek advice based on the taxpayer's particular circumstances from an
independent tax advisor.
Although the "opt-out" disclosures offer "bright-line" exceptions from the Covered
Opinion rules and are straightforward enough, implementing them will not be so
easy. Even informal written communications will now be required to include onerous
"opt-out" disclosure language not easily explained to clients.31
The "opt-out" disclosures will have obvious consequences for penalty protection
purposes. According to the Preamble to the Circular 230 final regulations, Regs.
§1.6664-4 will be amended to clarify that a taxpayer cannot rely upon written advice
that contains the "opt-out" disclosure for avoiding treatment as a Reliance Opinion or
Marketed Opinion in order to establish the "reasonable cause and good faith" defense
to the accuracy-related penalties.
After taking into account the foregoing exceptions, it becomes clear that certain
written advice constitutes a per seCovered Opinion. No exceptions are available for
written advice subject to conditions of confidentiality or written advice subject to
contractual protection. Similarly, no exceptions from the Covered Opinion definition
are provided for either a Reliance Opinion or a Marketed Opinion that concerns a
Listed Transaction or Principal Purpose Transaction. Practitioners should not be
surprised by, and most probably would not complain about the application of the
more stringent Covered Opinion rules to these categories of tax opinions.
Covered Opinion Requirements
Circular 230 begins with the basic requirement that the practitioner providing a
Covered Opinion must be competent to render such written advice by being
knowledgeable in all aspects of the relevant federal tax law. However, Circular 230
acknowledges that there may be occasions when a practitioner rendering a Covered
Opinion may need to rely on another practitioner more qualified in an area of federal
tax law relevant to one or more significant federal tax issues that the Covered
Opinion must address. Unless the practitioner knows or should have reason to know
that the other practitioner is not qualified, a practitioner is allowed to rely on the
opinion of another practitioner, as long as the opinion identifies the other opinion
relied upon and sets forth the conclusions in that other opinion. 32
A practitioner providing a Covered Opinion must comply with each of the
requirements set forth in §10.35(c) of Circular 230. Yet, no assurance is given that
compliance with the Covered Opinion requirements will shield a taxpayer from the
imposition of a penalty, since the persuasiveness of, and the taxpayer's good faith
reliance on the Covered Opinion will be evaluated separately.33 Following is a
summary of the Covered Opinion requirements:
a.
Factual matters:34
i.
Due Diligence. The practitioner must use reasonable efforts to
identify and ascertain all relevant facts, including facts relating to
future events if the transaction is prospective or proposed, and the
opinion must identify and consider all facts that the practitioner
determines to be relevant.
ii.
No unreasonable factual assumptions. The practitioner must not
base the opinion on any unreasonable factual assumptions
(including assumptions as to future events), and the opinion must
identify in a separate section all factual assumptions (including a
projection, financial forecast, or appraisal) relied upon by the
practitioner. For example, Circular 230 provides that it is
unreasonable for a practitioner to assume that a transaction has a
business purpose or is potentially profitable apart from tax benefits,
or to make an assumption with respect to a material valuation issue.
It is also unreasonable to rely on a projection, financial forecast, or
appraisal if the practitioner knows or has reason to know that the
report is incorrect or incomplete or was prepared by an unqualified
person.
iii.
No unreasonable factual representations, statements, or findings.
The practitioner must not base the opinion on any unreasonable
factual representations, statements or findings of the taxpayer or
any other person, and the opinion must identify in a separate
section all factual representations, statements or findings of the
taxpayer relied upon by the practitioner. It is unreasonable to rely
on a factual representation that the practitioner knows or should
know is incorrect or incomplete. For example, a practitioner may
not rely on a factual representation that a transaction has a business
purpose if the representation does not include a specific description
of the business purpose or the practitioner knows or should know is
incorrect or incomplete.
b.
c.
d.
e.
f.
Application of law to facts. The opinion must relate the applicable law
(including potentially applicable judicial doctrines) to the relevant facts and
must not contain any internally inconsistent legal analyses or conclusions.
The practitioner must not assume the favorable resolution of any significant
federal tax issue, except as permitted in a Limited Scope Opinion, as
discussed below, or an opinion that relies in part on another opinion, or
otherwise base an opinion on any unreasonable legal assumptions,
representations, or conclusions.
Evaluation of all significant federal tax issues. The opinion must consider all
significant federal tax issues, except as permitted in a Limited Scope
Opinion or an opinion that relies in part on another opinion, and the opinion
must provide the practitioner's conclusion as to the likelihood that the
taxpayer will prevail on the merits with respect to each significant federal
tax issue, or else state that the practitioner is unable to reach a conclusion
with respect to one or more issues, and describe the reasons for the
conclusion(s) or failure to reach such conclusion(s). If the practitioner fails
to reach a "more likely than not" conclusion with respect to one or more
significant federal tax issue, the opinion must include the appropriate
disclosure(s), described below. In evaluating the significant federal tax
issue(s), the opinion must not take into account the possibility that a tax
return will not be audited, that an issue will not be raised on audit, or that an
issued will be resolved through settlement if raised.
Overall conclusion. The opinion must provide the practitioner's overall
conclusion as to the likelihood that the federal tax treatment of the subject
transaction or matter is the proper treatment and the reasons for the
conclusion. If the practitioner is unable to reach an overall conclusion, the
opinion must state that the practitioner is unable to reach an overall
conclusion and describe the reasons for the inability to reach a conclusion. A
marketed opinion must provide the practitioner's overall conclusion that the
federal tax treatment of the subject transaction or matter is the proper
treatment at a confidence level of at least "more likely than not."
Limited Scope Opinion. A practitioner may provide a "Limited Scope
Opinion" that considers less than all of the significant federal tax issues,
provided that (1) the practitioner and the taxpayer agree that reliance for
penalty avoidance purposes is limited to the federal tax issue(s) addressed in
the opinion; (2) the opinion does not involve a Listed Transaction, Principal
Purpose Transaction, or a Marketed Opinion; and (3) the opinion includes
the required disclosure(s). A practitioner may make a reasonable assumption
regarding the favorable resolution of a federal tax issue but must identify in
a separate section of the opinion all issues for which a favorable resolution is
assumed.
Marketed Opinion special rules. A Marketed Opinion must include the
required disclosure(s). A Marketed Opinion must evaluate all of the
significant federal tax issues and provide a conclusion that the taxpayer will
prevail on the merits at a confidence level of at least "more likely than not"
conclusion with respect to each significant federal tax issue addressed. The
practitioner is not permitted to provide a Marketed Opinion if unable to
reach a "more like than not" conclusion with respect to each significant
federal tax issue. In that case, the practitioner may render written advice
only if the non-marketed opinion "opt-out" disclosure is provided.
Of the Covered Opinion requirements, two are most troublesome, especially as
applied to what previously were informal tax opinions. One is the extensive factual
due diligence that must be undertaken and recorded in the opinion. Practitioners
frequently rely on factual assumptions in rendering informal advice, but are now told
that it is unreasonable, for example, to make a valuation assumption (if value is a
material issue) or to assume that a transaction has a business purpose. Similarly, the
informal opinion practice of relying on factual descriptions provided by a colleague
close to the transaction would not satisfy the factual due diligence requirement of a
Covered Opinion. The opinion can make reasonable assumptions concerning a
projection, financial forecast, or appraisal, as long as the report is evaluated for
completeness and correctness. Any and all factual assumptions must be identified in a
separate section of the opinion. Likewise, practitioners can continue to rely on
reasonable taxpayer factual representations through an Officer's Certificate or a thirdparty factual representation, provided the opinion identifies in a separate section all
such representations, statements, or findings relied upon.
The other troublesome requirement is the detailed analysis required in applying the
law to the facts. Practitioners well aware of the applicable judicial doctrines have a
sense of when a step transaction analysis, for example, is appropriate under the
circumstances. For deals driven by genuine business considerations, an analysis of the
economic substance might have been thought unnecessary when opining informally.
Whether it is appropriate to conduct an extensive analysis of the facts under the
applicable judicial doctrines is no longer a matter of seasoned professional judgment
in informal opinions. The Covered Opinion requirements apply with equal force to
informal opinions. Yet, many clients accustomed to receiving informal opinions do
not want to pay for such an extensive analysis.
Certainly, with many routine transactions, the tax treatment may be clear and may not
raise a "significant" federal tax issue. In such cases, the tax practitioner is free to give
informal written advice not subject to the Covered Opinion requirements. In other
cases, however, the tax practitioner faces a quandary. Assuming the subject
transaction is not a Listed Transaction or a Principal Purpose Transaction, the tax
practitioner can provide either written tax advice with "opt-out" disclosure
language—leaving the client with little confidence in the advice given—or else a fullblown Covered Opinion—at significantly greater cost to the client.
For the client who requests targeted advice but still expects penalty protection, the
compromise offered by Circular 230 is a Limited Scope Opinion with disclosure. The
Limited Scope Opinion enables a practitioner to provide a "more likely than not"
opinion on selected significant federal tax issues, without having to comply with the
Covered Opinion requirements for the other federal tax issues. However, as discussed
below, the Limited Scope Opinion must prominently disclose that it cannot be used
for penalty protection purposes on the federal tax issues not addressed therein.
Unfortunately, this disclosure language may suggest a lack of confidence in the
advice and will likely have a chilling effect on the client relations.
Covered Opinion Disclosures
The Covered Opinion must include certain required disclosures that are designed to
provide taxpayers with the information necessary to evaluate and rely on the written
advice. The practitioner cannot provide advice that is contrary to or inconsistent with
a required disclosure. The required disclosures are as follows:35

Disclosure of relationship between promoter and practitioner: An
opinion must prominently disclose the existence of (1) any compensation
arrangement, such as a referral fee or a fee-sharing arrangement, between the
practitioner (or the practitioner's firm or any person who is a member of,
associated with, or employed by the practitioner's firm) and any person



(other than the client for whom the opinion is prepared) with respect to
promoting, marketing, or recommending the (or any similar) entity, plan, or
arrangement that is the subject of the opinion; or (2) any referral agreement
between the practitioner (or the practitioner's firm or any person who is a
member of, associated with, or employed by the practitioner's firm) and a
person (other than the client for whom the opinion is prepared) engaged in
promoting, marketing, or recommending the (or any similar) entity, plan, or
arrangement that is the subject of the opinion.
Marketed Opinion disclosure: A Marketed Opinion must prominently
disclose that (1) the opinion was written to support the promotion or
marketing of the transaction(s) or matter(s) addressed in the opinion; and (2)
the taxpayer should seek advice based on the taxpayer's particular
circumstances from an independent tax advisor.
Limited Scope Opinion disclosure: The Limited Scope Opinion must
prominently disclose that (1) the opinion is limited to one or more federal
tax issues(s) addressed in the opinion; (2) additional issues may exist that
could affect the federal tax treatment of the transaction or matter that is the
subject of the opinion and the opinion does not consider or provide a
conclusion with respect to any additional issues; and (3) with respect to any
significant federal tax issues outside the limited scope of the opinion, the
opinion was not written, and cannot be used by the taxpayer, for the purpose
of avoiding penalties that may imposed on the taxpayer.
Disclosure for opinion that fails to reach a "more likely than not"
conclusion: An opinion that fails to reach a confidence level of at least
"more likely than not" with respect to a significant federal tax issue must
prominently disclose that (1) the opinion does not reach a conclusion at a
confidence level of at least "more likely than not" with respect to one or
more significant federal tax issues addressed by the opinion; and (2) with
respect to those significant federal tax issues, the opinion was not written,
and cannot be used by the taxpayer, for the purpose of avoiding penalties
that may be imposed on the taxpayer.
As a practical matter, the new Circular 230 rules effectively shut down the ability to
issue and mass market a Marketed Opinion concerning a Listed Transaction or a
Principal Purpose Transaction because of the more onerous requirements that attach
to this form of Covered Opinion. The Marketed Opinion must reach an overall
conclusion at a confidence level of "more likely than not." To reach such a
conclusion, the Marketed Opinion must address each significant federal tax issue and
satisfy all of the Covered Opinion requirements, without exception, since a Marketed
Opinion cannot be a Limited Scope Opinion. Factual assumptions relating to business
purpose or that the transaction is potentially profitable apart from the tax benefits are
not permitted in a Covered Opinion. The Marketed Opinion must also include certain
required disclosures and, to the extent applicable, disclosures concerning conditions
of confidentiality, contractual protection, and any relationship between the promoter
and practitioner.
Standards for Other Written Advice
Standards for written advice outside the definition of a Covered Opinion are governed
by §10.37. A practitioner must not give Other Written Advice if the practitioner (1)
bases the written advice on unreasonable factual or legal assumptions; (2)
unreasonably relies upon representations, statements, finding or agreement of the
taxpayer or any other person; (3) fails to consider all relevant facts; or (4) takes into
account the possibility that a tax return will not be audited, that an issue will not be
raised on audit, or that an issue will be settled.
As discussed, most written tax advice will fall outside of the Covered Opinion
definition and will be subject to these rather vague rules for Other Written Advice.
We are simply told that the scope of the engagement and the type and specificity of
the advice sought by the client, in addition to other facts and circumstances, will be
considered in determining whether a practitioner has failed to comply with the
requirements. A more useful directive is found in the Preamble, which states that
§10.37, unlike §10.35, does not require the practitioner to describe in the written
advice the relevant facts (including assumptions and representations), the application
of the law to those facts, or the practitioner's conclusion with respect to the law and
the facts.
Also unclear is the extent of the tax practitioner's accountability under Circular 230
for Other Written Advice conveyed to a client by another firm attorney. The tax
practitioner in a firm often provides oral or informal written tax advice concerning the
structuring of a transaction to a transaction attorney, who is responsible for
implementing the recommended tax structure. The tax practitioner may send an
internal e-mail suggesting a tax structure to the transaction attorney, who then
communicates the information to the client orally or may even forward the tax
practitioner's e-mail to the client. Because the tax practitioner presumably would be
responsible for such tax advice conveyed by another firm attorney to the client and
the forwarded e-mail would be subject to scrutiny under Circular 230, tax
practitioners will now have to monitor these internal communications more closely.
DISCLOSURE FRAMEWORK POST-AJCA
Historically, Congress and the IRS have attempted to discourage taxpayers from
participating in and tax practitioners from promoting abusive tax shelters through a
series of required disclosures—reportable transaction disclosures by taxpayers, tax
shelter registration by advisors and investor list maintenance rules. As discussed more
fully below, the enactment of the AJCA not only modified this framework but more
importantly added several new penalty provisions that impose significant penalties on
taxpayers and their advisors for failing to make the required disclosures.
Taxpayer Disclosure of Reportable Transactions
Required Disclosure
The regulations under §6011 provide that any taxpayer, including an individual, trust,
estate, partnership, S corporation, or other corporation, that has participated36 in a
reportable transaction and is required to file a U.S. federal income tax return or
information return must attach a disclosure statement to its tax return. There are six
categories of reportable transactions, sometimes also referred to as "filters"—(1)
Listed Transactions,37 (2) confidential transactions,38 (3) transactions with contractual
protection,39 (4) loss transactions,40 (5) transactions with a significant book-tax
difference,41 and (6) transactions involving a brief asset holding period. 42 The
regulations also provide that the status of a particular transaction as a reportable
transaction under Regs. §1.6011-4(b) does not affect the legal determination of
whether the taxpayer's treatment of the transaction is proper.43
To disclose participation in a reportable transaction, the regulations require most
taxpayers to complete and attach Form 8886, Reportable Transaction Disclosure
Statement, to their returns (or amended returns in the case of a loss carry-back that
results in a reportable transaction).44 Such taxpayers must also send a copy of Form
8886 to the Office of Tax Shelter Analysis (OTSA) at the same time.45 For taxable
years ending on or after December 31, 2004, certain corporate taxpayers may satisfy
the disclosure requirement for significant book-tax differences by filing a completed
Schedule M-3, rather than Form 8886, with its timely filed original tax return for the
taxable year at issue.46 Such taxpayers also must send a copy of their Schedule M-3 to
the OTSA. Schedule M-3, Net Income (Loss) Reconciliation for Corporations with
Total Assets of $10 Million or More, is a new attachment to Form 1120, U.S.
Corporation Income Tax Return. Of course, corporate taxpayers filing Schedule M-3
must file Form 8886 if they participate in a transaction that falls within one of the
other five reportable transaction categories.
Penalties for Failure to Disclose Reportable Transactions
Through the AJCA, Congress recently added new §6707A,47 which imposes penalties
on taxpayers who fail to disclose reportable transactions. Under this provision, the
penalty for failing to disclose a reportable transaction (other than a Listed
Transaction) is $10,000 for individuals and $50,000 for all other taxpayers. 48 The
penalty for failing to disclose a Listed Transaction is $100,000 for individuals and
$200,000 for all other taxpayers.49 Taxpayers required to file periodic reports with the
SEC must disclose the imposition of this penalty on their SEC filings. 50 Specifically,
SEC filing companies must disclose payment of penalties under §§6707A (penalty for
failure to disclose a any reportable transaction under §6011), 6662A (30% penalty
relating to understatement attributable to undisclosed Listed Transaction and
reportable avoidance transaction), and 6662(h) (gross valuation misstatement penalty
attributable to undisclosed Listed Transaction or reportable avoidance transaction).
The failure to make this disclosure to the SEC is considered a failure to disclose a
Listed Transaction.51
In advance of forthcoming regulations under §6707A, the IRS has issued interim
guidance providing that the penalty under §6707A applies to each failure to disclose a
reportable transaction in a timely manner and in the prescribed form.52 Thus, for
example, if a taxpayer dutifully attaches Form 8886 to its original or amended federal
income tax return but fails to provide a copy of Form 8886 to the OTSA, the §6707A
penalty will apply because the taxpayer failed to comply with both disclosure
requirements.
With the exception of penalties imposed for failing to disclose a Listed Transaction,
which have strict liability, the IRS may rescind all or any portion of the penalty
imposed under §6707A if rescinding the penalty would promote compliance with the
tax laws and effective tax administration.53 Because the IRS Commissioner must
report annually to Congress regarding the total number and aggregate amount of
penalties imposed and rescinded under §6707A,54 the IRS may be even less inclined
to waive §6707A penalties. The IRS's denial of a rescission request is not subject to
judicial review.55
The §6707A penalty applies to tax returns and statements due after October 22, 2004,
the date of AJCA's enactment. A potential trap for the unwary can arise if a
transaction becomes a Listed Transaction after the taxpayer has filed the tax return for
the relevant taxable year but before the taxable year has closed. In such case, the
regulations under §6011 require the taxpayer to file Form 8886 as an attachment to its
next tax return filed after the date the transaction was listed disclosing that it
participated in a Listed Transaction in a prior taxable year even though the transaction
at issue was not a Listed Transaction when the taxpayer filed its tax return for the
prior taxable year.56 Disclosure is required not only in the subsequent year in which
the transaction becomes a Listed Transaction, but for each year that the taxpayer
participates in and receives tax benefits from the transaction. Failing to disclose a
subsequently declared Listed Transaction after October 22, 2004, will trigger a
penalty under §6707A.
To avoid foot-faulting into the failure to disclose penalty, taxpayers must closely
monitor the IRS's published guidance regarding new Listed Transactions to determine
whether transactions from prior taxable years that remain open are the same or
substantially similar to a new Listed Transaction. It is unclear whether written advice
opining as to whether a transaction completed in a prior open taxable year is
substantially similar to a transaction characterized as a Listed Transaction in a
subsequent taxable year constitutes a Circular 230 Covered Opinion if the tax
practitioner does not opine as to the proper tax treatment of the transaction at issue.
To err on the side of caution and ensure avoidance of the Covered Opinion
requirements, the written advice could include the Limited Scope Opinion disclosure.
Amended Accuracy-Related Penalty
With a few notable exceptions discussed below, the AJCA left the accuracy-related
penalty under §6662(a) largely unchanged. Section 6662(a) imposes a penalty equal
to 20% of the tax underpayment attributable to certain types of misconduct. Section
6662(b) specifies five categories of misconduct: (1) negligence or disregard of the
rules or regulations;57 (2) any substantial understatement of income tax; (3) any
substantial valuation misstatement; (4) any substantial overstatement of pension
liabilities; and (5) any substantial estate or gift tax valuation understatement. Section
6662 includes special rules that apply to tax shelters.
For purposes of §6662, a "tax shelter" is defined as a partnership or other entity, any
investment plan or arrangement, or any other plan or arrangement, "if a significant
purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion
of Federal income tax" (a "Tax Shelter").58 Thus, post-AJCA, a Tax Shelter includes
any Reportable Avoidance Transaction and any other transaction with a significant
purpose of tax avoidance or evasion. Transactions that are reportable under Regs.
§1.6011-4 but lack a significant purpose of tax avoidance, by definition, should not
qualify as a Tax Shelter.
The accuracy-related penalty is tied to key definitions in §6662(d). A "substantial
understatement" is defined as the excess of the amount of tax required to be shown on
the return over the amount that is shown on the return.59 The AJCA modified the
substantial understatement threshold for corporations to be the lesser of (1) 10% of
the tax required to be shown on the return (or, if greater, $10,000), or (2)
$10,000,000.60 An understatement does not include amounts attributable to: (1) a
position (not involving a tax shelter) that is supported by substantial authority, 61 or
(2) a position that has a reasonable basis and is adequately disclosed. 62 Pre-AJCA, the
reasonable basis and adequate disclosure exception described above was available to
non-corporate taxpayers if there was substantial authority for the taxpayer's position
and the taxpayer was able to demonstrate that at the time he filed the return he
reasonably believed that his treatment of the Tax Shelter item was more likely than
not the proper treatment.63 This relief was not available to corporate taxpayers.
Congress attempted to close this loophole by amending §6662(d)(2)(C)(i) to provide
that no taxpayer may reduce the amount of its understatement attributable to a Tax
Shelter item.64 Perhaps, an unintended consequence of this statutory change was that
any attempt post-AJCA to reduce or eliminate the accuracy-related penalty
attributable to a Tax Shelter item relies exclusively upon the "reasonable cause and
good faith" exception of §6664(c), which effectively reinstates the pre-AJCA
distinction between corporate and non-corporate taxpayers.
The existing regulations under §6664(c) provide a special rule for corporate taxpayers
that have participated in a Tax Shelter. Specifically, the rule provides that in order for
a corporate participant in a Tax Shelter to qualify for the "reasonable cause and good
faith" exception, the corporation must be able to demonstrate that it reasonably
believed, at the time the return was filed, that its tax treatment of the transaction was
more likely than not the proper treatment.65 In most cases, such belief would be
evidenced by reliance upon an opinion of a nondisqualified tax advisor concluding
that there was a greater than 50% likelihood that the taxpayer's treatment of the
transaction was correct. In contrast, non-corporate taxpayers may invoke the
"reasonable cause and good faith" exception upon a showing of a "reasonable basis"
for the tax reporting position.66 The "reasonable basis" standard is greater than
"substantial authority" but less "more likely than not," which effectively reinstates
pre-AJCA distinction in pre-2004 AJCA §6662(d)(2)(C)(i). Presumably, the IRS can
resolve this issue easily by amending the regulations under §6664 to expand the
"more likely than not" standard of belief to all taxpayers, not just corporations, that
participate in a Tax Shelter.
Disclosures under certain circumstances affect the ability to establish the exception,
however.67 A taxpayer may not rely on an opinion or advice that a regulation is
invalid, unless the taxpayer adequately disclosed the position that the regulation in
question is invalid.68 Further, if any portion of an underpayment is attributable to a
"reportable transaction," within in the meaning of §6011, then failure by the taxpayer
to disclose the transaction is a strong indication that the taxpayer did not act in good
faith with respect to the portion of the underpayment attributable to the reportable
transaction.69
One final point worth noting with respect to the accuracy-related penalty of §6662,
and any other penalty for that matter, is that in June of 2004, the IRS released a Chief
Counsel's Notice (CC-2004-036) reminding attorneys in the Office of Chief Counsel
that they should not use the waiver of penalties as a bargaining tool in taxpayer
settlement discussions, because doing so undermines the role of penalties in tax
administration. In particular, this notice admonishes Chief Counsel attorneys to
evaluate penalties based on their respective merits and hazards of litigation
independent of the underlying tax adjustments.
Heightened Accuracy-Related Penalty for Certain Reportable Transactions
As part of the government's effort to discourage taxpayers from participating in tax
shelters and other tax avoidance transactions, Congress enacted new §6662A,
effective for taxable years ending after October 22, 2004. 70 Section 6662A imposes a
new accuracy-related penalty on any Listed Transaction and any reportable
transaction (other than a Listed Transaction) the significant purpose of which is the
avoidance or evasion of U.S. federal income tax (Reportable Avoidance
Transaction).71 Unlike a Listed Transaction, a Reportable Avoidance Transaction may
have a potential for tax avoidance but the return position ultimately may be sustained
on the merits and accepted by the IRS.
The Reportable Avoidance Transaction concept is particularly problematic due to the
difficulty of actually determining what constitutes "a significant purpose of tax
avoidance or evasion." Moreover, the similarity between a Reportable Avoidance
Transaction, for purposes of §6662A, and a Significant Purpose Transaction, within
the meaning of Circular 230, further complicates matters. Conceptually, a Reportable
Avoidance Transaction represents a subset of the Significant Purpose Transaction,
namely, those Significant Purpose Transactions that fall within one of the six filters
for which disclosure is required under §6011. To date, the IRS has not issued
meaningful guidance with respect to the meaning of a Significant Purpose
Transaction or "a significant purpose of tax avoidance or evasion." Such guidance is
necessary given the significance placed upon the phrase "a significant purpose of tax
avoidance or evasion" in Circular 230 and the reportable transaction disclosure
framework post-AJCA.
Certain reportable transactions filters, such as contractual protection, confidentiality,
or the brief asset holding period, are more likely to have a significant purpose of tax
avoidance or evasion and, thus, to trigger the §6662A penalty. Each of the other two
reportable transaction filters, losses, and significant book-tax differences, may have a
real business nexus and, under certain circumstances, should arguably be subject only
to the §6662 accuracy-related penalty. Section 6662 will continue to apply to those
Reportable Avoidance Transactions not described in §6662A.
In contrast to the accuracy-related penalty of §6662, which only applies if there is a
substantial understatement of taxes due, the new accuracy-related penalty under
§6662A applies if there is an increase in taxable income or a reduction in tax credits
allowed due to the disallowance of the intended tax benefits of the reportable
transaction. Accordingly, a taxpayer may be subject to a penalty under §6662A even
though there is no understatement (e.g., the taxpayer has a net operating loss before
and after the IRS's adjustment). Although any tax understatement upon which a
penalty is imposed under §6662A is not also subject to the accuracy-related penalty
of §6662, the amount of the tax understatement will be increased by the amount of
the reportable transaction understatement for purposes of determining whether the tax
understatement is substantial under §6662, as amended by the AJCA. 72
To illustrate the interplay between the two accuracy-related penalties, assume that
Corporation X reports and pays taxes of $10 million on its 2005 return. Two years
later, following an audit of this return, the IRS disallows $10 million of losses
claimed on the return in connection with a Reportable Avoidance Transaction and
recharacterized $3 million of previously deducted expenses as non-deductible capital
expenditures. These adjustments resulted in a $4.5 million understatement, of which
$3.5 million was attributable to the Reportable Avoidance Transaction and $1 million
was attributable to the recharacterization of the capital expenditures. Assuming the
reasonable cause and good faith exception does not apply, $3.5 million of the gross
understatement will be subject to §6662A (the "reportable transaction
understatement"). As noted above, the reportable transaction understatement also
factors into determining whether the remaining portion of the understatement is
"substantial" for purposes of §6662. Without the $3.5 million reportable transaction
understatement, the remaining $1 million of the gross understatement would not be
"substantial" under §6662(d) ($1 million does not exceed 10% of the $14.5 million in
taxes due in 2005 or $10 million). However, when the reportable transaction
understatement is taken into account for this purpose, the $1 million understatement
is deemed to be "substantial" for purposes of §6662, as amended by the AJCA.
The penalty rate under §6662A is 20% of the understatement attributable to the
offending transaction if the taxpayer previously disclosed its participation in the
transaction pursuant to the regulations under §6011, and 30% if the taxpayer did not
adequately disclose the relevant facts affecting the tax treatment of the transaction.73
Like payment of a §6707A penalty, a taxpayer required to file periodic reports with
the SEC must disclose payment of a §6662A penalty in its SEC filings if the
applicable §6662A rate is 30%.74 Failing to make this disclosure could result in the
imposition of an additional $200,000 penalty under §6707A.75
To determine the amount of the §6662A penalty, the applicable rate is applied to the
amount of the "reportable transaction understatement," which, as noted above, is not
synonymous with a "substantial understatement of income tax" within the meaning of
§6662. The "reportable transaction understatement" is calculated as follows:
(a) Determine the increase, if any, in taxable income that results from the
proper tax treatment of an item affected by a reportable transaction subject to
§6662A.
(b) Multiply the above increase by the highest applicable tax (35% for both
corporations and individuals).
(c) Plus the decrease, if any, in the aggregate amount of tax credits due to the
proper tax treatment of the reportable transaction.76
Unlike the §6707A penalty, which does not have a "reasonable cause and good faith"
exception, Congress provided such an exception for the §6662A accuracy-related
penalty.77 New §6664(d) provides that a showing of reasonable cause is predicated
upon (1) the taxpayer's disclosure of the reportable transaction under Regs. §1.60114,78 (2) substantial authority for the taxpayer's treatment, and (3) a finding that the
taxpayer reasonably believed that its treatment of the transaction was more likely than
not the proper treatment.79 Because the reasonable cause exception requires that the
taxpayer adequately have disclosed its participation in a reportable transaction, the
failure to do so not only precludes the taxpayer from qualifying for the reasonable
cause exception, it also increases the §6662A penalty rate from 20% to 30%. Put
another way, the reasonable cause exception of §6664(d) only seems to apply if the
applicable §6662A penalty rate is 20%.
A taxpayer will be considered to have a reasonable belief with respect to the tax
treatment of an item only if such belief (1) is based on the facts and law in existence
at the time the taxpayer filed its tax return for the year in question; and (2) relates
solely to the taxpayer's chances of success on the merits and does not take into
account the possibility that (i) a return will not be audited, (ii) the treatment will not
be raised on audit, or (iii) the treatment will be resolved through settlement if raised. 80
As discussed below, the "reasonable belief" rules of §6664(d)(3) contemplate that the
taxpayer may rely on a tax opinion and are similar to the Circular 230 Covered
Opinion requirements.
Material Advisor Disclosure of Reportable Transactions
As part of the AJCA, Congress replaced the registration of tax shelters concept under
former §6111 with the requirement that each material advisor with respect to any
reportable transaction (within the meaning of the §6011 regulations) timely file an
information return with the IRS.81 Amended §6111 provides that the information
return will include (1) information identifying and describing the transaction, (2)
information describing any potential tax benefits expected to result form the
transaction, and (3) such other information the Secretary of the Treasury may
require.82 For purposes of amended §6111, the term "material advisor" means any
person (1) who provides any material aid, assistance, or advice with respect to
organizing, managing, promoting, selling, implementing, insuring, or carrying out
any reportable transaction; and (2) who directly or indirectly derives gross income
from such advice or assistance in excess of certain minimum thresholds ($50,000 for
noncorporate persons or $250,000 for corporations). 83 For Listed Transactions, the
minimum fee threshold is reduced to $10,000 for noncorporate persons and $50,000
for corporations.84
The IRS has issued interim guidance for material advisors specifying that material
advisors use Form 8264, Application for Tax Shelter Registration, with certain
modifications to comply with amended §6111 until it revises this form or issues
another form for this purpose. 85 Notice 2005-2286 provides that a person will be
treated as becoming a material advisor upon the occurrence of each of the following
events: (1) material advisor makes a tax statement, (2) material advisor receives (or
expects to receive) the minimum fee, and (3) the taxpayer enters into the transaction.
A material advisor must file Form 8264 by the last day of the month that follows the
end of the calendar quarter in which the advisor becomes a material advisor. 87 Thus,
if a person became a material advisor after October 22, 2004, and on or before March
31, 2005, that person must file Form 8264 before April 30, 2005. For substantially
similar transactions, a material advisor is required to file only one Form 8264. 88
The AJCA also significantly amended §6707,89 which previously imposed a penalty
on persons who failed to register tax shelters under former §6111. Effective for
information returns due after October 22, 2004, amended §6707 now imposes a
penalty on any material advisor who fails to file the information return required under
amended §6111, or who files a false or incomplete information return. 90 The amount
of the penalty is $50,000, unless the reportable transaction is a Listed Transaction, in
which case the amount of the penalty increases to the greater of (1) $200,000, or (2)
50% (75% in the case of an intentional disregard of the requirement to file an
information return) of the gross income derived by such person from the
transaction.91 Amended §6707 incorporates by reference the limited waiver authority
of new §6707A.92 As with waivers of the §6707A penalty, the IRS Commissioner
must report to Congress regarding waivers of penalties under §6707.
Investor List Maintenance Rules
The AJCA amended §6112 to provide that each material advisor with respect to any
reportable transaction is required to maintain a list that identifies each person with
respect to whom such advisor acted as a material advisor with respect to the
reportable transaction.93 Any person who is required to maintain this list is required to
make the list available to the IRS for inspection upon its written request.94 If a
material advisor fails to provide the investor list material to the IRS within 20
business of the request, §6708, which was also amended by the AJCA,95 imposes a
$10,000 per day penalty for each day after the 20th day. 96
Extended Statute of Limitations for Undisclosed Listed Transactions
In addition to the §6707A penalty for failure to disclose a reportable transaction, new
§6501(c)(10) extends the statute of limitations for assessment of the tax liability
associated with the Listed Transaction until one year after the earlier of (1) the date
on which the taxpayer makes the required disclosure under §6011, or (2) the date a
material advisor makes its required investor list maintenance disclosure. For example,
if a transaction undertaken in 2005 becomes a Listed Transaction in 2007 and the
taxpayer fails to disclose the transaction as required, the transaction is subject to the
extended statute of limitations, and the §6707A failure to disclose penalty can apply
as well.97 The amendment is effective for tax years that are still open on the date of
enactment, October 22, 2004.
OPINION STANDARDS FOR ACCURACY-RELATED PENALTY
PROTECTION POST-AJCA
Taxpayers have long been able to rely on an opinion from a professional tax advisor
in support of various exceptions, including the §6664(c) "reasonable cause and good
faith" exception, to the accuracy-related penalties under §6662.98 While leaving intact
this "reasonable cause and good faith" exception as a defense to the accuracy-related
penalty of §6662, the AJCA introduced a new "reasonable cause and good faith"
exception in §6664(d) applicable to the heightened penalties under §6662A for Listed
Transactions and Reportable Avoidance Transactions.
For any penalty protection opinion issued post-AJCA, careful crafting of the tax
opinion cannot be overestimated. A tax opinion, even one rendered by a prominent
law firm, is not per se penalty protection for the taxpayer. This is the lesson to be
learned not only from the new Circular 230 rules and the disclosure framework but
also from the recent decision in Long Term Capital Holdings.99
In denying the hedge fund's capital losses by either disregarding the transaction or
recasting it under the step transaction doctrine, the U.S. District Court in Long Term
Capital Holdingsconcluded that the tax shelter transaction had no business purpose
other than tax avoidance and lacked economic substance beyond the creation of tax
benefits. Of significance here is that the court upheld the IRS's application of the 40%
gross valuation misstatement penalty under §6662(h) or, in the alternative, the 20%
substantial understatement penalty under §6662(a). In doing so, the court took pains
to provide a 40-page critique of the underlying legal opinions.
The facts and circumstances failed to demonstrate reasonable reliance on any prefiling tax advice for several reasons. No written opinion was issued before the filing
date of the tax return, and the testimony concerning reliance on prior oral advice was
either too vague or inconsistent to support a finding of reasonable reliance. The court
concluded that the written opinion, even if provided prior to the filing date, would
have failed to satisfy the threshold requirements for reasonable good faith reliance.
The opinion expressly relied on, without independent evaluation, various
representations and assumptions concerning business purpose and the expectation of
a material pre-tax profit. The opinion also contained what appeared to be a canned
discussion of the judicial doctrines, since no attempt was made to analyze the
applicable law of the Second Circuit. Nor was there any file memoranda providing
further analysis in support of the opinion. Though aspects of the decision may be
subject to criticism,100 practitioners must heed the teachings of Long Term Capital
Holdings, which sound very similar to the Covered Opinion requirements under
Circular 230.
As discussed below, the Covered Opinion requirements under Circular 230 largely
parallel the AJCA disclosure and penalty framework. The Reliance Opinion
confidence level tracks the penalty protection confidence level required for a
transaction with "a significant purpose of tax avoidance or evasion." Certainly, in the
view of Long Term Capital Holdings, many of the other Covered Opinion
requirements reflect the standards already required of a tax shelter opinion intended
for penalty protection purposes. Post-AJCA, the Covered Opinion requirements are
legislated by §6664(d) as well as Circular 230.
Depending on the exception applicable to the misconduct, the confidence level
standard for a tax opinion ranges from "reasonable basis," "realistic possibility," and
"substantial authority" to "more likely than not." 101 The "reasonable basis" position
generally has been viewed, despite disagreement among commentators, as having a
10-20% or 20-25% likelihood of success.102 The "realistic possibility" standard is a
reporting position that has a one-in-three, or greater, possibility of being sustained on
the merits.103 The "substantial authority" position reflects some percentage higher
than a "reasonable basis" position but below "a greater than 50%" certainty. 104 The
"more likely than not" standard is defined as a greater than 50% likelihood of the
reporting position being upheld.105
Technically, there are two confidence level standards for a tax opinion prepared for
protection from the accuracy-related penalties post-AJCA. In the case of a non-Tax
Shelter item or a transaction without "a significant purpose of tax avoidance or
evasion," a tax opinion could conclude at a confidence level of at least a "reasonable
basis" for purposes of §6662 penalty protection. In the case of a corporate Tax Shelter
item under §6662 or for purposes of the reportable transaction understatement penalty
under §6662A,106 the tax opinion must conclude at the higher confidence level of at
least "more likely than not." Although a tax opinion could still provide penalty
protection for a non-shelter item based on a confidence level of less than "more likely
than not," few taxpayers would be willing to pay for opinions offering such limited
protection, absent government clarification of what constitutes "a significant purpose
of tax avoidance or evasion."
The higher confidence level is required whenever a transaction has "a significant
purpose of tax avoidance or evasion"—namely, a corporate Tax Shelter under
§6662(d), a Reportable Avoidance Transaction under §6662A, or a Significant
Purpose Transaction under the Circular 230 definition of a Covered Opinion.
Unfortunately, the phrase "a significant purpose of tax avoidance or evasion," despite
its prevalence in federal tax law, is not easily defined. Any transaction resulting in a
significant tax savings arguably is caught by this web.
On the other hand, statutorily permitted tax-free exchanges, such as a non-recognition
transaction under §1031 or §368, arguably should escape the web, if the transaction
falls within well-defined regulatory or other published guidelines. That is to say, if
the IRS would have no reasonable basis for challenging a federal tax issue material to
the transaction's qualification for tax-free treatment, then the transaction should lack
"a significant purpose of tax avoidance or evasion." At least this proffered distinction
is consistent with the definition of a Reliance Opinion. Written advice does not
constitute a Reliance Opinion and, thus, need not satisfy the Covered Opinion
requirements, if the written advice concerns a transaction that does not implicate a
"significant" federal tax issue as to which the IRS has a reasonable basis to challenge.
Further guidance defining "a significant purpose of tax avoidance or evasion" would
obviously be helpful. Whether such guidance will be forthcoming is another matter.
The government may simply be reluctant to issue "angel lists" similar to those
provided for reportable transaction disclosure under §6011. Given the difficulty in
determining what constitutes "a significant purpose of tax avoidance or evasion," in
the absence of clear guidance, the better practice—and certainly the more prudent
practice—would be to use a "more likely than not" confidence level in all tax
opinions written for purposes of penalty protection.
Therefore, as a practical matter, a Reliance Opinion concluding with a confidence
level of "more likely than not" has been legislated for nearly all written advice
intended to be used for penalty protection purposes. If a tax practitioner uses another
confidence level standard, even a higher standard such as "should" or "will," which is
not defined under the current statutory or regulatory framework, it would be
necessary to explain how that confidence level relates to the "more likely than not"
standard.
The heightened "reasonable cause and good faith" exception of §6664(d) that
accompanies the new §6662A accuracy-related penalty contains other defined terms
that correspond to, but do not track as neatly, the Circular 230 Covered Opinion
definitions. To avoid the heightened accuracy-related penalty for reportable
transaction understatements, a taxpayer may not rely upon the opinion of a
"disqualified tax advisor" or a "disqualified opinion" to establish its reasonable belief
regarding the proper tax treatment of the transaction.107
A "disqualified tax advisor" is any advisor who (1) is a material advisor (within the
meaning of §6111(b)(1), as amended)108 and participates in the organization,
management, promotion, or sale of the transaction or is related to any person who so
participates; (2) is compensated directly or indirectly by a material advisor with
respect to the transaction; (3) has a fee arrangement with respect to the transaction
which is contingent on all or part of the intended tax benefits from the transaction
being sustained; or (4) has a disqualifying financial interest in the transaction.109 To
be tainted as a "disqualified tax advisor," the material advisor must "participate" in
the "organization, management, promotion, or sale" of the Listed Transaction or
Reportable Avoidance Transaction. The "participation" by the material advisor here
appears to require greater involvement than the level of activity—"any material aid,
assistance, or advice with respect to … carrying out a reportable transaction"—within
the meaning of the definition of "material advisor" under §6111(b)(1)(A). Although it
sounds like the material advisor must be a promoter in order to become a
"disqualified tax advisor," what, if anything, was intended by the difference in the
material advisor's level of activity is not entirely clear.
No guidance on this issue can be gleaned from Circular 230, which does not employ
the term "material advisor." More striking, the Covered Opinion requirements contain
no proscription relating to a "disqualified tax advisor" similar to §6664(d)(3)(B)(ii).
Under the Circular 230 rules, it is sufficient if the practitioner prominently discloses
the promoter relationship in the Covered Opinion.110 Moreover, a Covered Opinion,
by definition, can even include written advice subject to "contractual protection."
Although revised rules under Circular 230 are expected to address contingent fee
issues, it remains to be seen whether these new rules will coordinate with the rules
under the post-AJCA disclosure framework and the PCAOB proposed rule
concerning auditor independence and contingent fees.111
In light of the "disqualified tax advisor" rules under the "reasonable cause and good
faith" exception of §6664(d), a taxpayer who received an opinion as to the proper tax
treatment of a prospective transaction should consider obtaining a second tax opinion
from another tax advisor after the transaction is consummated but before the tax
return is prepared. A second opinion from an independent tax advisor would be
necessary if subsequent events cause the practitioner who rendered the first tax
opinion to become a "disqualified tax advisor." For example, a practitioner could
became a "material advisor" later if the total fees paid to his or her firm, including
subsequent fees paid for documenting the transaction, ultimately exceeded the
threshold amount. Or, if the IRS subsequently declared the transaction in question to
be a Listed Transaction, the taxpayer would not be able to rely upon an earlier
opinion to support a reasonable belief at the time the return is filed that the reported
position reflects the proper tax treatment of the transaction.
Written advice becomes a "disqualified opinion" if it (1) is based on unreasonable
factual or legal assumptions (including assumptions as to future events); (2)
unreasonably relies on representations, statements, findings, or agreements of the
taxpayer or any other person; (3) does not identify and consider all relevant facts; or
(4) fails to meet any other requirements prescribed the Secretary of the Treasury. 112
These due diligence requirements sound very similar to the new Covered Opinion
requirements under Circular 230. However, §35.10(f) of Circular 230 specifically
states that even if the written advice meets the Covered Opinion requirements, the
persuasiveness of the opinion and the taxpayer's good faith reliance on the opinion
will be determined separately.
Still, the Covered Opinion requirements should provide a roadmap for avoiding the
taint of a "disqualified opinion" under §6664(d)(3)(B)(iii). The current regulations
under §6664(c) already cross-reference the Circular 230 rules.113 It would not be
surprising if the full panoply of Covered Opinion requirements is eventually
incorporated into the "reasonable cause and good faith belief" exceptions of §6664(c)
and (d) to the accuracy-related penalties of §§6662 and 6662A. Nor would it be
surprising if the "disqualified tax advisor" and "disqualified opinion" taints under
§6664(d) find their way into the law under §6664(c).
Given the new reportable transaction disclosure and penalty framework post-AJCA,
the Covered Opinion requirements under Circular 230 were not unexpected. What is
perhaps most troubling is the treatment given to informal tax advice. Many forms of
informal tax advice now must include the "opt-out" disclosure language or else be
subject to the Covered Opinion requirements. A policy decision was clearly made in
favor of forcing this choice whenever written advice addresses a Significant Purpose
Transaction. Unfortunately, the free-flow of tax advice may suffer as a result.
CONCLUSIONS
In sum, we question whether the new AJCA provisions and Circular 230 rules will
portend the sea change in tax practice about which many practitioners have
complained. To be sure, tax advisors issuing Covered Opinions will face new
requirements, some of which are onerous and difficult to explain to clients or even
colleagues who are not tax practitioners. Yet many of the Covered Opinion rules are
embodied in the §6664(c) and (d) "reasonable cause and good faith" exceptions and
have always constituted "best practices." The new rules may simply limit the viability
of a Marketed Opinion and put an end to "informal" advice, which now must be
identified as such through "opt-out" disclosure language if the Covered Opinion
requirements are to be avoided.
On the enforcement side, certainly the higher penalty amounts will deter a greater
number of taxpayers from engaging in Reportable Avoidance Transactions. In
addition, the IRS arsenal has been equipped with new weapons that may signal a new
era of enforcement against delinquent taxpayers and practitioners. But if past
experience is any guide, IRS enforcement efforts will remain limited. The agency's
ability to engage in effective enforcement is hampered by inadequate funding,
personnel shortages, and lack of resources. Malpractice litigation, more so than the
Director of the Office of Professional Responsibility, has served to enforce
professional standards.
To a large extent, a chilling effect on the tax shelter industry has already occurred
from the public attention drawn to the misconduct of certain high profile companies
and corporate officers, their selected prosecution, and the identification of Listed
Transactions. In the end, the responsibility for compliance remains with the tax
practitioner who must police both the client and his or her own tax practice. While the
majority of practitioners have always aspired to "best practices," it remains to be seen
whether stiffer penalties, greater transparency, and the self-policing framework will
prove sufficient to deter the misconduct of those who are driven more by the culture
of greed.
*
Susan T. Edlavitch is a partner and Brian S. Masterson is an associate in Venable LLP's tax practice.
1
Recently, the IRS announced that it had collected more than $3.2 billion from taxpayers in the Son-of-BOSS tax
settlement initiative. IRS News Release 2005-37 (3/24/05). While this figure is noteworthy, it pales in comparison
to the estimated annual net tax gap of more than $250 billion. IRS News Release 2005-38 (3/29/05).
2
As revealed in the Nov. 2003 hearings on tax shelters held by the Permanent Subcommittee on Investigations of
the U.S. Senate Committee on Governmental Affairs, the "tax shelter industry" consists of registered public
accounting firms, investment advisory firms, international financial institutions, and major law firms, on the one
hand, and wealthy individuals, corporations, and other taxpayers eagerly seeking methods to effect tax arbitrage,
on the other hand. SeeU.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial Professionals,
Hearings before the Permanent Subcommittee on Investigations of the Senate Committee on Governmental
Affairs, 108thCong., 1st Sess.(2003); and S. Rep. No. 34, 108th Cong., (2003). See also Staff of the Joint Comm.
on Tax'n, 108th Cong., Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax
and Compensation Issues, and Policy Recommendations (Comm. Print 2003).
A recent study highlights the financial benefits derived from corporate use of tax shelters. Because tax shelters
lower taxes, a corporate taxpayer has less incentive to take on debt in order to lower taxes through accrued interest
deductions. Tax-sheltering companies had debt-to-asset ratios that were one-third lower than companies that did
not use tax shelters. The artificially inflated financial statements that result from tax shelters make these taxsheltering companies more attractive to investors. Using tax shelters instead of debt-related tax deductions also
reduces debt costs and improves the company's credit rating. See Graham & Tucker, "Tax Shelters and Corporate
Debt Policy" (Dec. 2004), reprinted in Daily Tax Rep. (12/2/04), available in TaxCore-Miscellaneous Documents.
The U.S. Government Accountability Office reported that 207 of the Fortune 500 companies engaged in tax
shelter transactions during 1998–2003 with an estimated potential tax revenue loss of nearly $56 billion. Of these,
sixty-one companies obtained tax shelter services from their external auditors. SeeGAO Report to the Ranking
Minority Member, U.S. Senate Permanent Subcommittee on Investigations, Committee on Homeland Security and
Governmental Affairs, Tax Shelters—Services Provided by External Auditors (Feb. 2005).
3
Section 201(a) of the Public Company Accounting Reform and Investor Protection Act of 2002, P.L. 107-204
(popularly known as the Sarbanes-Oxley Act), expressly prohibits eight types of non-audit services as well as
other services that the PCAOB determines is impermissible for auditors to provide to their public company audit
clients, but allows a registered publicly accounting firm to engage in non-audit tax services if approved in advance
by the issuer's audit committee. As directed by the Sarbanes-Oxley Act, the SEC adopted new auditor
independence rules prohibiting auditors from furnishing non-audit services to audit clients. The SEC rules also
implemented the requirement that all auditing and non-audit services, including tax services, which are not
expressly prohibited, be pre-approved by a client company's audit committee. See Revision of the Commission's
Auditor Independence Requirements, Securities Act Release No. 33-7919 (11/21/00); and Strengthening the
Commission's Requirements Regarding Auditor Independence, Securities Act Release No. 33-8183 (1/28/03).
4
SeeProposed Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees
(PCAOB Rulemaking Docket Matter No. 017), PCAOB Release No. 2004-015 (12/14/04). Section 103(b) of the
2002 Sarbanes-Oxley Act directs the PCAOB to establish rules on auditor independence and ethics standards for
registered public auditors.
5
PCAOB Proposed Rule 3521. Fees fixed by courts or other public authorities and not dependent on a finding or
result would be excluded from the definition of "contingent fee." The proposed rule would eliminate the "tax
matters" exception in SEC Rule §210.2-01(f)(10) for tax matters fees if determined based on the results of judicial
proceedings or the findings of governmental agencies.
6
PCAOB Proposed Rule 3522(a), (b), and (c).
7
PCAOB Proposed Rule 3523.
8
Such routine tax consulting would include tax return preparation, tax compliance, general tax planning and
advice, international assignment tax services, and employee personal tax services. SeeProposed Ethics and
Independence Rules Concerning Independence, Tax Services, and Contingent Fees (PCAOB Rulemaking Docket
Matter No. 017), PCAOB Release No. 2004-015 (12/14/04).
9
P.L. 108-357.
10
Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended, and the
regulations promulgated thereunder.
11
At the same time, the AJCA amended §7525 to except from the confidentiality privilege written
communications in connection with a "tax shelter," as defined broadly by §6662(d)(2)(C)(ii) to include any plan or
arrangement with a significant purpose of a tax avoidance. Whereas, the common law protection of attorney client
privilege remains, the privilege for written tax advice from accountants has effectively been eliminated because of
the broad definition of tax shelter.
12
Regulations Governing Practice Before the Internal Revenue Service, T.D. 9165, 69 Fed. Reg. 75839 (12/20/04)
(to be codified at 31 CFR pt. 10). [Editor’s Note: T.D. 9201, 70 Fed. Reg. 28824 (5/19/05), revised § 10.35 in
certain respects. See the Editor’s Note at the beginning of this article.]
13
Circular 230 sets forth the rules governing the practice before the IRS. T.D. 9165, 69 Fed. Reg. 75839
(12/20/04), which adopts the 2003 proposed rules as revised, was promulgated pursuant to 31 USC §330 granting
authority to the Secretary of the Treasury to regulate practice before the Treasury Department. As defined in
§10.2(e), a "practitioner" means any attorney, certified public account, enrolled agent, or enrolled actuary who is
not currently under suspension or disbarment from practice before the IRS, as described in §10.3(a), (b), (c), or
(d), respectively. Other individuals qualifying under §10.5(d) (temporary recognition by the Director of Practice)
and §10.7(d) (special appearances) are eligible to practice before the IRS to the extent provided therein.
14
See Preamble to T.D. 9165, 69 Fed. Reg. 75839 (12/20/04).
15
The discussion does not address state and local bond opinions, excluded from the definition of a Covered
Opinion, for which proposed regulations (REG-159824-04, 69 Fed. Reg. 75887 (12/20/04)) were issued
concurrently with T.D. 9165. The discussion also does not address the final regulation (§10.38) providing for
advisory committees on the integrity of tax professionals. Nor does the discussion address other professional
standards that apply to practitioners.
16
Section 10.52 of Circular 230 provides that a practitioner may be censured, suspended, or disbarred from
practice before the IRS for the following "prohibited conduct:" (1) willfully violating any of the Circular 230 rules
(other than the §10.33 "best practices"); or (2) recklessly or through gross incompetence violating these final
regulations (§§10.35, 10.36 or 10.37) and §10.34 (standards for advising with respect to tax return positions and
for preparing or signing returns). Under an amendment to 31 USC §330 made by the AJCA, the Treasury and the
IRS now have authority to impose a monetary penalty against a practitioner who violates any provision of Circular
230.
17
Section 10.36 of Circular 230 provides that the practitioner who has principal authority and responsibility for
overseeing a firm's tax practice must take reasonable steps to ensure that the firm has adequate procedures in
effect to ensure compliance with the Covered Opinion rules of §10.35.
By requiring the tax department head to take steps to ensure that adequate procedures for compliance with the
Covered Opinion requirements are in place, the new rules give recognition to the reality that the firm culture can
influence tax practice. To demonstrate the quality controls, a tax department head should disseminate the required
procedures in writing, conduct meetings to communicate the procedures to affected practitioners, and establish a
plan for monitoring written advice prepared by practitioners. Rules that address the firm-wide tax practice are
clearly a step in the right direction, though some have argued that the rules do not go far enough. SeeSheppard,
"Shelter Penalties: Or Else What? Part 2," 106 Tax Notes141 (1/10/05).
18
The complexity of the Circular 230 rules is illustrated graphically by the decision matrixes provided in
Giancana, "Circular 230 Decision Matrixes," 106 Tax Notes1295 (3/14/05); and a flowchart by Jeffrey H.
Paravano and Melinda Reynolds, Baker & Hosteller LLP, reproduced in Sheppard, "Shelter Penalties: Or Else
What? Part 3," 106 Tax Notes899 (2/21/05). Many practitioners have already incorporated the new rules,
notwithstanding difficulties in implementation, as part of their "best practices."
19
Circular 230 §10.33(a).
20
Id. §10.33(b).
21
To date, the IRS has identified 31 "listed transactions" as abusive tax shelters in notices or other published
guidance. See Notice 2005-13, 2005-9 I.R.B. 630 (designating sale-in, lease-out arrangements as a Listed
Transaction). The current list can be viewed on the IRS website at www.irs.gov.
22
Circular 230 §10.35(b)(4).
23
Id. §10.35(b)(5).
24
Id.§10.35(b)(6). But for the minimum fee requirement applicable in the reportable transaction context, Circular
230 defines "conditions of confidentiality" in similar fashion to the definitions found in the reportable transaction
regulations discussed below. Compare Circular 230 §10.35(b)(6), with Regs. §1.6011-4(b)(3).
25
At least one commentator has gone so far as to suggest that tax practitioners should consider adding a waiver of
confidentiality to written advice not intended to be a Covered Opinion. Lipton et al., "The World Changes: Broad
Sweep of New Tax Shelter Rules in AJCA and Circular 230 Affect Everyone," J. Tax'n 134, 147 (Mar. 2005).
26
The meaning of the phrase "contractual protection" in Circular 230 is essentially identical to the meaning of
such term in the reportable transaction regulations. Compare Circular 230 §10.35(b)(7), with Regs. §1.60114(b)(4).
27
Circular 230 §10.35(b)(3). A "federal tax issue" is a question concerning the federal tax treatment of an item of
income, gain, loss, deduction, or credit, the existence or absence of a taxable transfer of property, or the value of
property for federal tax purposes.
28
Section 10.35(b)(9) of Circular 230 defines a "State or local bond opinion" as written advice included in any
materials delivered to a purchaser of a state or local bond in connection with the issuance of the bond in a public
or private offering, including an official statement that concerns the gross income exclusion under §103,
application of §55, the status of a state or local bond as a qualified tax-exempt obligation under §265(b)(3), the
status of a state or local bond as a qualified zone academy bond under §1397E, or any combination of the above.
29
Circular 230 §10.35(b)(2)(ii).
Id. §10.35(b)(8). [Editor’s Note: T.D. 9201, 70 Fed. Reg. 28824 (5/19/05), revised § 10.35(b)(8) to read: “An
item is prominently disclosed if it is readily apparent to a reader of the written advice. Whether an item is readily
apparent will depend on the facts and circumstances surrounding the written advice including, but not limited to,
the sophistication of the taxpayer and the length of the written advice. 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.”]
30
31
The New York State Bar Association Tax Section's Report on Circular 230 Regulations (3/3/05), among many
recommendations, has suggested replacing the "opt-out" system with a bifurcated regime: (a) an "opt-out"
approach limited to Marketed Opinions and written advice with respect to Listed Transactions; and (b) an "opt-in"
approach for all Other Written Advice, whereby written advice could elect to be subject to the Covered Opinion
requirements by stating that the tax opinion is intended to be relied upon for penalty protection purposes.
32
Circular 230 §10.35(d).
33
Id. §10.35(f).
34
Id. §10.35(c)(1)(i)-(iii).
35
Id. §10.35(e).
36
Whether a taxpayer has "participated" in a particular reportable transaction depends upon the type of
transaction. The regulations provide specific rules for each type of reportable transaction, as well as for certain
types of taxpayers. Regs. §1.6011-4(c)(3).
37
A listed transaction is a transaction that is the same as or substantially similar to one of the types of transactions
that the IRS has determined to be a tax avoidance transaction and identified by notice, regulations, or other form
of published guidance as a listed transaction. Regs. §1.6011-4(b)(2).
38
This category includes a transaction offered to a taxpayer under conditions of confidentiality and for which the
taxpayer has paid an advisor a minimum fee. Regs. §1.6011-4(b)(3)(i). The regulations state that a transaction will
be considered offered under conditions of confidentially if (i) the advisor who is to be paid the minimum fee limits
the taxpayer's ability, whether legally binding or not, to disclose the tax treatment or tax structure of the
contemplated transaction and (ii) the limitation on disclosure serves to protect the confidentiality of the advisor's
tax strategies. Regs. §1.6011-4(b)(3)(ii). The minimum fee criteria are $250,000 for corporate taxpayers and
$50,000 for all other taxpayers. Regs. §1.6011-4(b)(3)(iii).
39
A transaction has contractual protection if the taxpayer or a related party has the right to a full or partial refund
of fees if all or part of the intended tax consequences from the transaction are not sustained. Regs. §1.60114(b)(4)(i). Transactions with contractual protection also include transactions in which the advisor's fees are
contingent on the taxpayer's realization of the desired tax benefits from the transaction. The IRS has published a
list of certain transactions with contractual protection that are not reportable transactions for purposes of the
disclosure rules under Regs. §1.6011-4(b)(4). See Rev. Proc. 2004-65, 2004-50 I.R.B. 965.
40
A loss transaction is any transaction resulting in the taxpayer claiming a loss under §165 of (a) at least $10
million in a single taxable year or $20 million in any combination of taxable years for corporations (or
partnerships with only corporations as partners); (b) at least $2 million in any single taxable year or $4 million in
any combination of taxable years for partnerships, individuals, S corporations, and trusts; or (c) at least $50,000 in
any single taxable year for individuals or trusts if the loss is attributable to §988. Regs. §1.6011-4(b)(5). See Rev.
Proc. 2004-66, 2004-50 I.R.B. 966 (listing certain losses that not taken into account in determining whether a
transaction is a loss transaction).
41
A transaction has a significant book-tax difference if any item or items of income, gain, expense, or loss from
the transaction differs by more than $10 million on a gross basis from the amount of the item or items for book
purposes in any taxable year. Regs. §1.6011-4(b)(6)(i). This category of reportable transactions is limited to
entities with required to make filings with the SEC or other business entities with at least $250 million in gross
assets at the end of the entity's taxable year. Regs. §1.6011-4(b)(6)(ii). For a list of specific items not taken into
account in determining whether a transaction has a significant book-tax difference, see Rev. Proc. 2004-67, 200450 I.R.B. 967.
42
A transaction involving a brief asset holding period is any transaction resulting from in the taxpayer claiming a
tax credit greater than $250,000, including a foreign tax credit, if the underlying asset giving rise to the credit is
held by the taxpayer for 45 days or less. Regs. §1.6011-4(b)(7). In Rev. Proc. 2004-68, 2004-50 I.R.B. 969, the
IRS listed a handful of transactions with brief asset holding periods that do not constitute reportable transactions
under Regs. §1.6011-4(b)(7).
43
Regs. §1.6011-4(a).
44
Regs. §1.6011-4(a), (e). A regulated investment company (RIC), as defined in §851, or an investment vehicle
that is at least 95% owned by one or more RICs at all times during the course of an otherwise reportable
transaction is not required to file Form 8886 for any transaction other than a Listed Transaction. Regs. §1.60114(b)(8)(ii).
45
Regs. §1.6011-4(e)(1).
46
Rev. Proc. 2004-45, 2004-31 I.R.B. 140. Effective for taxable years ending on or after Dec. 31, 2004, any
domestic corporation (including a U.S. consolidated tax group consisting of a U.S. parent corporation and
additional includible corporations listed on Form 851, Affiliations Schedule) required to file Form 1120 that
reports on Schedule L of Form 1120 total consolidated assets at year-end of $10,000,000 or more must complete
Schedule M-3 in lieu of Schedule M-1, Reconciliation of Income (Loss) per Books with Income per Return.
Corporations that are not required to file Schedule M-3, nevertheless, may elect to file Schedule M-3.
47
P.L. 108-357, §811 (codified at 26 USC §6707A).
48
§6707A(b)(1).
49
§6707A(b)(2).
50
§6707A(e)(2)(A).
51
§6707A(e).
52
Notice 2005-11, 2005-7 I.R.B. 493.
53
H.R. Rep. No. 755, 108th Cong., 2d Sess. 599 (2004). The Conference Report states that in assessing whether to
waive an §6707A penalty, the IRS should consider whether—(a) the taxpayer has a good compliance history, (b)
the violation was due to an unintentional mistake of fact, and (c) imposing the penalty would be against equity and
good conscience. Id.; see also Notice 2005-11, 2005-7 I.R.B. 493 (noting these same factors).
54
§6707A(d)(1).
55
§6707A(d)(2).
56
Regs. §1.6011-4(e)(2)(i) (requiring disclosure of any transaction that becomes a reportable transaction by reason
of becoming a Listed Transaction in a subsequent tax year). As discussed below, new §6501(c)(10) extends the
statute of limitations for undisclosed Listed Transactions.
57
A reporting position that has a "reasonable basis" (as defined in Regs. §1.6662-3(b)(3)) is not considered
negligent. "Negligence" includes (a) any failure to make a reasonable attempt to comply with the Code provisions
or to exercise ordinary and reasonable care in the preparation of a tax return; (b) any failure to keep adequate
books and records; and (c) any failure to substantiate items properly. Regs. §1.6662-3(b)(1).
The penalty for disregarding a rule or regulation applies if (i) the taxpayer's position is contrary to a rule or
regulation; and (ii) the taxpayer carelessly, recklessly, or intentionally disregards the rule or regulation. Regs.
§1.6662-3(a). The penalty for disregarding a rule or regulation can be avoided under two circumstances in
addition to the §6664(c) "reasonable cause and good faith" exception. First, the penalty for disregarding a rule or
regulation does not apply if the reporting position has a "reasonable basis" and is adequately disclosed (including
contrary authority disclosure on Form 8275 (or Form 8275-R)) and, in the case of a position contrary to a
regulation, the position represents a good faith challenge to the validity of the regulation. Regs. §1.6662-3(c).
Second, a taxpayer who takes a reporting position contrary to a revenue ruling or a notice has not disregarded the
ruling or notice if the contrary position has a "realistic possibility" of being sustained on the merits. Regs.
§1.6662-3(b)(2). Regs. §1.6662-3(a) refers to Regs. §1.6694-2(b) for a description of the "realistic possibility"
standard.
58
§6662(d)(2)(C)(ii). The AJCA did not change the definition of a "tax shelter" within the meaning of §6662.
59
§6662(d)(2).
60
§6662(d)(1)(B), as amended by §819(a) of the AJCA.
61
The substantial authority standard is an objective standard based on an analysis of the law and an application of
the law to the relevant facts. See generallyRegs. §1.6662-4(d)(2) and (3). The confidence level is less stringent
than the "more likely than not" standard, but more stringent than the "reasonable basis" standard. The taxpayer's
subjective belief is not relevant. Substantial authority for the tax treatment of an item exists only if, taking into
account all relevant authorities, the weight of the authorities supporting the treatment is substantial in relation to
the weight of authorities supporting contrary treatment. There may be substantial authority for more than one
position with respect to the same item. Whether a position has substantial authority is determined when the return
is filed or on the last day of the taxable year. The published list of positions that constitute substantial authority
pursuant to §6662(d)(2)(D) is contained in the regulations. For the nature of the analysis, types of authorities and
special rules, see Regs. §1.6662-4(d)(3)(ii), (iii), and (iv).
62
§6662(d)(2)(B)(i), (ii). The penalty for a substantial understatement can be avoided if the reporting position has
a "reasonable basis" and the return includes contrary authority disclosure on Form 8275 (or Form 8275-R) and, in
the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of the
regulation. Regs. §1.6662-4(e), (f). This exception will not apply if the substantial understatement is attributable to
a tax shelter item, the position is not properly substantiated, or the taxpayer failed to keep adequate books and
records with respect to the item or the position.
63
Pre-2004 AJCA §6662(d)(2)(C)(i)(II).
64
§6662(d)(2)(C)(i).
65
Regs. §1.6664-4(f)(2)(i)(B).
66
Reliance by a taxpayer on professional tax advice constitutes "reasonable cause and good faith" if, under all the
circumstances, such reliance was reasonable and the taxpayer acted in good faith. Regs. §1.6664-4(b)(1). "Tax
advice" is defined broadly to include any communication from a professional tax advisor or another person (other
than the taxpayer) and does not have to be in any particular form. Regs. §1.6664-(c)(2). The minimum
requirements for taxpayer reliance on a tax opinion or advice are two-fold, although satisfying these minimum
requirements will not necessarily establish the exception. First, the advice must be based upon all pertinent facts
and circumstances and the law as it related to those facts and circumstances. Second, the advice must not be based
on unreasonable factual or legal assumptions (including assumptions as to future events) and must not
unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.
Regs. §1.6664-4(c)(1).
67
The Preamble to T.D. 9165 (final regulations under Circular 230) states that the IRS will amend Regs. §1.66644 to clarify that a taxpayer cannot rely upon written advice that contains the "opt-out" disclosure for avoiding
treatment as a Reliance Opinion or Marketed Opinion in order to establish the "reasonable cause and good faith"
defense to the accuracy-related penalties.
68
Regs. §1.6664-4(c)(1)(iii) (referencing the adequate disclosure rules in Regs. §1.6662-3(c)(2)).
69
Regs. §1.6664-4(d) refers to Regs. §1.6011-4(b) (or Regs. §1.6011-4T(b), as applicable) for the definition of
"reportable transaction," and the disclosure requirements of Regs. §1.6011-4 (or Regs. §1.6011-4T, as applicable).
70
P.L. 108-357, §812 (codified at 26 USC §6662A).
71
§6662A(b)(2). Section 6662A(d) incorporates by reference the definitions of Listed Transaction and reportable
transaction set forth in §6707A(c).
One commentator, albeit perhaps a bit "tongue-in-cheek", referred to Reportable Avoidance Transactions as
"RATs." See Beller, "The New Penalty Regime: Proceed With Caution," 106 Tax Notes 311 (1/17/05).
72
§6662A(e)(1).
73
§6662A(a), (c). In Notice 2005-12, 2005-7 I.R.B. 494, the IRS provided that a taxpayer will be considered to
have adequately disclosed the relevant facts for purposes of §§6662A and 6664(d)(2)(A) (the reasonable cause
exception) if the taxpayer filed Form 8886 or Schedule M-3.
74
§6707A(e)(2)(B).
75
§6707A(e).
76
§6662A(b).
77
P.L. 108-357, §812(c) (codified at 26 USC §6664(d)).
78
A taxpayer failing to adequately disclose a reportable transaction will be treated as satisfying this threshold
requirement for the reasonable cause exception if the IRS rescinds the §6707A penalty for failing to disclose the
taxpayer's participation in the transaction. §6664(d)(2) (flush language).
79
§6664(d)(2).
80
§6664(d)(3)(A).
81
P.L. 108-357, §815 (codified at 26 USC §6111).
82
§6111(a).
83
§6111(b)(1). For purposes of determining the applicable minimum fee threshold, a partnership or a trust with
only corporate partners or beneficiaries is deemed to be a corporation. Regs. §301.6112-1(c)(3) (also applying a
look-through rule to any partners or beneficiaries that are themselves a partnership or trust).
84
Notice 2004-80, 2004-50 I.R.B. 963 (restating the applicability of the threshold amounts specified in Regs.
§301.6112-1(c)(3)); see also Notice 2005-22, 2005-12 I.R.B. 756 (providing that one of the tests for determining
when a person will be treated as becoming a material advisor under §6111 is when that person receives (or expects
to receive) the minimum fee).
85
Notice 2005-22, 2005-12 I.R.B. 756 (clarifying and modifying Notice 2004-80, 2004-50 I.R.B. 963
(announcing that pending issuance of regulations under new §§6111, 6112, and 6708, the current regulations, in
part, will apply as interim guidance)).
86
2005-12 I.R.B. 756.
87
Notice 2005-22, 2005-12 I.R.B. 756. The IRS issued Notice 2005-22 in response to critical comments from the
tax bar regarding the requirement set forth in Notice 2004-80, which had required an advisor to file Form 8264
within 30 days of becoming a material advisor. See Comments Concerning Notice 2004-80, ABA Tax Sec.
(2/7/05), reprinted in Daily Tax Rep. (2/9/05), at TaxCore-IRS Documents; "NYSBA Suggests Clarifications For
Interim Material Advisor Rules," Daily Tax Rep. (2/24/05) at G-6.
88
Notice 2004-80, 2004-50 I.R.B. 963.
89
P.L. 108-357, §816 (codified at 26 USC §6707).
90
§6707(a).
91
§6707(b).
92
§6707(c).
93
P.L. 108-357, §815 (codified at 26 USC §6112).
94
§6112(b)(1).
95
P.L. 108-357, §816 (codified at 26 USC §6708).
96
§6708(a).
97
H.R. Rep. No. 755, 108th Cong., 2d Sess. 599 (2004).
98
As announced in the Preamble to T.D. 9165, the regulations will be amended to clarify that, for purposes of
establishing the "reasonable cause and good faith" defense to the accuracy-related penalties, a taxpayer may not
rely upon written advice that contains the disclosure that the advice was not written to be used and cannot be used
for the purpose of avoiding penalties.
99
Long Term Capital Holdings v. U.S., 330 F. Supp. 2d 122 (D. Conn. 2004). For a discussion of the accuracyrelated penalty aspects of this decision, see Fisher, "Long Term Capital Holdings v. U.S.: The End of Penalty
Protection?," 46 Tax Mgmt. Memo. 19 (2005).
100
See, e.g.,Lipton, "Reliance on Tax Opinions: The World Changes Due to Long Term Capital Holdings and the
AJCA," J. Tax'n344 (Dec. 2004).
101
See generallyCummings, Jr., "The Range of Legal Tax Opinions, with Emphasis on the 'Should Opinion,'" 98
Tax Notes1125 (2/17/03).
102
Id.Regs. §1.6662-3(b)(3) defines "reasonable basis" as a relatively high standard of tax reporting, which is
significantly higher than the "not frivolous" standard and which is not satisfied by a return position that is merely
arguable or a colorable claim. A return position that is reasonably based on one or more of the enumerated
authorities (taking into account the relevance and persuasiveness of the authorities and subsequent developments)
will generally satisfy the "reasonable basis" standard, even though it may not satisfy the higher "substantial
authority standard as defined in Regs. §1.6662-4(d)(2)."
103
Circular 230 §10.34(d)(1). See also Regs. §1.6694-2(b), which describes the "realistic possibility" standard as a
one in three, or greater, likelihood of being sustained on the merits.
104
See alsoIRM 535.1(20).
105
Circular 230 §10.35(b)(4)(i). See alsoRegs. §1.6662-4(d)(2).
106
A tax shelter item of a non-corporate taxpayer can invoke the "reasonable cause and good faith" exception of
§6664(c) without the modification of Regs. §1.6662-4(f) applicable to corporate Tax Shelters requiring the higher,
"more likely than not" confidence level.
107
§6664(d)(3)(B)(i).
108
See supra note 83 and accompanying text (defining material advisor).
109
§6664(d)(3)(B)(ii). See Notice 2005-12, 2005-7 I.R.B. 494 (setting forth detailed interim guidance regarding
(1) the level of activities that constitute participation in the "organization, management, promotion or sale" of a
transaction, and (2) disqualifying compensation arrangements).
110
SeeCircular 230 §10.35(e).
111
See supranote 5 and accompanying text (PCAOB Proposed Rule 3521 on contingent fee arrangements).
112
§6664(d)(3)(B)(iii).
113
Regs. §1.6664-4(c)(3).