effects of anti-tax-shelter rules on nonshelter tax … · 2008. 8. 20. · adviser’s tax...

EFFECTS OF ANTI-TAX-SHELTER RULES ON NONSHELTER TAXPRACTICEBy Michael Schler

Table of Contents

I. Proposed Substantive Rules . . . . . . . . . . . 915A. Antiabuse Rules . . . . . . . . . . . . . . . . . . 915B. Economic Substance Test . . . . . . . . . . . . 915C. The Zelenak-Chirelstein Proposal . . . . . . 916

II. The Reportable Transaction Regime . . . . . 916A. Background . . . . . . . . . . . . . . . . . . . . . 916B. Listed Transactions . . . . . . . . . . . . . . . 916C. Tax Losses and Book/Tax Differences . . . 916D. Conclusions . . . . . . . . . . . . . . . . . . . . . 917

III. Tax Opinions by ‘Disqualified TaxAdvisers’ . . . . . . . . . . . . . . . . . . . . . . . . . 917A. Background . . . . . . . . . . . . . . . . . . . . . 917B. Consequences . . . . . . . . . . . . . . . . . . . . 918C. Conclusions . . . . . . . . . . . . . . . . . . . . . 918

IV. Circular 230 . . . . . . . . . . . . . . . . . . . . . . . 918A. Complexity . . . . . . . . . . . . . . . . . . . . . 919B. Overbreadth and Ambiguity . . . . . . . . . 919C. Penalties . . . . . . . . . . . . . . . . . . . . . . . 919D. Evaluation of Specific Aspects of Circular

230 . . . . . . . . . . . . . . . . . . . . . . . . . . . 919E. Conclusions . . . . . . . . . . . . . . . . . . . . . 922

Current and proposed rules that are aimed at stoppingabusive tax shelter transactions can have a significanteffect on day-to-day tax practice involving normal busi-ness transactions. In some cases, the likely benefits ofthose rules in stopping tax shelters probably outweighthe adverse effects of the rules on nonshelter tax practice.In other cases, the rules appear to have a low potential forbenefit as compared with their serious adverse effects onnonshelter tax practice.

I. Proposed Substantive Rules

A. Antiabuse RulesAn antiabuse rule provides that if a transaction is

structured in a manner designed to reduce taxes in amanner unintended by Congress, the tax reduction isdisallowed. Those rules are quite controversial because oftheir vagueness and their resulting potential to inhibitnormal business transactions. As I have stated elsewhere,I believe broad statutory antiabuse rules are necessary tocombat tax shelters, because specific statutory languagewill never be sufficient to keep ahead of creative taxplanners.1 I also believe that tax lawyers are capable, aspart of their usual job of interpreting the code, ofdetermining in most cases whether an antiabuse ruleapplies to a particular ordinary business transaction. As aresult, I do not believe that antiabuse rules impose anundue burden on normal tax practice or normal businesstransactions.

B. Economic Substance Test

An economic substance test disallows a loss if atransaction fails the specified indicia of economic sub-stance and the tax result is unintended by Congress. Thatis in reality a ‘‘double trigger’’ for a loss disallowance andcan be viewed as an antiabuse rule that comes into playonly if the economic substance test is failed. I believe aneconomic substance test is of limited usefulness in stop-ping tax shelters, because it is relatively easy for taxplanners to add some nontrivial level of economic sub-stance to almost any transaction, and the court decisionsare mixed in applying the economic substance test.Moreover, economic substance is by definition a test thatrequires projecting the likelihood of economic profit in

1Michael L. Schler, ‘‘Ten More Truths About Tax Shelters: TheProblem, Possible Solutions, and a Reply to Professor Weis-bach,’’ 55 Tax L. Rev. 325, 379-384 (2002).

Michael Schler is a partner at Cravath, Swaine &Moore LLP, New York. The views expressed are solelythe personal views of the author.

This article discusses the effects that certain anti-tax-shelter rules have (or would have) on a nonsheltertax practice. The author believes that antiabuse ruleswould not have a serious adverse effect on tax prac-tice. However, recent requirements regarding report-able transactions and (especially) under Circular 230have had a very burdensome effect on tax practice thatappears to exceed their benefits in attacking tax shel-ters.

This article is a revised version of a paper presentedat the Columbia Law School Deals Roundtable on‘‘Narrowing the Tax Gap,’’ held on October 14, 2005.The author is grateful for comments from DianaWollman and others on that paper and at the round-table.

TAX NOTES, November 14, 2005 915

(C) T

ax Analysts 2005. A

ll rights reserved. Tax A

nalysts does not claim copyright in any public dom

ain or third party content.

Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




the future, which is an area in which tax lawyers (ornontax lawyers) have little or no expertise.

However, the potential application of an economicsubstance test is not commonly an issue in normalbusiness transactions. As a result, while I believe aneconomic substance test would provide only limitedbenefit in attacking tax shelters, I likewise believe itwould cause little harm to normal business transactions.

C. The Zelenak-Chirelstein ProposalA proposal by Profs. Lawrence Zelenak and Marvin

Chirelstein disallows deductions for noneconomic losses,and adds back to gross income of a taxpayer any incomethat is uneconomically shifted from the taxpayer to atax-exempt party.2 Their proposal codifies and greatlyexpands on the principles of an existing tax regulationthat has not generally been used to attack tax shelters.3 Ibelieve this proposal would be very useful in attackingthe specified categories of tax shelters, and that it wouldnot unduly burden normal tax practice. However, thereare many transactions it would not cover4 so the need forantiabuse rules would remain.

II. The Reportable Transaction Regime

A. BackgroundToday, if certain fee thresholds are met, a law firm or

other tax adviser must keep records and make filingswith the IRS for specified categories of transactions forwhich it provides tax advice.5 The categories are (1) listedtransactions, (2) transactions in which the adviser re-quires confidentiality of the tax treatment to protect theadviser’s tax strategies, (3) transactions in which theadviser’s fee is contingent on the taxpayer achieving thedesired tax benefits, (4) transactions with a gross tax lossthat exceeds certain thresholds, (5) transactions with abook-tax difference that exceeds certain thresholds, and(6) transactions that involve tax credits and a shortholding period for assets. The IRS has issued so-calledangel lists exempting specified transactions from catego-ries (3)-(6).6

B. Listed TransactionsIn my experience, category 1 (listed transactions), as

well as categories 2, 3, and 6, are not problems in normaltax practice. Some have complained that category (1) istoo broad because the category includes transactions thatare ‘‘substantially similar’’ to listed transactions, and thattest is difficult to apply. However, I believe that is not amajor problem under a fair reading of virtually all thelisted transactions. In fact, because listed transactions arespecified in some detail, those are the easiest transactionsfor tax advisers to deal with.

Another potential burden arises from listed transac-tions because once a transaction is listed, advisers arerequired to report even past transactions of the specifiedtype. Thus, every time a new transaction is listed, eachadviser must determine whether he had ever previouslydone such a transaction. However, because listed trans-actions have a very serious tax motivation, those trans-actions should be relatively easy for a tax adviser en-gaged in normal business transactions to remember.Consequently, the burden on normal tax practice shouldnot be too great. At some point, however, adviser report-ing for past transactions should apply only to listedtransactions that were done during some reasonableperiod of time before the listing.

C. Tax Losses and Book/Tax DifferencesTransactions with either tax losses or book/tax differ-

ences cause by far the greatest difficulties to tax advisersin normal tax practice, for several reasons:

First, an enormous number of ordinary transactionsresult in tax losses or book-tax differences. In addition,the reporting rules apply if anyone in the firm (even anontax person) gives tax advice on such a transaction,and that advice is often given in practice by corporatelawyers. Regarding transactions involving book-tax dif-ferences, the reporting requirements are triggered only ifsomeone in the firm makes a statement relating to thebook-tax difference in the transaction. However, thatcould easily happen in a discussion between an attorneyand a client. As a result, in practice, most firms assumethat if they are involved in any transaction with a loss orbook-tax difference, the transaction is reportable unlessan exception applies.

Second, it is extremely difficult for a law firm to besure that it has identified all of its transactions thatinvolve tax losses or book-tax differences. Many of thosetransactions have only routine tax consequences, so taxlawyers may have little or no involvement in the trans-action. Moreover, whether or not tax lawyers are in-volved, the lawyers in a law firm working on an ordinarytransaction would normally have little or no interest,except for reportable transaction purposes, in whetherthe client happened to have a tax loss on a sale of abusiness asset, or whether the client would be reportingthe transaction differently for book and tax purposes.

Third, the angel lists for loss transactions and book-taxdifferences exclude many common transactions. How-ever, the exclusions themselves are unclear in manyrespects. In particular, the exclusion for loss transactions

2Lawrence Zelenak and Marvin Chirelstein, ‘‘A Note on TaxShelters,’’ Duke Law School Legal Studies, Research Paper No.67 (June 2005), to be published as ‘‘Tax Shelters and the Searchfor a Silver Bullet,’’ 105 Colum. L. Rev. 1939 (Oct. 2005).

3Treas. reg. section 1.165-1(b). See Schler, supra note 1, at 377.4The authors of the proposal acknowledge that it would not

cover the transaction at issue in Gregory v. Helvering, 293 U.S. 465(1935). Likewise, it would not cover the purported tax-freereorganization that was rejected by the court in Tribune Companyv. Commissioner, 135 T.C. No. 8, Doc 2005-19801, 2005 TNT 187-12(Sept. 27, 2005).

5Section 6111(a); Treas. reg. sections 301.6112-1(c), 1.6011-4;Notice 2005-22, 2005-1 C.B. 756, Doc 2005-3777, 2005 TNT 37-3.

6Rev. Procs. 2004-65 through Rev. Proc. 2004-68, 2004-2 C.B.965, 966, 967, 969, Doc 2004-22048, 2004 TNT 222-9, Doc 2004-22049, 2004 TNT 222-10, Doc 2004-22050, 2004 TNT 222-11, andDoc 2004-22051, 2004 TNT 222-12, respectively.

COMMENTARY / SPECIAL REPORT

916 TAX NOTES, November 14, 2005

(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




depends on the seller having a ‘‘qualifying basis’’ in thesold asset.7 That itself may require going back over manyyears to determine all prior basis adjustments to theasset.

Fourth, the penalties for nonreporting a reportabletransaction are enormous. The penalty for not filing atimely quarterly return reporting a nonlisted transactionis a flat $50,000.8 The statutory scheme makes it verydifficult for that penalty to be waived.9 Also, if a report-able transaction is overlooked, the firm will not becomplying with the separate requirement to maintain alist of reportable transactions and information aboutthose transactions. The penalty for not providing the IRSwith a complete list on request is $10,000 per day.10 Thereis no statutory limit on the number of days the penaltycan apply. While this penalty can be waived at thediscretion of the IRS for reasonable cause, that is of scantcomfort to a law firm faced with the risk of a considerablepenalty if it happens to overlook a common businesstransaction that has a tax loss or a book-tax difference.

Fifth, several states have adopted reporting rules thatparallel the federal rules and that require tax advisers tomake state filings similar to the federal filings. Thosestates include New York, California, Illinois, and Minne-sota, and others are likely to follow. Any federal filing bya tax adviser will therefore require research by theadviser as to which states might require a similar filing.That will depend on such factors as where the taxpayerfiles its own tax returns and where the adviser carries onbusiness. Compliance with numerous and varying staterules will impose a significant further burden on taxadvisers, and subject advisers to the risk of furtherpenalties for noncompliance.

D. ConclusionsThe reporting rules imposed on tax advisers for book-

tax and loss transactions impose a considerable burdenon tax advisers involved in normal business transactions.Every law firm in the country has been required to makean enormous effort to develop, and ensure ongoingcompliance with, procedures relating to those transac-tions. Given the penalties for noncompliance, that effortusually involves considerable partner time.

The government obtains some benefit from the report-ing of those transactions by tax advisers, because taxpay-ers are discouraged from engaging in tax shelter transac-tions that must be reported both by them and theiradvisers. However, for most tax advisers, the vast major-ity (if not all) of the transactions that fall in thosecategories are normal business transactions, not tax shel-ters.

Moreover, the benefit to the government from thereporting of those transactions is limited. For transactionswith book-tax differences, all large and midsize corpora-tions are now required to file Schedule M-3 with their taxreturns. That schedule provides considerable information

to the IRS concerning book-tax differences and makesadviser reporting of those differences less important tothe IRS. Also, adviser reporting of loss transactions willhave only limited effects on the tax shelter problem,because a taxpayer can engage in a tax shelter that is notsubject to that reporting. For example, reporting appliesonly to section 165 losses, not section 162 deductions.Likewise, taxpayers may try to have a transaction fit intoa category of transaction described on an angel list.

In contrast, the reporting of listed transactions byadvisers is of great benefit to the government, because itis difficult for taxpayers and advisers to avoid suchreporting. Moreover, the reporting of listed transactionsimposes a relatively low burden on tax advisers engagingin normal business transactions because very few, if any,of their transactions will be listed transactions or substan-tially similar to a listed transaction.

The government has been very reluctant to expand thenumber of listed transactions, apparently because it hasbecome a ‘‘badge of dishonor’’ to engage in a listedtransaction. However, there are numerous transactionsthat the government could add to the list of listedtransactions. In fact, many transactions have not beenlisted even though they have been the subject of govern-ment litigation, adverse technical advice memoranda, ornewspaper articles.

If transactions were regularly added to the list, therewould be far less need for the reporting by advisers oftransactions giving rise to losses or book-tax differences.It is true that the IRS might not find out about certaintransactions as quickly if that reporting was eliminated.However, that delay should not prevent the IRS fromeventually finding out about the transactions it is con-cerned about. The IRS could then list them and (becauseof the retroactive reporting requirement for listed trans-actions) obtain information about taxpayers who hadengaged in those transactions in the past.

Consequently, consideration should be given to theapproach of expanding the category of listed transactionsand narrowing the obligation of tax advisers to reporttransactions with losses and book-tax differences. Thatapproach would greatly alleviate the burden now borneby all tax advisers engaged in normal business transac-tions. Taxpayers could continue to be required to reporttheir own transactions giving rise to losses and book-taxdifferences. The burden of that reporting by taxpayers ismuch less than the burden on tax advisers, becausetaxpayers are familiar with their own book and taxsituations.

III. Tax Opinions by ‘Disqualified Tax Advisers’

A. BackgroundIf a taxpayer engages in a reportable transaction, and

a significant purpose of that transaction is tax avoidance,additional penalties apply to any understatement of tax.11

A taxpayer may not rely on an opinion of a ‘‘disqualifiedtax adviser’’ to avoid those penalties.12 A disqualified tax

7Rev. Proc. 2004-66, supra note 6, at section 4.02.8Section 6707.9Sections 6707(c), 6707A(d).10Section 6708(a)(1).

11Section 6662A.12Section 6664(d)(3)(B).



(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




adviser is one who meets certain fee thresholds and whoparticipates in the organization, management, promo-tion, or sale of the transaction. The fee thresholds arequite low, relative to fees charged by a law firm for asignificant transaction.13

The fees that count against the threshold for a dis-qualified tax adviser include all fees earned by theadviser for advice on the transaction or for implementingthe transaction, not just fees for giving tax advice.14 Inaddition, the person drafting the documents for a trans-action is treated as participating in the organization of thetransaction.15

B. ConsequencesAs discussed above, a reportable transaction may be a

normal business transaction. Also, almost any transactionthat results in tax savings might be said to have asignificant purpose of tax avoidance. As a result, the rulesregarding disqualified tax advisers can potentially applyto normal business transactions.

Applying those rules, if a law firm is hired to draft thedocuments for a transaction, and the fee for that workexceeds the threshold, the firm will be a disqualified taxadviser. Consequently, that firm will not be permitted togive a tax opinion on which the taxpayer can rely toavoid these penalties.

As a result, if the taxpayer desires penalty protection,it must use one firm to draft the documents for thetransaction and another firm to give an opinion on the taxconsequences of the transaction. That is so even if the firstfirm is the taxpayer’s long-time outside counsel, onwhich the taxpayer relies for all its tax and corporateadvice. Moreover, the taxpayer may have less confidencein the second firm than in the first, and the second firmmay be a competitor to the first firm (and have anincentive to find fault with the first firm’s work). Thoseresults are very illogical.

It gets even worse. Suppose the taxpayer goes to asecond firm that will do nothing on the transactionexcept give a tax opinion. Fortunately, the mere giving oftax advice does not make the second firm a disqualifiedtax adviser, even if the second firm suggests ‘‘modifica-tions’’ to the transaction.16 Thus, the taxpayer can rely onan opinion of the second firm for penalty protection.

However, that result presupposes that the second firmis generally satisfied with the structure of the transactionas presented to it. If the second firm suggests ‘‘materialmodifications to the transaction that assist the taxpayer inobtaining the anticipated tax benefits,’’ the second firmitself is considered to be participating in the organizationof the transaction.17 If the fee threshold is satisfied for the

second firm, and the second firm suggests too manychanges to the transaction, the second firm thus becomesa disqualified tax adviser and the taxpayer cannot rely onthe tax opinion of the second firm either. Perhaps thetaxpayer will then go to a third firm, and, the taxpayerwould hope, that firm will not suggest too many addi-tional changes to the structure (or charge too much).

C. Conclusions

Those results obviously put the taxpayer, as well asthe tax adviser(s), in difficult positions. The taxpayercan’t achieve penalty protection from its regular taxadviser, and perhaps not even from a second tax adviser.The first tax adviser can’t provide penalty protection onthe transaction because it is the firm that did the corpo-rate work on the transaction.

The second tax adviser is in an even more peculiarposition. Assuming the fee threshold is satisfied, it can’tprovide penalty protection if it suggests too manychanges to the transaction. To make things worse, it isimpossible to determine exactly when any suggestedchanges would cross the ‘‘materiality’’ threshold. Thesecond adviser is thus under pressure to avoid taking anyrisks in that regard and to give an opinion on thetransaction ‘‘as is,’’ as opposed to trying to improve thetax position of the taxpayer. If the second adviser thinksthat some changes would improve the tax position of thetaxpayer, the adviser can either (1) suggest the changes,helping the taxpayer on the merits but hurting thetaxpayer on penalty protection, or (2) refrain from sug-gesting the changes and give the opinion nonetheless,hurting the taxpayer on the merits but helping thetaxpayer on penalty protection.

It is difficult to see the tax policy behind this set ofrules.

IV. Circular 230

The recent amendments to Circular 23018 have createdby far the biggest current problem for a nonshelter taxpractice. Those amendments affect every piece of writtentax advice, including every e-mail containing tax advice,provided by every tax adviser in the country (and insome cases outside the country). Law firms engaged innormal business transactions have spent extraordinaryamounts of partner, associate, and staff time to complywith those rules.

It is very doubtful that the benefit to the governmentfrom certain of those rules is worth the burden imposedon tax advisers in attempting to comply with them. It isalso questionable whether the government, for the pur-pose of attacking tax shelters, is justified in adopting such

13The threshold is $250,000 if only C corporations are in-volved, and $50,000 otherwise. Treas. reg. section 301.6112-1(c)(3)(i). Lower thresholds apply for listed transactions.

14Treas. reg. section 301.6112-1(c)(3)(iii).15Notice 2005-12, 2005-7 C.B. 494, section 3(a), Doc 2005-1215,

2005 TNT 13-9.16Id. (excluding the case in which the tax adviser’s ‘‘only

involvement is rendering an opinion regarding the tax conse-quences of the transaction’’).

17Id.

18T.D. 9165 (December 2004). Circular 230 is based on theauthority of the Treasury to regulate practice before the IRS. See31 U.S.C. section 330(a)(1). The American Jobs Creation Act of2004 added 31 U.S.C. section 330(d), authorizing the Treasurysecretary to impose standards for tax advice relating to transac-tions having the potential for tax avoidance or evasion. Circular230 appears at 31 CFR part 10.



(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




a detailed and restrictive set of rules regulating normalday-to-day tax practice. Others have made similarpoints.19

A. ComplexityThe rules in Circular 230 are very complex. Every

piece of written tax advice, including every e-mail, mustbe evaluated before being given to determine, amongother things, whether (1) the transaction has the principalpurpose of tax avoidance, (2) the transaction has asignificant purpose of tax avoidance, (3) the advice willbe used by the recipient to promote, market, or recom-mend the transaction to others, (4) the advice reaches aconclusion with which the IRS would have a reasonablebasis to disagree, and (5) the advice reaches a ‘‘morelikely than not’’ or higher level of comfort on any taxissue. The first four of those questions are very subjectiveand are often subject to vigorous debate among taxpractitioners.

Depending on the answers to those questions (andothers) for any particular tax advice, (1) the tax advisermay be prohibited from giving the advice, regardless oflegends or anything else, (2) the adviser may be permit-ted to give the advice without a legend, (3) the advisermay be permitted to give the advice, but only if it‘‘prominently displays’’ the so-called nonmarketing leg-end, (4) the adviser may be permitted to give the advice,but only if it displays the so-called marketing legend, and(5) the taxpayer receiving the advice may or may not beable to rely on the advice for penalty protection.

As noted above, this regime applies to all written taxadvice, including e-mails, given by every tax adviser.That is so despite the fact that only a very tiny fraction ofall tax advice has ever related to tax shelters. That factalone raises serious questions about the justification forthe rules.

B. Overbreadth and AmbiguityThe rules are clearly overbroad and ambiguous in

many critical respects. Government officials do not dis-pute those points and promise to eventually fix thoseproblems. However, in the meantime tax advisers areforced to spend considerable time in determining howthe rules apply to their day-to-day tax practice. Manyquestions have no answers and the debates among taxadvisers are endless. Tax clubs, bar associations, ande-mail discussion groups have also spent uncountablehours and days on these issues. That time is nonproduc-tive, has nothing to do with tax shelters, and doesnothing to prevent tax shelters.

The overbreadth and ambiguity in the rules alsocreates other significant problems. Diligent advisers whodo not wish to risk a violation of Circular 230 are forcedto take positions, such as putting legends on certain

documents, that make no sense in order to comply withthe literal requirements of the rules (or to avoid violatingan ambiguous rule).

Even worse, different firms may interpret a particularrule differently. Clients may be confused because differ-ent firms giving advice to the client are adopting differentpolicies under Circular 230. Also, particular advisers mayfeel forced to take positions that are less advantageous toclients — or more time-consuming for the adviser — thancompetitor firms are taking. Finally, different firms work-ing on the same transaction, such as an offering thatinvolves a disclosure document, may have to spend timenegotiating among themselves over the proper positionto be taken in the disclosure documents.

C. PenaltiesTax advisers are subject to sanctions if they willfully,

recklessly, or through gross incompetence violate therules.20 ‘‘Gross incompetence’’ includes ‘‘gross indiffer-ence.’’21 It is not clear whether those standards areviolated if a tax adviser disregards a rule that literallyapplies to the particular situation but was probably notintended to apply. Also, given the breadth and ambiguityin the rules, and the volume of tax advice given by mosttax advisers by e-mail, virtually every tax adviser is likelyto inadvertently violate some technical aspect of the ruleson a regular basis.

That state of affairs gives the IRS an enormous amountof discretion in deciding whom to charge with violatingthe rules. The result is that there is at least a theoreticalrisk of an IRS enforcement action for virtually every taxadviser in the country, even though the vast majority ofthem do not engage in tax shelters and are simply tryingto give good advice to their clients.

D. Evaluation of Specific Aspects of Circular 230Part of the confusion and complexity in Circular 230

arises because the regulation attempts to accomplishseveral entirely different goals at once. The regulation canbest be evaluated by separately considering several as-pects of Circular 230.1. General standards of tax practice. Section 10.37 ofCircular 230 requires that all written tax advice meetcertain general standards. For example, the advice mustnot be based on unreasonable factual or legal assump-tions, unreasonably rely on representations from thetaxpayer, or evaluate a tax issue by taking into accountthe likelihood of audit. In general, reputable tax practi-tioners have always complied with those rules, and theydo not cause a problem in normal tax practice.

In fact, in the past, most tax opinions on abusive taxshelters violated those standards. If the IRS were toseriously enforce those rules, the rest of the new rulesunder Circular 230 would be largely unnecessary.2. Special rules for listed transactions, confidentialtransactions, and transactions with contingent fees.

19See, e.g., Jeffrey H. Paravano and Melinda L. Reynolds,‘‘The New Circular 230 Regulations — Best Practices or ScarletLetter,’’ BNA Tax Mgmt. Memo., Aug. 22, 2005. (‘‘The extremeburden these regulations put on generally compliant tax advis-ers and their clients suggests that the IRS, even though well-intentioned, has missed the mark here by a wide margin . . . [theregulations] seem to be in need of a significant overhaul.’’)

20Circular 230, section 10.52. The persons in charge of afirm’s tax practice are also subject to sanctions if they do nottake reasonable steps to have procedures in place to ensurecompliance with the rules. Circular 230, section 10.36(a).

21Circular 230, section 10.51(l).



(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




Section 10.35 of Circular 230 contains a variety of specialrules directed at listed transactions, confidential transac-tions, and transactions with contingent fees. Those situ-ations do not usually arise in normal business transac-tions. Few, if any, objections have been raised to thoserules.3. Restrictions on the legality of tax advice. In at leastone case, section 10.35 of Circular 230 simply prohibitsthe giving of tax advice, regardless of legends or penaltyprotection or anything else, even if the advice is wellreasoned and turns out to have been correct. In particular,that prohibition potentially applies if the principal pur-pose of a transaction is tax avoidance and the transactionis not under an exception that applies when the taxbenefits claimed are consistent with the statute andcongressional purpose. In this situation, any tax adviceon the transaction must meet a detailed set of require-ments, including a requirement to discuss every relevantfederal tax issue. Thus, for example, if such a transactionraises two significant issues, the tax adviser is simply notpermitted to give advice to his own client on one of thoseissues without also fully discussing the other issue.Amazingly enough, this prohibition applies only if thetax advice is ‘‘favorable,’’ because there is an exceptionallowing negative advice.22

This restriction can affect normal nonshelter tax plan-ning. Many transactions would not be done absent thetax benefits and thus may fail the ‘‘principal purpose’’test. Moreover, it is often not completely clear whether atransaction is consistent with congressional purpose.Indeed, that is the reason an opinion may be less than a‘‘would’’ opinion. Those transactions may in fact ‘‘work’’for tax purposes.23

Nevertheless, section 10.35 flatly prohibits the givingof favorable advice on such a transaction unless theadvice discusses every issue in detail. That rule appliesnot only to so-called marketed opinions but also toadvice given by a tax adviser entirely to his own client.The client may have reached its own conclusion concern-ing one or more issues, or may be willing to bear theexpense only of having its tax adviser evaluate a singleissue. Nevertheless, the adviser is not permitted to givefavorable advice on any issue unless it gives advice on allthe issues.

That rule might be justifiable in the case of an opinionthat will be used by an intermediary to market thetransaction. However, even then the rule might moreappropriately be directed at the marketer rather than thetax adviser giving advice to the client that is the marketer.

In any event, in the case of a tax adviser giving adviceto his own client, this rule seems to be a serious intrusionby the IRS into the adviser-client relationship. The only

apparent justification is to protect the unsophisticatedclient from its own unscrupulous adviser, who wasperhaps recommended to the client by a tax shelterpromoter. In that case, the adviser might give favorableadvice on a single issue without discussing the risksraised by other aspects of the transaction. It is not clearthat the IRS should be adopting detailed rules to protecta taxpayer from its own adviser even in that situation. Inany event, the rule applies to every taxpayer and everyadviser, no matter how sophisticated the taxpayer. Itseems inappropriate for the IRS to adopt such a broad-based prohibition.4. Substantive requirements for opinions providingpenalty protection. Section 10.35 provides elaborate rulesconcerning the required contents of any tax advice that iseligible to provide penalty protection to a taxpayer. Therequirements are quite onerous, and most tax advisersbelieve that few of those opinions will ever be given. Taxadvisers will not be willing to spend the time to draftthose opinions, and their clients will not be willing tospend the money that their advisers will charge for them.

The substantive requirements for penalty protection isa policy issue for the IRS or Congress. Some believe thatno tax opinion should ever provide penalty protection.Not going that far, I previously suggested that a taxpayershould be permitted to receive penalty protection for atax opinion only if the opinion is attached to an originalfiled tax return.24

Assuming that the policy decision has been made thatat least some tax opinions should provide penalty pro-tection, the requirements of section 10.35 for penaltyprotection go too far. They are so detailed and technicalthat they appear to create unnecessary burdens on taxadvisers and taxpayers, traps for the unwary, uncertaintyabout whether any particular opinion provides penaltyprotection, and risks to the tax adviser who mightinadvertently fail to comply with the technical rules. Therules also greatly increase the costs to small businessesand nonwealthy individuals of obtaining penalty protec-tion. Prior law appears to have been adequate in provid-ing standards for opinions that provide penalty protec-tion.25 I believe the new rules should be greatly narrowedand simplified.5. The legending requirement. Clearly the most complexand burdensome requirement of Circular 230 is thelegending requirement. Section 10.35 requires that mosttax advice that is not eligible for penalty protection (asdescribed above) contain a legend that it is not eligible forpenalty protection.

In fact, there are two legends: the ‘‘nonmarketinglegend’’ and the ‘‘marketing legend.’’ The proper legenddepends on whether the particular tax advice meets thedefinition of being ‘‘marketed’’ advice. For all advice, thelegend must state that the advice was not written or

22Illustrating the complexity of the rules, advice meets thedefinition of negative advice only if it is ‘‘very’’ negative. If theadvice says, ‘‘you’ll probably lose, but taking the positionwould not be frivolous,’’ the advice is not considered negativeand is subject to the rules in the text.

23See, e.g., Cottage Savings Assoc. v. Comm’r, 499 U.S. 554(1991), in which the Supreme Court allowed a loss on a pool ofdepreciated mortgages exchanged for another similar pool,when the only reason for the exchange was to recognize the loss.

24Schler, supra note 1, at 371-372.25See, e.g., Long Term Capital Holdings LP v. United States, No.

04-5687, Doc 2005-19826, 2005 TNT 187-16 (2d Cir., Sept. 27,2005) (upholding tax penalties for a taxpayer that received afavorable tax opinion, in part on the ground that the opinionwas based on assumptions that the taxpayer knew to be false).



(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




intended to be used, and cannot be used, to avoid taxpenalties. For marketed advice, the legend must alsostate that the advice was written to support the promo-tion or marketing of the transaction, and that the tax-payer should consult an independent tax adviser to seekadvice based on its own particular circumstances.

The difficulties with the legending requirement are toonumerous to describe in any detail here.26 Most funda-mentally, the rules are very vague and complex andsubject to numerous exceptions (and exceptions to excep-tions). Considerable time is needed to determine whethera legend, and which legend, applies to any particularadvice.

The problems with the legending requirement aregreatly exacerbated by the unclear scope of the definitionof ‘‘marketing.’’ That is quite a fundamental problem,because that definition is critical to the entire structure ofthe regulations. Numerous rules apply to marketing butnot to nonmarketing opinions.

Another critical problem is that the definition ofmarketing, even when it is clear, is extremely broad. Thatresults in the literal requirement of a marketing legend innumerous situations in which the legend makes no senseat all and was probably not intended. For example, themarketing legend (‘‘consult an independent tax advisor’’)applies to written advice given by a lawyer to her ownclient, when the client will rely on the advice to orallyrecommend the transaction to a third party but will notforward the written advice to the third party.

In some cases, the marketing legend may literally evenbe required in situations in which it could create a risk ofsecurities law liability on the tax adviser or the taxpayerthat would not have otherwise existed. For example, therequired statement that the tax opinion ‘‘was written tosupport the promotion or marketing’’ of the transactionmight have that effect. Nevertheless, tax advisers risksanctions if they ‘‘willfully’’ fail to comply with theserules.

The application of the legending requirements toe-mails is particularly burdensome. E-mails containingtax advice are sent innumerable times a day by taxlawyers, and many such e-mails are also sent by nontaxlawyers in a law firm. But, under the rules, each of thosee-mails must be evaluated to determine whether a legendis required, and if so, which one. Many large law firmshave ‘‘solved’’ that problem by automatically adding the‘‘nonmarketing’’ legend at the end of every e-mail, atleast for e-mails sent by tax lawyers.

That solution still leaves several problems. The taxlawyer must still evaluate each e-mail giving tax adviceto determine whether the marketing legend is appropri-ate, in which case a manual substitution is necessary. Thetax lawyer who does not manually remove the legendwill be including the legend on personal e-mails such asinvitations to dinner and so forth, which looks quiteridiculous. The nontax lawyer must remember to add the

appropriate legend to any e-mail giving tax advice. Onecommon illustration of the latter problem is when a taxlawyer sends an e-mail giving tax advice to a nontaxlawyer within the firm, not including the legend becausethe e-mail is not going to a client, and then the nontaxlawyer forwards the e-mail to a client and forgets to adda legend.

Some firms have attempted to solve the e-mail legend-ing problem by adding a legend at the end of everye-mail leaving the firm, regardless of who sends thee-mail and regardless of whether it contains tax advice. Inthat way, the IRS can never claim that a required legendwas not included on an e-mail. Of course, that means thatthe legend is included on probably a hundred times asmany e-mails as is legally necessary, including innumer-able e-mails having nothing whatever to do with tax, orwith law, solely to avoid the omission of a requiredlegend under Circular 230. Surely there is somethingwrong with a tax regulation that has driven many majorlaw firms to that ‘‘solution.’’

Also, even that solution is not perfect because of therequirement for different legends on marketing andnonmarketing advice. Firms using that approach attemptto comply with the requirement by combining the twolegends into one. To make matters worse, the combina-tion of legends is not specifically sanctioned by theregulations.

Yet another layer of difficulty is provided by the rulethat the legend on tax advice must be ‘‘prominentlydisclosed.’’ Highly compensated tax advisers have spenttime debating such questions as whether the legend mustbe above the signature in an e-mail, or may be below thesignature, and whether a legend must be added to ane-mail that merely forwards an underlying e-mail thatitself contains a legend.

Similarly, if a firm automatically adds a legend at theend of every e-mail leaving the firm, the legend isnormally added by the firm’s ‘‘gateway,’’ and that gen-erally requires as a technological matter that the legendbe at the very bottom of the e-mail. That may be at theend of a long string of e-mails, with the tax advice beingin the ‘‘top’’ e-mail. There is no guidance on whether thatsatisfies the requirement of ‘‘prominent disclosure.’’

Dealing with the legending requirement has taken upvast amounts of tax advisers’ time. It has also taken upvery large amounts of time of the technology depart-ments in every law firm, because every firm has had toadopt some procedure for automatic legending ofe-mails. BlackBerrys have created their own unique set oftechnological challenges (and the lengthy tax legendscontained in e-mails have made it very difficult to reade-mails on a BlackBerry screen).

In evaluating the legend requirements, it must beemphasized that those rules are not substantive ruleslimiting the ability of taxpayers to rely on tax advice toavoid penalties. Rather, they are entirely a matter of‘‘consumer protection.’’ The IRS has the authority towrite substantive regulations stating when a taxpayermay or may not rely on tax advice to avoid penalties. Thelegend included on the tax advice merely informs tax-payers about the substantive rules, and protects themfrom the incorrect belief that they can rely on the tax

26See, e.g., Paravano and Reynolds, supra note 19; letter datedOctober 19, 2005, to Michael Desmond and Cono R. Namoratofrom several practitioners (including the author of this article),Tax Notes, Nov. 7, 2005, p. 836.



(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




advice for penalty protection.27 The theory appears to bethat if the taxpayer is made aware of the substantiveno-penalty-protection rule, the taxpayer will be lesslikely to enter into a tax shelter.

It is possible that unsophisticated taxpayers mightreceive tax advice and (absent the legend) be unawarethat it could not be relied on for penalty protection.Moreover, the legend might in theory discourage thosetaxpayers from entering into a tax shelter.

However, as to the legending of e-mails, I am notaware of any reported situation in which any taxpayerever claimed penalty protection for advice contained inan e-mail. In fact, it is difficult to believe that a taxpayerwould ever enter into a tax shelter on the basis ofinformal advice such as an e-mail, let alone claim penaltyprotection on the basis of the e-mail.

Even as to the legending of more formal advice, it isnot at all clear that the requirement will in reality haveany material effect on tax shelters. Many taxpayerswould know about a substantive no-penalty-protectionrule even without the legend, because such a rule wouldreceive wide publicity. The legending requirement willhave no effect on those taxpayers. As to other taxpayers,it seems unlikely that many of them that would other-wise enter into a tax shelter would be discouraged fromdoing so solely on the basis of the required legend. Taxshelter promoters deserve more credit than that.

In any event, the legending rule adopted by the IRSappears greatly out of proportion to the tax shelterproblem it is targeting. At most, the IRS might be justifiedin requiring a tax adviser to provide a single writtennotice to each taxpayer (with receipt acknowledged bythe taxpayer in writing) informing the taxpayer that theadviser’s tax advice generally does not provide penaltyprotection. Instead, the legend must now be added tovirtually every piece of written advice sent to everytaxpayer, no matter how sophisticated the taxpayer orhow many times the taxpayer has previously received thesame legend.

E. ConclusionsThe rules in section 10.35 of Circular 230, particularly

the legending rules, are complex, vague, and difficult andtime-consuming to apply. They have placed a largeburden on normal tax practice. The burden appears to begreater than the benefit to the fisc, to taxpayers, or to thetax system. Those rules should be substantially revised toreduce the burden on normal tax practice.

27In fact, the IRS has not yet even adopted the substantiverules. It has announced that it will adopt rules stating that ataxpayer will not be able to rely on legended tax advice forpenalty protection. See T.D. 9165 (Dec. 2004). However, it isillogical for the substantive rules to be described in Circular 230,in the guise of a legending requirement, and for regulationsunder the code to adopt those rules as a substantive mattersolely by cross-reference to Circular 230. It would be far morelogical for the substantive rules to be adopted directly inregulations under the code, and for Circular 230 simply torequire legending when those substantive rules apply to denypenalty protection.



(C) T

ax Analysts 2005. A




Doc 2005-22068 (8 pgs)

(C) T

ax Analysts 2004. A




effects of anti-tax-shelter rules on nonshelter tax … · 2008. 8. 20. · adviser’s tax...

Documents