"You May Still Rely On This Advice" - What The New Circular 230 Tax Disclaimer Means For You

Friday, July 1, 2005 - 01:00

You may already have seen them - disclaimers on letters and emails that contain tax advice - disclaimers that say that the recipient of the advice cannot rely on the advice for the purpose of avoiding penalties. These ominous-looking disclaimers are the result of new Treasury Regulations that made changes to Circular 230, the rules governing practice before the Internal Revenue Service.

The new rules stem primarily from the tax-shelter scandals of recent years and the government's concern that tax advisors were able to facilitate their clients' participation in abusive tax shelters through the provision of opinions that such transactions were at least more likely than not to produce the desired tax result. In some notorious cases, the tax advisor providing the opinion prepared numerous identical opinions without even considering each particular taxpayer's circumstances or whether certain factual representations made by a taxpayer might be unreasonable. The clients presumably were more willing to enter into these transactions, because the tax opinions provided protection (or at least were designed to provide such protection) under the general rule that reliance on the advice of a tax professional can protect a taxpayer from penalties (this general rule has since been made more difficult to apply in the wake of the tax-shelter scandals).

Unfortunately, the new Circular 230 rules apply to far more than these types of "tax-shelter opinions." Rather, they affect virtually any written communication containing tax advice, including informal emails. If the advice is subject to these rules, then in most cases the practitioner either must provide the written disclaimer mentioned above or must comply with burdensome and costly investigation and disclosure requirements (described below). Failure to comply can result in fines, censure, or suspension or disbarment from practice before the IRS.

Advice is subject to this "disclaim or investigate" requirement if it constitutes a "covered opinion." A covered opinion is written advice (including email) by a practitioner concerning one or more federal tax issues arising from (1) certain "listed" transactions identified by the IRS as abusive (or similar transactions); (2) any entity or arrangement the principal purpose of which is avoidance or evasion of tax ("Principal Purpose Opinions"); or (3) any entity or arrangement a significant purpose of which is avoidance or evasion of tax if the advice meets certain other requirements discussed below ("Significant Purpose Opinions"). Note that although the rules use the term "opinion," they apply broadly to "written advice," and it is widely expected that responsible practitioners will be treating all written advice, not merely formal opinion letters, as potentially coming within these rules.

Pursuant to an amendment to the rules just one month before they were effective, advice from in-house counsel to the employer solely for the purpose of determining the tax liability of the employer is exempt from these new "covered opinion" requirements. Other types of exempt advice include certain preliminary advice (where further written advice is expected); certain advice concerning the qualification of a qualified plan; state or local bond opinions; advice included in documents required to be filed with the SEC; certain advice prepared after the taxpayer has filed a tax return; and certain advice that does not resolve the matter in the taxpayer's favor.

If advice constitutes a covered opinion, then unless an exception applies (these are discussed below), the practitioner is required to do a significant amount of diligence in ascertaining the facts relevant to the advice and must recite that information in a detailed legal analysis included with the advice.

The practitioner must do the following generally (there also are additional requirements for certain types of advice, such as "marketed" or "limited scope" opinions): (1) use reasonable efforts to identify and ascertain the facts; (2) identify and consider all relevant facts; (3) not base the advice on any unreasonable factual assumptions (including that an arrangement has a business purpose or is potentially profitable apart from its tax benefits, or that a financial projection is reliable if the practitioner knows or should know that the information is incorrect or incomplete or was prepared by a person lacking the necessary skills or qualifications); (4) not base the advice on any unreasonable factual representations, statements, or findings of the taxpayer or another person; (5) identify in a separate section all factual representations, statements, or findings of the taxpayer upon which the practitioner relied; (6) relate the applicable law to the relevant facts; (7) not assume the favorable resolution of any significant federal tax issue (although there are special provisions allowing certain "limited scope opinions"); (8) not contain any internally inconsistent legal analyses or conclusions; (9) provide a conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each significant federal tax issue considered; (10) state if the practitioner is unable to reach a conclusion on one or more issues; (11) describe the reasons for conclusions, including the facts and analysis supporting each one; (12) if the practitioner fails to reach a conclusion at a confidence level of more likely than not with respect to one or more significant federal tax issues, include a prominent disclaimer to that effect, and that the advice cannot be used for penalty protection with respect to such issues; (13) 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 issue will be resolved by settlement if raised; and (14) provide the practitioner's overall conclusion as to the likelihood that the federal tax treatment of the arrangement is the proper treatment and the reasons for the conclusion.

As this list of requirements illustrates, unless an exception applies, obtaining written tax advice from outside counsel will become much more time consuming and expensive.

Advice constitutes a Principal Purpose Opinion if a tax avoidance or evasion purpose exceeds any other purpose. However, the principal purpose of an arrangement will not be considered tax evasion or avoidance if its purpose is to claim tax benefits in a manner consistent with the applicable statute and with Congressional purpose. For example, advice recommending that a corporation elect to be taxed under subchapter S presumably would not be considered to have as its principal purpose the evasion or avoidance of tax. However, it still might be treated as a Significant Purpose Opinion.

Advice constitutes a Significant Purpose Opinion if a tax avoidance or evasion purpose is a significant purpose of the arrangement and the advice constitutes (a) a "reliance opinion;" (b) a "marketed opinion;" (c) an opinion subject to conditions of confidentiality; or (d) an opinion subject to contractual protection.

While it may seem obvious that most standard business transactions are consummated for legitimate non-tax reasons, and that there is nothing wrong with structuring those transactions in the most tax-efficient manner, such transactions often would be considered to have a significant tax-avoidance purpose. For example, advice that a stock sale may result in less tax than an asset sale or that a statutory merger may be accomplished tax-free would appear to constitute advice with a significant tax-avoidance purpose. Despite pleas from the practitioner community, the IRS has not provided guidance on what constitutes a significant tax-avoidance purpose, so the practitioner community virtually has no choice but to assume that regular, everyday tax advice comes under this rubric.

Most standard legal advice from outside counsel will likely constitute a Significance Purpose Opinion if it is a "reliance opinion." As discussed below, the disclaimer is an exception to the characterization of written advice as a reliance opinion. The other types of Significant Purpose Opinions will be less common, and the burdensome Circular 230 requirements discussed above will apply to them (and to Principal Purpose Opinions) even if the general disclaimer is made. Written advice is "subject to contractual protection" if the taxpayer has a right to a refund of fees if all or part of the intended tax consequences are not sustained or if the fees are contingent on a realization of tax benefits. Written advice is "subject to conditions of confidentiality" if the practitioner imposes on the recipient of the written advice a limitation on disclosure of the tax treatment or tax structure of the transaction. 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 in promoting, marketing, or recommending the arrangement to one or more taxpayers. The advice is not treated as a "marketed opinion" if it contains a disclaimer to the effect that the advice cannot be relied upon for penalty protection, the advice was written to support the promotion of or marketing of the matter discussed in the advice, and the recipient should seek advice from an independent tax advisor.

The disclaimers that will now be commonplace in written materials from tax practitioners and other legal advisors arise from a Significant Purpose Opinion that constitutes a "reliance opinion," which is written advice that concludes at a confidence level of more likely than not (a greater than 50 percent likelihood) that one or more significant federal tax issues would be resolved in the taxpayer's favor. Written advice is not considered to constitute a reliance opinion if the practitioner prominently discloses in the written advice that the advice was not intended or written by the practitioner to be used, and that it cannot be used by the recipient, for the purposes of avoiding penalties. The disclaimer is considered to be prominently disclosed if it is readily apparent to the reader, which at a minimum means that the disclaimer must be set apart in a separate section (not a footnote) in a typeface that is the same size or larger than the typeface of the body of the written advice.

Use of the disclaimer to ensure that written advice does not constitute a reliance opinion will be widespread, because tax practitioners (or any legal advisor giving advice that could be considered within the realm of tax advice) do not have a reasonable choice under these rules that would allow them to forego use of the disclaimer. Without it, virtually any informal advice in written form could run afoul of the rules and potentially subject the tax practitioner to penalties. The only other alternatives are to engage in lengthy and extremely costly diligence and disclosure for every piece of informal advice or provide all informal advice orally. These choices are completely inadequate - clients rightly expect to be able to receive sound, concise, and timely tax advice without having to make voluminous representations, open up their books for inspection, or pay for a dissertation.

Clients also rightly expect to be able to make use of email technology to receive advice from their counselors. Email provides great flexibility in allowing communications without the necessity of all parties being available simultaneously. In addition, email greatly enhances the ability to communicate complex tax concepts that are often much more difficult to follow when presented orally. The disclaimer will allow taxpayers to continue to have access to email as a means for receiving tax advice and to continue to be able to dictate the level of formality and cost of the tax advice they receive. Most informal advice, including emails, from tax practitioners is not intended for use in penalty protection, so the disclaimer will have no effect. If a taxpayer is seeking penalty protection, then obviously the practitioner can provide the advice without the disclaimer and can attempt to comply with the diligence and disclosure requirements described above.

In conclusion, the disclaimer you have or will be seeing on written advice from outside lawyers and accountants was forced on the practitioner community by the IRS and does not mean that the advice of those practitioners is any less reliable than it would be without the disclaimer. The disclaimer means only that the recipient of the advice cannot invoke the advice as protection from IRS penalties in the event of a dispute.

Brian A. Silikovitz is Counsel in the Tax Department of Lowenstein Sandler PC, Roseland, New Jersey.

Please email the author at bsilikovitz@lowenstein.com with questions about this article.