Article

IRS Rules on Tax Advice

In 1921, the Internal Revenue Service published Circular Number 230, which covers the tax practices of attorneys, certified public accountants, enrolled agents, actuaries, appraisers, others rendering written tax advice and other persons representing taxpayers before the IRS.

In 2004, the IRS significantly expanded Circular 230 to combat bogus opinion letters and the widespread promotion of illegal tax shelters. The 2004 regulations imposed tough requirements on professionals issuing any written tax advice, especially advice that was considered to be a "covered opinion." Those rules broadly defined the term "covered opinion" to include most written tax advice. Anything from a formal legal opinion to a simple email could have been a covered opinion.

With the2004 changes, the IRS targeted tax professionals who promoted illegal tax schemes, which were often lucrative to the promoters. Tax practitioners violating these regulations could be penalized, censured, suspended, or disbarred from practicing before the IRS.

Circular 230 Requirements for All Written Tax Advice

The 2004 requirements under Circular 230 were extensive. For example, practitioners providing written tax advice were required to consider "all relevant facts" that the practitioners knew or should have known, and relate those facts to the law, including any judicial decisions. They were also required to use reasonable methods and assumptions to determine the facts.

Tax practitioners could not give written federal tax advice based on unreasonable factual or legal assumptions, including assumptions as to future events. They could not rely on unreasonable representations, statements, findings, or agreements of the client or any other person.

When evaluating a federal tax issue, practitioners were not allowed to consider the possibility that the tax return would not be audited, that an issue would not be raised during an audit, or that a raised issue would be settled favorably. This prevented, for example, professionals from playing the "audit lottery" by recommending a tax scheme based on the expectation that the tax return would probably not be audited or that the auditor would not understand the scheme.

Old Rules on Covered Opinions (which no Longer Apply)

Under the 2004 Circular 230 definition, there were six types of covered opinions. The first type included "listed transactions," which referred to a list of specific tax-avoidance transactions that the IRS had determined to be illegal.

The second type covered written advice when tax avoidance or evasion was the principal purpose of the proposed transaction or arrangement. However, if the purpose was to claim tax benefits in a manner consistent with the statute and Congressional purpose, the principal purpose was not considered to be tax avoidance or evasion.

The final four types included any plan which had a "significant purpose of avoiding any tax, if the plan fits into one of these four categories."

The third type covered "reliance opinions," which indicated that the professional believed that, if challenged, the client had a greater than 50% likelihood of resolving the issue in the client 's favor. However, if the practitioner "prominently discloses" in the written advice that it was not intended to be used by the client and could not be used by the client to avoid tax penalties, it was not considered to be a covered opinion. Therefore, written advice was considered a reliance opinion only if it reached a "more likely than not" confidence level as to a significant federal tax issue and failed to state that the client could not rely on the written advice to avoid penalties. (Prior to these 2004 rules, taxpayers receiving assessments for back taxes were often able to avoid penalties by simply showing that they had relied on a professional 's written advice when implementing the scheme. Therefore, when using aggressive tax schemes involving large dollar amounts, some persons paid generous legal fees for opinion letters as a form of protection from penalties.)

The fourth type of covered opinion was a "marketed opinion," which included any written advice that the practitioner knew or had reason to know would be used by anyone other than the practitioner to promote, market, or recommend an arrangement to a potential client. However, if the written material disclosed that the practitioner did not intend for the advice to be used for the purpose of avoiding penalties, it was not considered to be a covered opinion.

The fifth type of covered opinion was written tax advice with conditions of confidentiality. This occurred when the practitioner forbid disclosure of his or her tax plan to others, in order to protect the confidentiality of the practitioner 's tax strategy. Because selling tax shelters could be lucrative, promoters often wanted to limit access to only those who had paid their fees.

The sixth type of covered opinion had "contractual protection." This referred to situations where the client was offered a full or partial refund of fees paid to the tax practitioner if the intended tax benefits were disallowed by IRS. It also applied to situations in which the fees were contingent on the client 's realization of tax benefits from the transaction. Circular 230 stated that "any agreement to provide services without reasonable compensation" also constituted contractual protection. However, an agreement to defend the intended tax consequences without additional compensation did not by itself make the advice a covered opinion.

Despite the broad scope of Circular 230, there was still some written tax advice that was not considered to be a covered opinion under those rules. When the practitioner planned to provide subsequent written advice that met the requirements of Circular 230, any preliminary advice was not considered to be a covered opinion. Also, any advice that dealt with qualified retirement plans, state or local bonds, or SEC documents was excluded from the definition of covered opinion. Also, correspondence concerning a tax return that had already been filed was not a covered opinion (section 10.35(b)(2)(ii)(C)). In addition, advice given by in-house counsel regarding the employer 's tax liability was not covered. And, written advice which told a client that the desired tax benefits would not be achieved was not considered to be a covered opinion.

Additional Old Rules for Issuing Covered Opinions

Extensive rules applied when a covered opinion was issued. For example, the rules required that the opinion "must identify and consider all facts that the practitioner determines to be relevant." Also, the opinion "must identify in a separate section all factual assumptions relied upon by the practitioner."

Tax practitioners were also required to provide their conclusions as to the likelihood that, if challenged by the IRS, the taxpayer would prevail. Also, the reasons for that conclusion must have been explained. The practitioners were required to be knowledgeable in all tax aspects of any opinion given to a client. These are just a few examples; the list of requirements was lengthy.

2014 Changes to Rules for Written Tax Advice

In September 2012, the IRS proposed changes to Circular 230, which were finalized effective for advice given after July 12, 2014. These changes are significant. Among the changes was the elimination of the rules addressing covered opinions.
These are the new rules concerning written tax advice:

§ 10.37 Requirements for written advice.

(a) Requirements.

(1) A practitioner may give written advice (including by means of electronic communication) concerning one or more Federal tax matters subject to the requirements in paragraph (a)(2) of this section. Government submissions on matters of general policy are not considered written advice on a Federal tax matter for purposes of this section. Continuing education presentations provided to an audience solely for the purpose of enhancing practitioners ' professional knowledge on Federal tax matters are not considered written advice on a Federal tax matter for purposes of this section. The preceding sentence does not apply to presentations marketing or promoting transactions.
(2) The practitioner must -
(i) Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events);
(ii) Reasonably consider all relevant facts and circumstances that the practitioner knows or reasonably should know;
(iii) Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter;
(iv) Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable;
(v) Relate applicable law and authorities to facts; and
(vi) Not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.
(3) Reliance on representations, statements, findings, or agreements is unreasonable if the practitioner knows or reasonably should know that one or more representations or assumptions on which any representation is based are incorrect, incomplete or inconsistent.
(b) Reliance on advice of others. A practitioner may only rely on the advice of another person if the advice was reasonable and the reliance is in good faith considering all the facts and circumstances. Reliance is not reasonable when -
(1) The practitioner knows or reasonably should know that the opinion of the other person should not be relied on;
(2) The practitioner knows or reasonably should know that the other person is not competent or lacks the necessary qualifications to provide the advice; or
(3) The practitioner knows or reasonably should know that the other person has a conflict of interest in violation of the rules described in this part.
(c) Standard of review.
(1) In evaluating whether a practitioner giving written advice concerning one or more Federal tax matters complied with the requirements of this section, the Commissioner, or delegate, will apply a reasonable practitioner standard, considering all facts and circumstances, including, but not limited to, the scope of the engagement and the type and specificity of the advice sought by the client.
(2) In the case of an opinion the practitioner knows or has reason to know 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 to one or more taxpayers a partnership or other entity, investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code, the Commissioner, or delegate, will apply a reasonable practitioner standard, considering all facts and circumstances, with emphasis given to the additional risk caused by the practitioner 's lack of knowledge of the taxpayer 's particular circumstances, when determining whether a practitioner has failed to comply with this section.

(d) Federal tax matter. A Federal tax matter, as used in this section, is any matter concerning the application or interpretation of---

(1) A revenue provision as defined in section 6110(i)(1)(B) of the Internal Revenue Code;
(2) Any provision of law impacting a person 's obligations under the internal revenue laws and regulations, including but not limited to the person 's liability to pay tax or obligation to file returns; or
(3) Any other law or regulation administered by the Internal Revenue Service.
(e) Effective/applicability date. This section is applicable to written advice rendered after June 12, 2014.

In addition, the Circular 230 addresses the competence of those who issue opinion letters:

§ 10.35 Competence.

(a) A practitioner must possess the necessary competence to engage in practice before the Internal Revenue Service. Competent practice requires the appropriate level of knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged. A practitioner may become competent for the matter for which the practitioner has been engaged through various methods, such as consulting with experts in the relevant area or studying the relevant law.

(b) Effective/applicability date. This section is applicable beginning June 12, 2014.

Summary

The Circular 230 requirements are primarily intended to prevent the promotion of illegal tax shelters, but the rules cover most written tax advice including compensation opinion letters that are used for tax purposes. These regulations include language that is open to broad interpretation and should be read carefully. This is a brief summary of complex rules and should be used for discussion purposes only.