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MALPRACTICE IN TAX REPRESENTATION
OF CLOSELY HELD BUSINESSES
By: Richard A. Shaw, Esq.
Higgs, Fletcher & Mack, LLP
401 West A Street, Suite 2600
San Diego, California 92101
Telephone: (619) 236-1551
Facsimile: (619) 696-1410
TABLE OF CONTENTS
Page
I. GENERAL......................................................................................................................... 1
II. PRIMARY ETHICAL STANDARDS IN THE PROFESSIONAL
RELATIONSHIP WITH THE CLIENT. .......................................................................... 1
A. General................................................................................................................... 1
1. Ethical Considerations Do Not Create Civil Causes Of Action. ............... 2
2. Independent Civil Cause Of Action........................................................... 2
B. American Bar Association Standards. ................................................................... 2
1. ABA Canons of Professional Ethics (1908). ............................................. 2
2. ABA Model Code of Professional Responsibility (1969( (the
“Model Code”)........................................................................................... 2
3. Model Rules With Professional Conduct (1983). ...................................... 2
4. California Rules. ........................................................................................ 3
5. State Licensing........................................................................................... 3
6. United States Tax Court............................................................................. 3
C. Significant Ethical Rules Affecting Attorney Client Relationship. ....................... 4
1. ABA Rule 1.1. - Competence. ................................................................... 4
2. Expert Attorney Standard of Competence. ................................................ 4
3. ABA Model Rule 1.3. - Diligence. ............................................................ 6
4. California Rule of Professional Conduct Rule 3.110................................. 7
5. Fiduciary Duty of Attorney to Client......................................................... 8
6. Duty of Confidentiality. ............................................................................. 9
7. Duty of Undivided Loyalty and Fidelity – Conflicts of Interest.............. 13
8. The State of California has Adopted a Series of Rules of
Professional Conduct Dealing with Conflicts of Interest. ....................... 17
9. Conflicts of Interest - Organization as Client. ......................................... 21
D. Significant Ethical Rules Affecting Accountant-Client Relationship. ................ 24
1. Principle of Professional Conduct, ET Section 52................................... 25
2. Integrity.................................................................................................... 25
3. Objectivity and Independence.................................................................. 25
4. Conflicts of Interest.................................................................................. 27
5. Competence and Due Care....................................................................... 28
6. Confidential Client Information............................................................... 30
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TABLE OF CONTENTS
(continued)
Page
III. ABA AND IRS GUIDANCE IN TAX PRACTICE. ...................................................... 31
A. American Bar Association Guidance in Tax Practice.......................................... 31
1. Significant Formal ABA Tax Opinions: .................................................. 31
2. ABA Formal Opinion 314 (April 27, 1965). ........................................... 31
3. Formal Opinion 85-352 (July 2, 1985). ................................................... 33
4. ABA Section of Taxation Special Task Force on Formal Opinion
85-352 (1986)........................................................................................... 34
B. AICPA Standards for Tax Return Positions. ....................................................... 35
1. Definition of a Tax Return Position......................................................... 35
2. Standards for Recommending a Tax Return Position or Preparing a
Separate Tax Return on Refund Claims................................................... 35
C. Circular 230 Standards for Practice Before the IRS. ........................................... 36
1. Treasury Regulations of Practice before the IRS..................................... 36
2. Selected Duties and Restrictions Relating to Practice Before the
IRS ........................................................................................................... 36
D. Tax Shelter Opinions. .......................................................................................... 44
1. Background. ............................................................................................. 44
2. Best Practice For Tax Advisors. .............................................................. 45
3. Standards for Certain Tax Shelter Opinions ............................................ 46
4. Procedures to Ensure Circular 230 Compliance ...................................... 51
5. Establishment of Advisory Committees .................................................. 52
-ii-
MALPRACTICE IN TAX REPRESENTATION
OF CLOSELY HELD BUSINESSES
By: Richard A. Shaw, Esq.
Higgs, Fletcher & Mack, LLP
401 West A Street, Suite 2600
San Diego, California 92101
Telephone: (619) 236-1551
Facsimile: (619) 696-1410
I. GENERAL.
The purpose of this presentation is to examine malpractice considerations in tax
representation of closely held businesses. The examination will include consideration of
the primary causes of action that arise from fiduciary relationships, contractual
obligations or tortuous conduct, as well as an evaluation of the alternative remedies and
damages that may flow from the existence of malpractice.
In the process it is also appropriate to give attention to the ethical considerations that are
to be applied in the lawyers or the accountants professional relationship with the client.
These will of necessity include a review of professional standards of competency and
expertise that apply within the professions. It will include due consideration to the
relationship of the professional to the client taking into account the professional’s level of
skill and experience the character of the relationship, including the fiduciary duty of
loyalty and fidelity, the obligation to preserve confidences, the avoidance of conflicts of
interest, and the existence of presumptions of undue influence.
II. PRIMARY ETHICAL STANDARDS IN THE PROFESSIONAL RELATIONSHIP
WITH THE CLIENT.
A. General.
Although professional rules generally expressly provide that ethical
considerations do not create legal standards to be applied in determining the
existence of malpractice, it is apparent that ethical conduct is an essential factor in
determining the legal consequences flowing from the relationship, whether as a
fiduciary, under contract or in fulfilling a duty of care. It is evident that ethical
rules and canons of the professions frequently overlap or are the same as those
legal factors applied in the malpractice cases.
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1. Ethical Considerations Do Not Create Civil Causes Of Action.
a. California Rule of Professional Conduct – Section 1-100 Purpose
and Function:
“These rules are not intended to create new causes of action.
Nothing in these rules shall be deemed to create augment,
diminish, or eliminate any substantial legal duty of the lawyer or
the disciplinary consequences of violating such a duty.”
2. Independent Civil Cause Of Action.
Some cases hold that there is no independent civil cause of action for a
breach of the fiduciary duties. Wilhelm v. Pray, Price, Williams and
Russell, 186 Cal.App.3d 1324, 1986; Nobbles, v. Sears Roebuck & Co.,
33 Cal.App.3d 654 (1973). Although a breach of the model rule standing
alone generally will not represent negligence per se, the courts have
frequently taken the position that a violation of the rules represents either a
rebuttal presumption or some evidence of negligence. See Lipton v.
Boesky, 110 Mich. App. 589, 313 N.W. 2nd 163 (1961); Martinson Bros.
v. Hjellum, 395 N.W. 2nd 865, 872 (ND 1985); Sawabini v. Desenberg,
143 Mich. App. 373, 372G N.W. 2nd 559 (1985); and Carlson v. Morton,
229 Mont. 234, 745 P. 2nd 1133 (1987) (suggesting that proof of the
violation of some disciplinary rules made by itself established negligence)
B. American Bar Association Standards.
1. ABA Canons of Professional Ethics (1908).
2. ABA Model Code of Professional Responsibility (1969( (the “Model
Code”).
The Model Code consists of three parts:
a. Canons: Statements of broad axiomatic professional norms
b. Ethic Consideration: Aspirational objectives toward which
lawyers should strive
c. Disciplinary Rules: Mandatory statements prescribing minimal
levels of conduct.
3. Model Rules With Professional Conduct (1983).
The Model Rules consist of specific standards of conduct accompanied by
explanatory comments. It is important to recognize that the American Bar
Association Model Rules are only advisory since the American Bar
Association does not exercise disciplinary authority over its members.
2
Significant amendments to the Model Rules were approved by the ABA in
2002 as a result of the comprehensive review undertaken by the ABA
Ethics 2000 Commission as adopted by the House of Delegates in
February 2002. The Model Rules are either imperative or permitted in all
of the states except for California, Iowa, Maine, Nebraska, New York,
Oregon and Tennessee.
4. California Rules.
California is the only state that does not follow either the ABA Canons,
Code, or Model Rules. The present California Rules of Professional
Conduct were approved by the California Supreme Court on November
28, 1988, with amendments to date.
5. State Licensing.
Any lawyer acting outside of the territorial limits of the state to which
admitted, remains subject to the governing authority of that state as the
licensing jurisdiction and may also be subjected to additional restrictions
in the second jurisdiction where the lawyering action takes place.
6. United States Tax Court.
Practice in the United States Tax Court is regulated by the United States
Tax Court Rules of Practice and Procedure which has adopted the
American Bar Association Model Rules and requires compliance for tax
practitioners before the Tax Court.
a. The United States Tax Court Rules of Practice and Procedure.
(July 1, 1990, as amended September 12, 1997). See in particular
Rules 200, 201 and 202.
b. Tax Court Rule 201(a).
Tax Court Rule 201(a): “General: Practitioners before the Court
shall carry on their practice in accordance with the letter and spirit
of The Model Rules of Professional Conduct of the American Bar
Association.”
Example: Duffey v. Commissioner, 91 T.C. 81 (1988). Attorney was
precluded from representation when he was likely to be a necessary
witness under Model Rule 3.7(a).
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C. Significant Ethical Rules Affecting Attorney Client Relationship.
1. ABA Rule 1.1. - Competence.
ABA Model Rule 1.1 requires that a lawyer shall provide competent
representation to a client. Such competent representation requires “the full
knowledge, skill, thoroughness and preparation reasonably necessary for
the representation.”
ABA Rule 1.1 Comment 5 (with respect to thoroughness and preparation)
explains: “Competent handling of a particular matter includes inquiry into
an analysis of the factual and legal elements of the problem, and use of
methods and procedures meeting the standards of competent practitioners.
It also includes adequate preparation. The required attention and
preparation are determined in part by what is at stake; major litigation and
complex transactions ordinarily require more elaborate treatment then
matters of lesser consequences.”
The knowledge and skill required in a particular matter depends on the
relative complexity and specialized nature of the subject matter, the
lawyer’s general experience, the lawyer’s training and experience in the
particular field, the preparation and study the lawyer is able to give to the
subject matter and whether it is feasible to refer the matter to an associate
or consult with a lawyer that has established competence in the field in
question.
The lawyer can give advice in an emergency on a matter in which the
lawyer does not have the skill ordinarily required where a referral,
consultation or representation is impracticable. In such an emergency,
assistance should be limited to that reasonably necessary under the
circumstances.
The lawyer can accept a representation when the necessary level of
competence can be achieved by reasonable preparation.
2. Expert Attorney Standard of Competence.
Under general legal principles, a professional has a duty arising out of the
professional relationship with the client to exercise the level of skill, care
and diligence that is commonly possessed and exercised by other members
of the profession under similar circumstances. If the professional
represents him or herself as possessing expertise in a field recognized as
requiring special skills beyond those of an ordinary lawyer, the
professional is held to a higher standard of care, requiring the same skill
and diligence expected of other persons practicing the same specialty. See
Horne v. Peckham, 97 Cal.App.3d 404 (1979), Bent v. Green, 39 Conn.
Supp. 416, 466(a) 2d 322 (1983); Bowman v. Doherty, 235 Kan. 870, 686
4
p. 2d 012 (1984); and Restatement (2nd) of Torts, Section 299A,
Comment D.
Although in earlier years only admiralty law and patent law were
considered areas requiring special skills, the courts in the 1970s began to
recognize that other areas of law required special skill and experience.
The premier case is Horne v. Peckham, supra, which in 1979 established
in California that the subject of federal income taxation was a area
requiring special skill and that a general practitioner who elects to practice
in the field of federal tax law should be held to the same standard of care
expected of other persons practicing in the tax law specialty. In Horne v.
Peckham, Horne wanted to shift income to his children under a ten-year
“Clifford Trust”. Under pre-1986 law the tax code permitted a taxpayer to
shift income to the beneficiary of a trust if the grantor transferred property
to the trust and relinquished dominion and control over the property and
its income for a term in excess of ten years. The attorney Peckham who is
not a tax lawyer transferred a non-exclusive five year license in a patent
(instead of the entire patent that he controlled) to a Clifford Trust. The
trial court and the California court of appeals found that the failure of the
trust to satisfy the ten-year income exclusion was obvious and found that
the attorney fell below the duty of competence required of the person
practicing as a tax expert.
The court in Horne v. Peckham understood that not all tax matters must be
considered solely by tax specialists. The court recognized that many “tax
matters are so generally known that they can be well handled by general
practitioners” citing Bucquet v. Livingston, 57 Cal.App.3d 914, 129
Cal.Rptr. 514 (Cal.App. 1976). In Bucquet v. Livingston a general
practitioner created an inter vivos trust as part of an estate plan designed to
reduce death taxes. He erroneously prepared a power of attorney that was
interpreted as a general power of appointment under section 2041 of the
Code thereby bringing unanticipated funds into the estate of the decedent.
In testing the attorney’s competence as a general practitioner rather than a
tax specialist, the court noted that a “marital deduction trust, such as the
one drafted in the instant case, is one of the best known estate planning
devices”. In evaluating whether the subject matter should be retained in
the providence of a specialist, the court observed several considerations:
(1) The marital deduction trust was very well known and significant
planning tool in the entire community; (2) section 2041 had been in
existence for at least ten years before the trust was drafted; and (3) the use
of general powers of appointment and special powers of appointment were
significant items well known in trust and estate law. The attorney was
held liable. See also H&R Block, Inc. v. Testerman, 338 A. 2d 48 (N.D.
1975) and Midwest Supply, Inc. v. Waters, 510 P. 2d 876 (Nev. 1973).
In H&R Block v. Testerman, supra, tax return preparers were found to be
“woefully-inadequate in terms of education and experience–for the tasks
5
which they had undertaken . . .” and the “errors Block had made bordered
on the absurd.” In the Testerman case, the Testermans operated a service
station as a sole proprietorship. For 1968 they visited H&R Block and
provided the employee with a cardboard box containing their business
records. After a quick examination of their profit control record book, the
H&R Block employee informed the Testermans they had lost money. The
court’s statement of facts explained: “By this time, the Testermans were
overcome by curiosity and asked how it was possible for [*39] them to
have “lost money” when in fact, they had made an adequate livelihood and
had drawn cash from the business for their personal use. Mrs. Weisberg
replied that “everybody loses [***6] money the first couple of years they
are in business”; and that the money transferred from their business
account to their personal checking account “was hard earned money that
was not taxable.” On the advice of the employee the Testermans reported
a loss for 1968 and filed a claim for refund of taxes for an earlier year. In
the words of the court: “This proved to be more than the IRS could
endure.” The agent accused the Testermans of putting $10,000.00 in their
pocket and reported the matter to the criminal intelligence division of the
IRS. In view of the Testermans’ limited education and apparent honesty
the intelligence division recommended against prosecution.
In Midwest Supply, Inc., supra, the tax return preparer was a temporary
employee previously engaged in construction work who had no formal
training in the preparation of tax returns.
3. ABA Model Rule 1.3. - Diligence.
Rule 1.3 Diligence, states “a lawyer shall act with reasonable diligence
and promptness in representing a client”
The ABA Rule 1.3 comment 1 explains that “a lawyer must also act with
commitment and diligence to the interest of the client and with zeal in
advocacy upon the client’s behalf.” The lawyer may have authority to
exercise professional discretion in determining the means by which the
matter should be pursued. The lawyer’s duty to act with reasonable
diligence does not require the use of offensive tactics or preclude the
treating of all persons involved in the legal process with courtesy and
respect. The rule contemplates that the lawyer must control his or her
workload so that each matter can be handled competently.
ABA Rule 3.1 provides that a “lawyer shall not bring or defend a
proceeding or assert or controvert an issue therein, unless there is a basis
for doing so that is not frivolous, which includes a good faith argument for
the extension, modification, or reversal of existing law.
6
4. California Rule of Professional Conduct Rule 3.110.
a. “Rule 3-110 - Failure to Act Competently.
(A) A member shall not intentionally, recklessly, or
repeatedly fail to perform legal services with
competence.
(B) For purposes of this rule, “competence” in any legal
service skill shall mean to apply the 1) diligence, 2)
learning and skill, and 3) mental, emotional, and
physical ability reasonably necessary for the
performance of such service.
(C) If a member does not have sufficient learning and
skill when the legal service is undertaken, the
member may nonetheless perform such services
competently by 1) associating with or, where
appropriate, professionally consulting another
lawyer reasonably believed to be competent, or 2)
by acquiring sufficient learning and skill before
performance is required.”
b. Illustrative cases.
The failure to take action in a case, despite numerous reminders
that the matter was pending, with inquiries from the client,
constituted, “willfulness” under the rule. King v. State Bar 53
Cal.3d 307 (1990). Repeated acts of negligence may justify a
finding of willfulness. In The Matter of Respondent G, 2 Cal.
State Bar Ct. Rptr. 175, 181 (1992). Habitual disregard of the
client’s interest, combined with a failure to communicate with the
client may constitute an act of moral turpitude justifying
substantial discipline, Carter v. State Bar 44 Cal.3d 1091, 1100
(1988). However, delay in the performance of a single client’s
matter may not give rise to the level of “reckless disregard” or
“repeated failure” to perform legal services competently. In The
Matter of Whitehead, 1 Cal. State Bar Ct. Rptr. 354, 365-366
(1991). An attorney’s standard for legal representation is the same
regardless whether the work is performed pro bono or for a fee.
Segal v. State Bar, 44 Cal.3d 1077 (1988).]
c. Supervision of Attorneys and Staff.
The duties set forth in Rule 3-110 include a duty to supervise the
work of subordinate attorneys and employees and agents. See
Waisman v. State Bar, 41 Cal.3d 452 (1986); Trousil v. State Bar,
38 Cal.3d 337, 342 (1985); Gadda v. State Bar 50 Cal.3d 344. 354
7
(1990) (the court held that an attorney cannot relinquish
responsibility for a client’s matter “simply by punting the file
downfield to whomever catches it”); In The Matter of Whitehead,
1 Cal. State Bar Ct. Rptr. 354 (1991) the court found that even
though the attorney acted in good faith, and was actively mislead
by his associate attorney as to the work performed, the attorney’s
prolonged failure to supervise the associate’s work justified finding
a violation of Rule 3-110.
5. Fiduciary Duty of Attorney to Client.
a. Fiduciary Relationship.
The relationship between the attorney and client is a fiduciary
relationship of the highest character. Cox v. Delmas, 99 Cal. 104
(1893) It binds the attorney to a relationship of the most
conscientious fidelity. The attorney must be a paragon of candor,
fairness, honor, fidelity in all of his dealings with those who place
their trust in his ability and integrity. Sanguinetti v. Rossen, 12
Cal.App. 623 (1910)
b. A Personal Relationship.
The fiduciary attorney-client relationship is a purely personal
relationship, involving the highest personal trust and confidence.
Am. Jur. 2d, Attorneys at Law Section 137. The attorneys
fundamental duties include individual loyalty to the client’s
personal interest. Dettamanti v. Lonpoc Union School District,
143 Cal.App.2d 715 (1956)
c. Undue Influence and Abuse with Confidence.
As a fiduciary the attorney is precluded from using any undue
influence or obtaining any personal gains by abusing the
confidence reposed by the client. Even after the termination of the
relationship the attorney is prohibited from engaging in any act that
would injure the former client in matters arising from the former
representation or use the former client’s information acquired
during the relationship. Trafton v. Youngblood, 69 Cal.2d 17, 442
P.2d 648 (1968); Lyders v. State Bar of California, 12 Cal.2d 261,
83 P.2d 500 (1938); Frazier v. Superior Court, 97 Cal.App.4th 23
(2002)
d. Communications, Confidences and Conflicts.
Numerous rules of ethics flow from the fiduciary relationship
period. In order to satisfy a duty of undivided loyalty and utmost
fairness to clients, the professional has an obligation to make full
8
disclosure in communications with the client. Among the most
significant duties are those that require the professional to preserve
the confidences and secrets of the client and not to engage in any
acts or representations that will conflict with the interests of the
client.
6. Duty of Confidentiality.
Among the most significant fiduciary duties of the attorney is an
obligation to preserve the confidences and secrets of the client.
a. ABA Model Rule 1.6 – Confidentiality of Information.
The controlling ABA Rule on Confidentiality and Information is
Model Rule 1.6 which was substantially revised in 2002 as a result
of the adjustments made by the ABA Ethics 2000 Commission,
and as modified by the House of Delegates.
“Rule 1.6 – Confidentiality of Information
(a) A lawyer shall not reveal information
relating to the representation of a client
unless the client gives informed consent, the
disclosure is impliedly authorized in order to
carry out the representation or the disclosure
is permitted by paragraph (b).
(b) A lawyer may reveal information relating to
the representation of a client to the extent
the lawyer reasonably believes necessary;
(1) to prevent reasonably certain death
or substantial bodily harm;
(2) to prevent the client from
committing a crime or fraud that is
reasonably certain to result in
substantial injury to the financial
interests or property of another and
in furtherance of which the client has
used or its using the lawyer’s
services;
9
(3) to prevent, mitigate or rectify
substantial injury to the financial
interests or property of another that
is reasonably certain to result or has
resulted from the client’s
commission of a crime or fraud in
furtherance of which the client has
used the lawyer’s services;
(4) to secure legal advice about the
lawyer’s compliance with these
Rules;
(5) to establish a claim or defense on
behalf of the lawyer in a controversy
between the lawyer and the client, to
establish a defense to a criminal
charge or civil claim against the
lawyer based upon conduct in which
the client was involved, or to
respond to allegations in any
proceeding concerning the lawyer’s
representation of the client; or
(6) to comply with other law or a court
order.”
A fundamental principle of the attorney-client relationship is that
the lawyer must not reveal any information relating to the
relationship, in the absence of the client’s informed consent. The
rule contributes to a sense of a trust that encourages the client to
seek legal assistance and to communicate fully and frankly with
the lawyer even as to subject matter that may be embarrassing or
legally damaging. The confidentiality rule of professional ethics
applies in addition to judicial and statutory bodies of law related to
the attorney-client evidentiary privilege and the work product
doctrine. For example, the confidentiality rule would apply not
only to matters which are communicated in confidence by the
client, but also to all other information relating to the
representation, whatever its source.
(i) Authorized Disclosure.
The lawyer is authorized to make certain disclosures about
a client when appropriate in order to carry out
representation. Rule 1.6 comment No. 5 explains that the
attorney may be impliedly authorized to admit a fact that
10
cannot properly be disputed or to make a disclosure that
facilitates a satisfactory conclusion to a matter. A lawyer
in a firm may disclose to each other information relating to
the client unless the client has expressly instructed that that
particular information be confined to specified attorneys.
(ii) Disclosure Adverse to the Client.
The 2002 changes to Rule 1.6 have made significant
changes in the circumstances in which a lawyer may
reasonably disclose information adverse to the client’s best
interest. Paragraph (b)(1) recognizes the overriding value
of life and physical integrity and permits disclosure
reasonably necessary to prevent reasonably certain death or
substantial bodily harm.
A more significant limitation now exists in paragraph (b)(2)
of the ABA rule on confidentiality that permits the lawyer
to reveal information to the extent necessary to enable
affected persons or appropriate authorities to prevent the
client from committing a crime or fraud that is reasonably
certain to result in substantial injury to the financial or
property interests of another, and in furtherance of which
the client has used or is using the attorney’s services.
Comment No. 7 explains that the client’s conduct is a
serious abuse of the attorney-client relationship that forfeits
the protection of the rule. Comment No. 7 further explains
“although paragraph (b)(2) does not require the lawyer to
reveal the client’s misconduct, the lawyer may not counsel
or assist the client in conduct the lawyer knows is criminal
or fraudulent. Rule 1.16 addresses the lawyer’s obligation
or right to withdraw from representation of the clients in
such circumstances.
A former senior government official has asserted that when
a taxpayer becomes aware of a failure to report a taxable
item on a previously filed tax return, the refusal of the
client to permit disclosure of the item in an audit, would be
a willful criminal act requiring the lawyer to withdraw from
representation under this rule, since there is a continuing
obligation to pay a proper tax.
In circumstances where wrongful conduct has occurred
there may be situations where losses suffered by an
affected person may be prevented, rectified or mitigated
under Rule 1.6(b)(3). This rule permits the lawyer to
disclose information related to the representation to the
11
extent necessary to enable the affected persons to prevent
or mitigate reasonably certain losses or attempt to recoup
those losses. Paragraph (3)(b) does not apply when the
person who has committed the crime or fraud thereafter
employs a lawyer for representation concerning that
offense.
This Rule also raises the question whether a tax lawyer who
knows of a willful failure to file has a right or obligation to
make a noisy withdrawal of representation. See Comment
No. 8.
(iii) Disclosure Upon Threat of Complicity.
Where a legal claim or disciplinary charge alleges
complicity of the lawyer in the client’s conduct or other
misconduct for the lawyer involving representation, the
lawyer may respond to the extent that the lawyer
reasonably believes necessary to establish a defense to the
charge. See Comment No. 10.
(iv) Prospective Client.
Under related Model Rule 1.18(b) a lawyer who has had
discussions with a perspective client is prohibited from
using or revealing information learned in the consultation
except under those circumstances on Rule 1.9 that would
permit the disclosure of information for a former client.
(v) Informed Consent.
Informed consent exists for purposes of Rule 1.6 only when
there is an “agreement by a person to a proposed course of
conduct after the lawyer has communicated adequate
information and explanation about the material risk of and
reasonably available alternatives to the proposed course of
conduct. See Rule 1.0(e).
b. State Laws.
Many states create a statutory fiduciary obligation of the attorney
to preserve confidences. California Business and Professions Code
Section 6068(e) provides that it is the duty of an attorney to
“maintain in violate the confidence and at every price to himself or
herself to preserve the secrets of his work or client.”
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7. Duty of Undivided Loyalty and Fidelity – Conflicts of Interest.
Since the attorney-client privilege is a fiduciary duty that requires the
highest duty of loyalty and fidelity, it is a violation of the duty for an
attorney to assume any position that is adverse or antagonistic to the client
without the client’s free and fully informed consent.
a. “ABA Model Rule 1.7 – Conflict of Interest: General Rule
(a) A lawyer shall not represent a client if the
representation of that client will be directly adverse
to another client, unless:
(1) the lawyer reasonably believes the
representation will not adversely affect the
relationship with the other client; and
(2) each client consents after consultation.
(b) A lawyer shall not represent a client if the
representation of that client may be materially
limited by the lawyer’s responsibilities to another
client or to a third person, or by the lawyer’s own
interests, unless:
(1) the lawyer reasonably believes the
representation will not be adversely
affected; and
(2) the client consents after consultation. When
representation of multiple clients in a single
matter is undertaken, the consultation shall
include explanation of the implications of
the common representation and the
advantages and risks involved.”
b. Procedures to Resolve Conflicts
(i) General Procedures.
The resolution of conflicts of interests problems under Rule
1.7 requires the lawyer to: (1) clearly identify the client or
clients; (2) determine whether a conflict of interest exists;
(3) decide whether the representation may be undertaken
despite the existence of a conflict - whether the conflict is
consentible; and (4) if so, consult with the clients affected
and obtain their informed consent, confirmed in writing.
The lawyer is required to adopt reasonable procedures
13
appropriate for the size and type of firm and practice, to
determine in both litigation and non-litigation matters the
persons and issues involved. Comment No. 3 explains that
ignorance caused by the failure to institute such procedures
will not excuse the attorney’s violation of the rule.
If a conflict arises after representation has commenced, the
lawyer ordinarily must withdraw from the representation
unless the lawyers obtain the informed consent of the
client. Where more than one client is involved, whether the
lawyer can continue to represent any of the clients is
determined both by the lawyer’s ability to comply with the
duties owed to the former client and by the lawyer’s ability
to represent adequately the remaining client or clients,
given the lawyer’s duties to the former client. See
Comment No. 4.
(ii) Consent
Consent is typically determined by considering where the
interests of the clients will be adequately protected if the
clients are permitted to give their informed consent to
representation burdened by a conflict of interest.
Representation would be prohibited in the circumstances
that the lawyer cannot reasonably conclude that he or she
would be able to provide confident and diligent
representation. See Comment No. 15.
(iii) Informed Consent
In order for a consent to be a fully informed consent each
affected client must be aware of the relevant circumstances
and the material and reasonably foreseeable ways in which
a conflict could have adverse effects on the interests of that
client. See Rule 1.0(e). The information required depends
on the nature of the conflict and the nature of the risks that
are involved. When the representation of multiple clients
in a single matter is undertaken, the information must
include the implications of common representation,
including possible effects on loyalty, confidentiality in the
attorney-client privilege and the advantages and risks
involved.
14
The consent must be confirmed in writing. The writing
may consist of a document executed by the client or one
that the lawyer promptly records and transmits to the client
following an oral consent. See ABA Rule 1.0(b). The
writing may include an electronic transmission. See ABA
Rule 1.0(n). If it is not feasible to obtain or transmit the
writing when the client is given informed consent, the
lawyer must obtain or transmit it within a reasonable time
thereafter.
(iv) Consent to Future Conflict
Comment No. 22 of Rule 1.7 describes the effect of an
effort to consent to a potential future conflict. As stated in
Comment No. 22:
“the effectiveness of a consent to future
conflict is determined to the extent to which
the client reasonably understands the
material risks that the waiver entails. The
more comprehensive the explanation the
future representations that might arise and
the actual and reasonably foreseeable
adverse consequences to those
representations, the greater the likelihood
that the client will have the necessary
understanding. Thus if a client agrees to
consent to a particular conflict with which
the client is already familiar, then the
consent will ordinary be effective as to that
type of conflict. If the consent is general
and open-ended, then the consent will
ordinarily be ineffective, because it is not
reasonably likely that the client will have
understood the material risks involved. If
the client is an experienced user of legal
services and is reasonably informed
regarding the risks that a conflict may arise,
such a consent will more likely be affective.
This is particularly the case if the client is
independently represented by other counsel
in given the consent and the consent is
limited to future conflicts unrelated to the
subject of representation.”
15
c. Conflicts of Interest – The Formal Client.
The ABA has also established a special conflict of interest rules of
protecting the interest of a former client.
“Rule 1.9 Conflict of Interest: Former Client
(a) A lawyer who has formerly represented a
client in a matter shall not thereafter
represent another person in the same or a
substantially related matter in which that
person’s interests are materially adverse to
the interests of the former client unless the
former client consents after consultation.
(b) A lawyer shall not knowingly represent a
person in the same or substantially related
matter in which affirm with which the
lawyer formerly was associated had
previously represented a client.
(1) whose interests are materially
adverse to that person; and
(2) about whom the lawyer had acquired
information protected by Rules 1.6
and 1.9(c) that is material to the
matter; unless the former client
consents after consultation.
(c) A lawyer who has formerly represented a
client in a matter or whose present or former
firm has formerly represented a client in a
matter shall not thereafter:
(1) use information relating to the
representation to the disadvantage of
the former client except as Rule 1.6
or Rule 3.3 would permit or require
with respect to a client, or when the
information has become generally
known; or
(2) reveal information relating to the
representation except as Rule 1.6 or
Rule 3.3 would permit or require
with respect to a client.”
16
8. The State of California has Adopted a Series of Rules of Professional
Conduct Dealing with Conflicts of Interest.
a. CRPC Rule 3-300 – Avoiding Interests Adverse to the Client –
Business Transactions.
(i) Rule 3-300 prohibits member from entering into a business
transaction with a client unless:
(a) The transaction and terms are (a) fair and
reasonable to the client; (b) are fully disclosed and
transmitted to the client; (c) in a manner which
should be reasonably understood by the client;
(b) The client is advised in writing that the client may
seek the advice of an independent lawyer;
(c) The client is given the opportunity to seek that
advice; and
(d) The client consents in writing.
(ii) General Comments.
The rule requiring the avoidance of interests which are
adverse to the client is not intended to apply to the
engagement agreement by which the attorney is retained by
the agreement. However if the agreement gives the
attorney an ownership or a possessory, security or other
pecuniary interest which is adverse to the client the rule
will apply. Although the rule would generally apply to
transactions which the attorney and client participate
jointly, it is not intended to apply where the attorney and
the client each participate in an investment in terms
tendered to the general public or a significant group of
investors. For example, the rule would not apply where
there is a syndicated LLC or limited partnership where the
attorney and the client are investors in the same investment.
Each is treated as investing with the third party limited
partnership and not with each other. Loans from the client
to the attorney create a common instance of adverse interest
created under this rule. See Sugarman v. State Bar of
California, 51 Cal.3d 609 (1990); Morgan v. State Bar of
California, 51 Cal.3d 598 (1990). Courts have held that the
failure of the attorney to provide security for a loan
obtained from a client is an indication that the transaction is
not fair and reasonable. Hunniecutt v. State Bar of
California, 44 Cal.3d 362 (1988)
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(iii) Presumption of Undue Influence.
There is substantial authority establishing a presumption of
undue influence arising from business transactions between
the attorney and the client. Although not absolutely
prohibited, such business relationships are carefully
“scrutinized by the courts with zealous care”. Felton v.
LeBreton, 92 Cal. 457 (1891).
Due to the fiduciary character of the relationship, any
transaction by which the attorney gains an advantage over
the client is subject to a rebuttable presumption that the
agreement was entered into under undue influence and
without sufficient consideration Bradner v. Vasquez, 43
Cal.2d 147, 151 (1954). The attorney bears the burden of
showing that the deal was fair and reasonable. Hunniecutt
v. State Bar of California, 44 Cal. 3d 362 (1988).
This presumption is based upon the fiduciary nature of the
attorney-client relationship and on the historical case law
involving transactions between a trust beneficiary during
the existence of the trust relationship. A professional is
deemed to have exercised influence to obtain an advantage
over the client or beneficiary and is presumed to have
entered into the relationship without sufficient
consideration and under undue influence. For example see
California Probate Code § 16004(c) creating a presumption
of undue influence in the trust relationship. The
presumption will apply even though it is the client who
induced the attorney into the business transaction. Gold v.
Greenwald, 247 Cal.App.2d 296 (2d Distr. 1966).
Undue influence is frequently found in estate planning
where a tax attorney prepares a will or trust where there is a
disposition made in favor of a professional. See In Re
Witts’ Estate, 198 Cal. 407 (1926). Attorneys may and
frequently do draw wills for members of the family or
relatives or close friends in which they receive gifts. Such
gifts are not considered improper when the gift to the
attorney is of moderate value but the lawyer takes a
substantial risk when preparing a will in which significant
bequests or a gift is included. Magee v. State Bar of
California, 58 Cal.2d 423 (1962).
Although the presumption of undue influence is a
rebuttable one, the burden rests upon the attorney. The
presumption has been rebutted when the client is a
18
sophisticated business person familiar with the legal
aspects of the transaction and where the attorney had
advised the client to reduce the agreement to writing and
the agreement is supported by adequate consideration per
the attorney. Oliker v. Gershunoff, 195 Cal.App.3d 1288
(1987). The attorney must prove that the client freely
entered into the agreement and that no advantage was taken
because of the confidential relationship. The attorney must
establish that the transaction was at arms-length, that the
deal was fair and just and that the client was fully advised
of his or her rights and liabilities. See Davis v. State Bar of
California, 20 Cal.2d 332 (1942); In Re Phillipi’s Estate, 76
Cal.App.2d 100 (1946); Krieger v. State Bar of California,
43 Cal.2d 604 (1954) and Gold v. Greenwald, 247
Cal.App.2d 296 (1966).
b. Rule 3-310 – Avoiding the Representation of Adverse Interests.
(i) The attorney shall not accept or continue representing a
client without written disclosure (consent not required)
where:
1. The attorney has a legal business, financial,
professional or personal relationship with a party in
the same matter; or
2. The attorney knows or should know that the
attorney previously had a relationship with a party
in the same matter, and the previous relationship
would substantially affect the attorney’s
representation; or
3. The attorney has or had a relationship with another
person or entity which the attorney knows or should
reasonably knew would be affected substantially by
resolution of the matter.
4. The attorney had a legal business, financial or
professional interest in the subject matter.
(ii) The attorney shall not without informed written consent (or
other written consent (or other written disclosure).
1. Accept representation of more than one client in a
matter in which the interests of the clients
potentially conflict;
19
2. Accept or continue representation of more than one
client in a matter when the interests actually
conflict;
3. Represent a client in one matter and also accept
another matter from a person whose interest in the
first matter is in conflict with the first client.
(iii) An attorney who represents two or more clients shall not
enter into an aggregate settlement of the claims of or
against the clients without the informed written consent of
each client.
(iv) An attorney shall not, without the informed written consent
of the client or former client, accept employment adverse to
the client or former client where, by reason of the
representation of the client or former client, the attorney
has obtained confidential information material to the
employment.
c. Case on Conflict of Interest.
It is well settled that an attorney may represent dual interests
provided that both clients consent to the relationship and there is
full written disclosure to the clients of all of the facts necessary to
enable the clients to make informed decisions regarding the subject
matter representation. American Mutual Liability Insurance
Company v. Superior Court, 38 Cal.App.3d 579 (3rd Dist. 1974).
The primary concern is the continued duty of fidelity and loyalty to
one’s client.
For example in appropriate circumstances, the attorney may act for
multiple parties, with the knowledge of each, in the preparation of
documents needed to affect it, purpose upon giving each client the
advice and guidance necessary for the protection of each. This
may occur with the preparation of the articles of incorporation, or
articles of organization or in drawing up dissolution documents for
a corporation or partnership or in acting on behalf of the grantor
and grantee on the sale of real property or in representing a
husband and wife that filed joint returns on an income tax audit.
The fact in each of these instances there is the stability of a conflict
is not a sufficient basis to preclude ethically professional dual
representation so long as there has been full disclosure with
common consent. See Lessing v. Gibbons, 6 Cal.App.2d 598 (1st
Dist 1935).
20
The conflict frequently arises as a result of a prior representation
where the attorney has obtained confidential information that is
material to a subsequent representation against a former client if
the nature of the former representation is such that confidences
could have been exchanged between the lawyer and the client, the
courts will conclusively presume that the confidences were
exchanged and disqualification will be required. See American
Airlines, Inc. v. Shepard Mullin Richter & Hampton, 96
Cal.App.4th, 1017 (2d Dist. 2002). When there is a substantial
relationship between two cases and the nature of the employment
is such that material confidential information would normally be
obtained by the lawyer there is a conclusive presumption that
confidential information has been obtained and disqualification
will apply unless there is informed written consent. H.F.
Ahmanson and Company v. Salomon Brothers, 229 Cal.App.3d
1445 (2d Dist. 1991). An exception would apply only when the
lawyer can show that there was no opportunity for confidential
information to have been disclosed. Cornish v. Superior Court,
209 Cal.App.3d 467 (1998).
A client cannot waive a dual representation of conflicting interest
when there is an actual conflict and the discharge of duty to one
client conflicts with the duty to the other. As a matter of law the
purported consent to such dual representation is considered neither
intelligent nor informed. Tsakos Shipping & Trading v. Juniper
Garden, 12 Cal.App.4th 74 (1993).
9. Conflicts of Interest - Organization as Client.
a. General.
Special consideration needs to be given to representation of an
organization as a client. There is frequently difficulty in
determining whether the lawyer represents only the entity or also
represents its constituents. With a corporation the issue would be
whether the attorney’s responsibility is to the entity itself or
primarily to the shareholders, directors, officers or other employees
responsible for a particular project. The same questions arise with
respect to whether representation of a general partner extends to
the partnership or limited partners, or in a limited liability
company whether responsibility is to the entity or to the manager,
manager members or other members of the entity.
21
b. “ABA Rule 1.13 – Organization as Client:
(a) A lawyer employed or retained by an organization
represents the organization acting through its duly
authorized constituents.
(b) If a lawyer for an organization knows that an officer,
employee or other person associated with the organization
is engaged in action, intends to act or refuses to act in a
matter related to the representation that is a violation of a
legal obligation to the organization, or a violation of law
which reasonably might be imputed to the organization,
and is likely to result in substantial injury to the
organization, the lawyer shall proceed as is reasonably
necessary in the best interest of the organization. In
determining how to proceed, the lawyer shall give due
consideration to the seriousness of the violation and its
consequences, the scope and nature of the lawyer’s
representation, the responsibility in the organization and the
apparent motivation of the person involved, the policies of
the organization concerning such matters and any other
relevant considerations. Any measures taken shall be
designed to minimize disruption of the organization and the
risk of revealing information relating to the representation
to persons outside the organization. Such measures may
include among others:
(1) asking reconsideration of the matter;
(2) advising that a separate legal opinion on the matter
be sought for presentation to appropriate authority
in the organization; and
(3) referring the matter to higher authority in the
organization, including, if warranted by the
seriousness of the matter, referral to the highest
authority that can act in behalf of the organization
as determined by applicable law.
(c) If, despite the lawyer’s efforts in accordance with
paragraph (b), the highest authority that can act on behalf
of the organization insists upon action, or a refusal to act,
that is clearly a violation of law and is likely to result in
substantial injury to the organization, the lawyer may
resign in accordance with Rule 1.16.
22
(d) In dealing with an organization’s directors, offices,
employees, members, shareholders or other constituents, a
lawyer shall explain the identity of the client when it is
apparent that the organization’s interest are adverse to those
of the constituents with whom the lawyer is dealing.
(e) A lawyer representing an organization may also represent
any of its directors, officers, employees, members,
shareholders, or other constituents, subject to the provisions
of Rule 1.7. If the organization’s consent to the dual
representation is required by Rule 1.7, the consent shall be
given by an appropriate official of the organization other
than the individual who is to be represented, or by the
shareholders.”
c. California Rule of Professional Conduct 3-600 – Organization as
Client.
(i) Rule 3-600 defines the ethical relationship between an
organization and its constitutional members.
(A) In representing an organization, a member shall
conform his or her representation to the concept that
the client is the organization itself, acting through
its highest authorized officer, employee, body of
constituent overseeing the particular engagement.
(D) The member shall not mislead any constituent into
believing that the constituent may communicate
confidential information to the attorney in a way
that will not be used in the organization’s interest if
that interest is adverse to the constituent.
(E) The attorney representing the organization may also
represent any of its directors, officers, employees,
members, shareholders, or other constituents subject
to the provisions of § 3-310:
• Consent for the organization must come from another
constituent or by the shareholders or members.
d. Comments.
Rule 3-600 recognizes the general principal that the attorneys
ethical responsibility is to the organization itself and not to its
constituents. Thus in the case of the corporation the responsibility
of the attorney may be either to its shareholders, officers or
directors or other employee within the organization who has
23
responsibility for overseeing a particular engagement. A principal
difficulty lies in determining who has the ultimate responsibility
with respect to a particular engagement. An attorney may
represent both the organization and other constituents provided that
the normal conflict of interest rules have been satisfied.
It is important to understand that since the client is the
organization, any information disclosed to the lawyer is deemed to
be a disclosure to the organization itself. In such instances where
there has been employee misconduct or the legal practices, the
lawyer will have an obligation of disclosure, when non-disclosure
would be an adverse to the interests of the organization.
When consent to dual representation is permitted, consents must be
given by an appropriate constituent of the corporation other than
the individual or constituent who is to be represented, or by the
shareholders or the organizations members. Metro-Goldwyn-
Mayer v. Tracinda Corp, 36 Cal.App.4th 1832 (1995).
Courts frequently have difficulty in determining whether or when
an attorney represents both the organization and other constituents.
In Responsible Citizens v. Superior Court, 16 Cal.App.2d 1717
(1993) the court explained that the representation of a partnership,
does not by itself, create an attorney client relationship with the
individual partners. A law firm has represented an association in a
binding lawsuit against individual A. A was a partner in a
partnership represented by the law firm in unrelated matters. In
Meehan v. Hopps, 144 Cal.App.2d 284, 301 (1956) the court
explained “the attorney for a corporation represents it, its
shareholders and its officers in their representative capacity. He in
no ways represents the officers personally. It would be a sorry
state of affairs if when a controversy arises between an attorney’s
corporate client and one of its officers he could not use on behalf
of his client information which that officer was required by reason
of his position with the corporation to give to the attorney.” See
also Johnson v. Superior Court, 38 Cal.App.4th 463 (1995).
Since the corporation is the client, it is the attorney’s duty when
necessary to claim the attorney-client privilege on behalf of the
corporation. Dickerson v. Superior Court, 135 Cal.App.3d 93
(1982). The privilege belongs to the corporation and not to its
constituents.
D. Significant Ethical Rules Affecting Accountant-Client Relationship.
Members of the American Institute of Certified Public Accountants are regulated
by the AICPA Code of Professional Conduct which shall apply to all professional
24
services performed, except where the wording of the rule indicates otherwise. ET
section 91.01 (adopted January 12, 1988, effective November 20, 1989).
1. Principle of Professional Conduct, ET Section 52.
ET section 52 requires that CPAs as professionals “should exercise
sensitive professional and moral judgments in all their activities.”
2. Integrity.
Principle of Professional Conduct, ET requires that each CPA should
“perform all professional responsibilities with the highest sense of
integrity” to maintain and broaden public confidence.
ET section 54.02: “Integrity requires a member to be, among other things,
honest and candid within the constraints of client confidentiality. Service
and public trust should not be subordinated to personal gain and
advantage. Integrity can accommodate the inadvertent error and the
honest difference of opinion; it cannot accommodate deceit or
subordination of principal.”
ET section 54.04: “Integrity also requires a member to observe the
principles of objectivity and independence and due care.”
3. Objectivity and Independence.
a. Principle of Professional Conduct, ET section 55 establishes
standards for objectivity and independence.
ET section 55: “A member should maintain objectivity and be free
of conflicts of interest in discharging professional responsibilities.
A member in public practice should be independent in fact and
appearance when providing auditing and other attestation services.”
Comment. The duty on independence on the part of the accountant
in public practice is a significant contrast to the attorney’s duty of
absolute loyalty to the client and to the client’s interest. In this
sense the advocacy role of the attorney and the independent
obligation for attestation services and responsibility to the public
for the CPA create fundamental differences which are frequently
incompatible.
The Unites States Supreme Court earlier focused on the public
responsibility of CPAs in auditing financial statements for public
corporations: “By certifying the public reports that collectively
depict a corporation’s financial status, the independent auditor
assumes a public responsibility transcending any employment
relationship with the client. The “public watchdog” function
25
demands that the accountant maintain total independence from the
client at all times and requires complete fidelity to the public trust.
United States v. Arthur Young, 465 US 805, 817-818 (1984).
b. Supporting Guidelines. The requirement for objectivity and
independence is supported by interpretive guidelines:
ET section 55.01: “Objectivity is a state of mind, a quality that
lends value to a member’s services. It is a distinguishing feature of
the profession. The principle of objectivity imposes the obligation
to be impartial, intellectually honest, and free of conflicts of
interest. Independence precludes relationships that may appear to
impair a member’s objectivity in rendering attestation services.”
ET section 55.02: “Members often service multiple interests in
many different capacities and must demonstrate their objectivity in
varying circumstances. Members in public practice render attest,
tax, and management advisory services. Other members prepare
financial statements in the employment of others, perform internal
auditing services, and serve in financial and management capacities
in industry, education, and government. They also educate and
train those who aspire to admission into the profession. Regardless
of service or capacity, members should protect the integrity of their
work, maintain objectivity, and avoid any subordination of their
judgment.”
ET section 55.03: “For a member in public practice, the
maintenance of objectivity and independence requires a continuing
assessment of client relationships and public responsibility. Such a
member who provides auditing and other attestation services should
be independent in fact and appearance. In providing all other
services. A member should maintain objectivity and avoid conflicts
of interest.”
ET section 55.04: “Although members not in public practice
cannot maintain the appearance of independence, they nevertheless
have the responsibility to maintain objectivity in rendering
professional services. Members employed by others to prepare
financial statements or to perform auditing, tax, or consulting
services are charged with the same responsibility for objectivity as
members in public practice and must be scrupulous in their
application of generally accepted accounting principles and candid
in all their dealings with members in public practice.”
26
4. Conflicts of Interest.
In order to fulfill the CPA’s responsibility for integrity and objectivity, the
CPA is required to be free of conflicts of interest and must not
misrepresent facts and subordinate his or her judgment to others.
a. Interpretation.
ET section 102-2 - Conflicts of Interest states: “ A conflict of
interest may occur if a member performs a professional services
for a client or employer and the member or his or her firm has a
significant relationship with another person, entity, product, or
service that could be viewed as impairing the member’s
objectivity. If this significant relationship is disclosed to and
consent is obtained from such client, employer, or other
appropriate parties, the rule shall not operate to prohibit the
performance of the professional service.
Certain professional engagements require independence.
Independence impairments under rule 101 [ET section 101.01] and
its interpretations cannot be eliminated by such disclosure and
consent.”
b. Interpretation ET section 101-1 defines impairments to
independence that cannot be remedied by disclosure and consent.
ET section 101-1:
“Independence shall be considered to be impaired if, for example, a
member had any of the following transactions, interests, or
relationships:
A. During the period of a professional engagement or at the
time of expressing an opinion, a member or a member’s
firm
1. Had or was committed to acquire any direct or
material indirect financial interest in the enterprise.
2. Was a trustee of any trust or executor or
administrator of any estate if such trust or estate had
or was committed to acquire any direct or material
indirect financial interest tin the enterprise.
3. Had any joint, closely held business investment
with the enterprise or with any officer, director, or
principal stockholders thereof that was material in
27
relation to the member’s net worth or to the net
worth of the member’s firm.
4. Had any loan to or from the enterprise or any
officer, director, or principal stockholder of the
enterprise except as specifically permitted in
interpretation 101-5 [ET section 101.07].
B. During the period covered by the financial statements,
during the period of the professional engagement, or at the
time of expressing an opinion, a member or a member’s
firm.
1. Was connected with the enterprise as a promoter,
underwriter or voting trustee, as a director or
officer, or in any capacity equivalent to that of a
member of management or of an employee.
2. Was a trustee for any pension or profit-sharing trust
of the enterprise.
The above examples are not intended to be all-inclusive.”
5. Competence and Due Care.
Principle of Professional Conduct, ET section 56 requires that the CPA:
“should observe the profession’s, technical and ethical
standards, strive continually to improve competence and
the quality of services, and discharge professional
responsibility to the best of the member’s ability.”
a. This obligation of due care incompetence is explained in the
following interpretations:
ET section 56.01: “The quest for excellence is the essence of due
care. Due care requires a member to discharge professional
responsibilities with competence and diligence. It imposes the
obligation to perform professional services to the best of a
member’s ability with concern for the best interest of those for
whom the services are performed and consistent with the
profession’s responsibility to the public.”
ET section 56.02: “Competence is derived from a synthesis of
education and experience. It begins with a mastery of the common
body of knowledge required for designation as a certified public
accountant. The maintenance of competence requires a
commitment to learning and professional improvement that must
28
continue throughout a member’s professional life. It is a member’s
individual responsibility. In all engagements and in all
responsibilities, each member should undertake to achieve a level
of competence that will assure that the quality of the member’s
services meets the high level of professional required by these
Principles.”
ET section 56.03: “Competence represents the attainment and
maintenance of a level of understanding and knowledge that
enables a member to render services with facility and acumen. It
also establishes the limitations of a member’s capabilities by
dictating that consultation or referral may be required when a
professional engagement exceeds the personal competence of a
member or a member’s firm. Each member is responsible for
assessing his or her own competence – of evaluating whether
education, experience, and judgment are adequate for the
responsibility to be assumed.”
ET section 56.04: “Members should be diligent in discharging
responsibilities to clients, employers, and the public. Diligence
imposes the responsibility to render services promptly and
carefully, to be thorough, and to observe applicable technical and
ethical standards.”
ET section 56.05: “Due care requires a member to plan and
supervise adequately any professional activity for which he or she
is responsible.”
b. The AICPA has also provided a specific standard for competence.
Section 201-1 – Competence: “ A member’s agreement to perform
professional services implies that the member has the necessary
competence to complete those professional services according to
professional standards, applying his or her knowledge and skill with
reasonable care and diligence, but the member does not assume a
responsibility for infallibility of knowledge or judgment.
Competence to perform professional services involves both the
technical qualifications of the member and the member’s staff and
the ability to supervise and evaluate the quality of the work
performed. Competence relates both to knowledge of the
profession’s standards, techniques and the technical subject matter
involved, and to the capability to exercise sound judgment in
applying such knowledge in the performance of professional
services.
29
The member may have the knowledge required to complete the
services in accordance with professional standards prior to
performance. In some cases, however, additional research or
consultation with others may be necessary during the performance
of the professional services. This does not ordinarily represent a
lack of competence, but rather is a normal part of the performance
of professional services.
However, if a member is unable to gain sufficient competence
through these means, the member should suggest, in fairness to the
client and the public, the engagement of someone competent to
perform the needed professional service, either independently or as
an associate.”
6. Confidential Client Information.
The disclosure of confidential information by a CPA is regulated by rule
301.
ET section 301: “A member in public practice shall not disclose any
confidential client information without the specific consent of the client.
This rule shall not be construed (1) to relieve a member of his or her
professional obligation sunder rules 202 and 203, (2) to affect in any way
the member’s obligation to comply with a validly issued and enforceable
subpoena or summons, or to prohibit a member’s compliance with
applicable laws and government regulations, (3) to prohibit review of a
member’s professional practice under AICPA or state CPA society or
Board of Accountancy authorization, or (4) to preclude a member from
initiating a complaint with, or responding to any inquiry made by, the
professional ethics division or trial board of the Institute or a duly
constituted investigative or disciplinary body of a state CPA society or
Board of Accountancy.
Members of any of the bodies identified in (4) above and members
involved with professional practice reviews identified in (3) above shall
not use to their own advantage or disclose any member’s confidential
client information that comes to their attention in carrying out those
activities. This prohibition shall not restrict members’ exchange of
information in connection with the investigative or disciplinary
proceedings described in (4) above or the professional practice reviews
described in (3) above.”
30
III. ABA AND IRS GUIDANCE IN TAX PRACTICE.
A. American Bar Association Guidance in Tax Practice.
1. Significant Formal ABA Tax Opinions:
a. ABA Opinion 314 (April 27, 1965). Ethical relationship between
IRS and lawyers practicing before it.
b. ABA Opinion 346 (January 29, 1982). Tax lawyer opinion in tax
shelter investment offerings.
c. ABA Opinion 85-352 (July 7, 1985) (reconsidering ABA
Opinion 314).
d. Report of the ABA Section of Taxation Special Task Force of
Formal Opinion 85-352 (February 2, 1986).
2. ABA Formal Opinion 314 (April 27, 1965).
Ethical relationship between the Internal Revenue Service and lawyers
practicing before it.
In 1965, the ABA issued Opinion 314 explaining the ethical
responsibilities of lawyers practicing with the Internal Revenue Service
and set forth a summary of general principles governing the relationship
between lawyers and the IRS.
a. Significant Points Were Emphasized.
(i) Warm Zeal. Under Canon 15 of the ABA the attorney
owes “warm zeal” to his client.
(ii) IRS Not a Tribunal. Model Rule 33 -- Lawyer shall not fail
to disclose controlling authority to a tribunal.
However, the IRS is not a tribunal or a quasi -judicial
institution. It has no procedure for adversarial proceedings
before impartial judges or arbitrators involving the
weighing of conflicting testimony of witnesses examined or
cross-examined by opposing counsel or the consideration
of arguments by both sides.
The ABA Opinion explained that the Service is not
designed and does not purport to be unprejudiced or
unbiased in the judicial sense.
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(iii) Violation of Law. Although a lawyer may owe a duty of
warm zeal to his client, the Canons do not permit any
violation of the law or any manner of fraud or chicane. He
must obey his own conscience and not that of his client.
(Canon 15)
(iv) Duty Not to Mislead. In his representation with the
Service, the lawyer is under a duty to not mislead the
Service deliberately and affirmatively, either by
misstatements or by silence or by permitting his client to
mislead. (Canons 15, 22, 29, 32)
(v) Settlement Negotiations. The attorney may always urge in
aid to a settlement of a controversy the strong points of the
client’s case and minimize the weak, with “warm zeal.”
The absolute duty not to make false assertions of fact does,
not require a disclosure of a weakness in the client’s case,
unless facts known to the attorney indicate beyond a
reasonable doubt that a crime will be committed. “A
wrong, or indeed sometimes an unjust, tax result in the
settlement of a controversy is not a crime.”
(vi) Advise to Correct Misstatement. If the client has mislead
the IRS without the lawyer's knowledge or participation,
then the lawyer must advise the client to correct the
statement.
(vii) Obligation to Withdraw. The lawyer may even have the
obligation to withdraw, if the lawyer believes that the
Service is relying on him to corroborate statements of his
clients which he knows to be false -- unless it is obvious
that the act of disassociation may effectively disclose
confidential communication and violate the attorney/ client
privilege imposed by Canon 37.
(viii) Reasonable Basis Test. The lawyer, in advising his client
in the course of the preparation of the client's tax returns,
may freely urge the statement of positions most favorable
to the client just as long as there is a reasonable basis for
the position taken.
If the lawyer believes that there is a reasonable basis, the
lawyer has no duty to advise that attachments be made to
the tax return explaining the circumstances surrounding the
transaction.
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3. Formal Opinion 85-352 (July 2, 1985).
a. Revision of Opinion 314.
Reference to Opinion 314 for ethical standard of practice in
relationship with IRS.
(i) The attorney may urge a position for the tax return most
favorable to the client, so long as there is a reasonable basis
for the position.
(ii) There was a fear that the standard for "reasonable basis"
had been construed to support the use of “any colorable
claim on a tax return to justify exploitation of the lottery of
the tax return audit selection process.”
(iii) The ABA determined to revise Option 314 in light of the
new Model Code and Model Rules.
b. Restatement of Standards.
(i) Not Criminal Or Fraudulent Conduct. A lawyer shall not
assist a client in conduct that the lawyer knows is criminal
or fraudulent. Model Rule 1.2(d).
The lawyer may discuss the legal consequences of any
proposed course of conduct with a client (including
criminal or fraudulent conduct), and may counsel or assist
the client to make a good faith effort to determine the
validity, scope, meaning or application of the law.
(ii) Non-Frivolous Good Faith Argument. A lawyer cannot
assert an issue unless there is a basis for doing so that is not
frivolous, which includes a good faith argument for an
extension, modification or reversal of existing law. Model
Rule 3.1.
(iii) Good Faith - Realistic Possibility of Success. "Good faith"
requires that there be a realistic possibility of success if the
matter is litigated.
If there is good faith position then lawyer has no duty to
require that the taxpayer explain the transaction on the
client's tax return.
(iv) Penalty And Legal Consequences. However, the lawyer
should counsel the client on whether the position is likely
33
to be sustained if challenged and the potential penalty
consequences to the client.
Competent representation would require the lawyer to
advise the client fully on whether there is substantial
authority for the position taken, the risk of penalties, and
the opportunity to avoid penalties by adequate disclosure.
Under these circumstances the lawyer's ethical duties are
satisfied even if the client decides to risk the penalty and
make no disclosure.
c. Summary of Ethical Opinions 85-352.
A lawyer may advise reporting a position on a return:
• Even though the lawyer believes the position probably will not
prevail;
• Even though there is no substantial authority to support the
position; and
• There is no disclosure on the return.
provided --
• The position asserted is one which the lawyer in good faith
believes is warranted in existing law or can be supported by a
good faith argument for an extension, modification or reversal
of existing law.
• There must be some realistic possibility of success if the
matter is litigated.
• Duty to explain potential penalties and legal consequences,
should the client take the position advised.
4. ABA Section of Taxation Special Task Force on Formal Opinion 85-352
(1986).
a. Guidelines for Ascertaining Realistic Possibility of Success.
The Task Force attempted to establish guidelines for ascertaining
the existence of a "realistic possibility of success” standard in
determining good faith.
(i) A position having only a 5% or 10% likelihood of success
in litigation is too low.
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(ii) A position having or likelihood of success approaching 1/3
would meet the standard.
(iii) There is a realistic possibility of success, if the position is
supported by "substantial authority".
b. The Position Falls Below the Standard.
(i) Nonetheless, the position may be advanced by payment of
the tax and a claim for refund setting forth the grounds
upon which the refund is claimed.
(ii) The position may be advanced in litigation if it is not
frivolous.
• I.e., there is a good faith argument for an extension,
modification or removal of existing law.
• In this context good faith does not require a possibility
of success that is realistic.
(iii) If the client is determined to assert a position in a tax return
that is not supported by a realistic possibility of success, the
lawyer must withdraw from the engagement. Model Rule
1.16.
B. AICPA Standards for Tax Return Positions.
The AICPA has standards that CPAs are required to follow in recommending a
tax return position and in preparing or signing a tax return, including a claim for
refund.
1. Definition of a Tax Return Position. “A “tax return position” is (1) a
position reflected on the tax return as to which the client has been
specifically advised by the CPA or (2) a position as to which the CPA has
knowledge of all material facts and, on the basis of those facts has
concluded that the position is appropriate.” TX section 112.01.
2. Standards for Recommending a Tax Return Position or Preparing a
Separate Tax Return on Refund Claims.
a. Good Faith-Realistic Possibility of Success – Tax Return Position.
A CPA should not recommend to the client a position to be taken
on the tax return of any item on the return unless the CPA has “a
good faith belief that the position has a realistic possibility of being
sustained administratively or judicially on its merits if challenged.”
TX section 112.02a. In explanation .07 the society explains that the
standard suggested for a good faith belief is one that is warranted in
35
existing law or can be supported by a good faith argument for an
extension, modification or reversal of existing law.
b. Good Faith – Realistic Possibility with Success - Preparation or
Signing a Tax Return or Refund Claim. A CPA should not prepare
or sign a return as an income tax return preparer if the CPA knows
the tax return takes a position that fails the realist possibility of
success standard. TX section 112.02b.
c. Full Disclosure of a Non-Frivolous Recommendation. Even though
the good faith realistic possibility of success standard cannot be
met, TX section 112.02c provides that the CPA may recommend a
position that the CPA concludes is not frivolous so long as the
position has been adequately disclosed on the return or claim for
refund. A position is considered a “frivolous” position. If it is one
that is knowingly advanced in bad faith and is patently improper.
d. Internal Revenue Code Tax Return Preparer Penalty. A CPA, as a
tax return preparer, is cautioned to take into consideration the
$250.00 penalty per return or claim imposed by Code section 6694
for understatements of taxpayer liability resulting from unrealistic
positions when (1) the position does not have a realistic possibility
of being sustained on the merits, (2) the tax return preparer should
know such position, and (3) the position is not adequately disclosed
on a reasonable basis for the tax treatment under section
6662(d)(2)(B)(ii) or is frivolous.
C. Circular 230 Standards for Practice Before the IRS.
1. Treasury Regulations of Practice before the IRS.
Treasury Department Circular 230. Title 31, Part 10, C.F.R., as revised
September 13, 1966, with amendment through July 26, 2002. See, in
particular, Subpart B, Duties and Restrictions Relating to Practice Before
the Internal Revenue Service, 10.20-10.34. On December 30, 2003, the
IRS proposed new §§ 10.33-10.37, dealing with Best Practices and Tax
Opinions. See 31 U.S.C. § 330, authorizing the Secretary of the Treasury
to regulate the practice of representatives before the Treasury Department.
2. Selected Duties and Restrictions Relating to Practice Before the IRS.
Cir. 230, Part 10(B).
a. Duty to Submit Information to the IRS.
(i) Submission of Records and Information. When a proper
and lawful request has been made by a duly authorized
officer or employee of the IRS, a practitioner is required to
promptly submit records and information to the IRS, unless
36
the practitioner believes in good faith and on reasonable
grounds that the records or information are privileged.
Cir. 230, § 10.20(a)(1). Prior to 2002, the Circular
permitted nondelivery if "the request is of doubtful
legality." The language was dropped because it was
duplicative.
(ii) When the practitioner does not have possession or control
of the requested records or information, the practitioner is
required to provide information the practitioner has
regarding the identity of any person he or she knows who
has possession or control. Circular 230 goes further and
requires the practitioner to make a reasonable inquiry to the
client regarding such identity. It does not require the
practitioner to make an inquiry of any other person or to
independently verify information provided by the client.
Cir. 230, § 10.20(a)(2).
(iii) The Director of Practice may require a practitioner to
provide information and even testify at any proceeding
regarding alleged violation of the regulations under part 10
of Circular 230, unless the practitioner believes in good
faith and on reasonable grounds that the information is
privileged. Cir. 230, § 10.20(b).
(iv) Interference With a Proper and Lawful Request. A
practitioner is prohibited from interfering or attempting to
interfere with any lawful and proper effort by the IRS to
obtain records or information, unless the practitioner
believes in good faith and on reasonable grounds that the
record or information is privileged. Cir. 230, § 10.20(c).
b. Knowledge of Client’s Omission.
If a practitioner knows that the client has not complied with the tax
laws, or has made an error in, or an omission in any return,
document, affidavit, or other paper which the client has submitted
or executed under the tax laws, then the practitioner must advise
the client promptly of the fact of such noncompliance, error or
omission. Cir. 230, § 10.21.
The 2002 changes also require that the client be advised of the
consequences under the code and regulations of such
noncompliance, error or omission.
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c. Due Diligence.
(i) Duty of Due Diligence. A practitioner has a duty to
exercise due diligence in preparing or assisting in the
preparation and filing of tax returns and other documents,
and in determining the correctness of oral or written
representations made by the practitioner to the Department
of the Treasury, or to the client on IRS matters. Cir. 230,
§ 10.22(a).
(ii) Reliance on Others. The practitioner is presumed to have
exercised due diligence if he or she relies on the work
product of another person, and the practitioner uses
reasonable care in engaging, supervising, training and
evaluating the person, taking proper account of the nature
of the relationship between the practitioner and that person.
Cir. 230, § 10.22(b). The 2002 changes added this
presumption of due diligence but excluded from the
presumption any exceptions provided in § 10.33 with
respect to tax shelters, and § 10.34 defining standards for
advice -- the realistic possibility of success standard.
d. Promptness.
A practitioner has a duty not to unreasonably delay the prompt
disposition of any matter before the IRS. Cir. 232, § 10.23.
e. Non-Assistance From Disbarred or Suspended Persons.
A practitioner may not employ or accept assistance from a person
disbarred or suspended before the IRS, or accept employment with
or share any fee with such person. Cir. 230, § 10.24.
See also § 10.51(j), defining “disreputable conduct” as including
knowingly aiding or abetting a person to practice before the IRS,
during suspension or disbarment, or ineligibility.
f. Practice by Partners of Former Government Employees.
A practitioner who is a partner of a former government employee
is prohibited from representing anyone in a matter in which such
government employee has substantially participated. Circular 230,
§ 10.25, sets forth numerous restrictions as to time (generally one
year or two years) and as to isolation firewalls for law firms
employing former government employees.
38
g. Notaries.
A practitioner is prohibited from taking acknowledgments,
administering oaths, certifying papers or acting as a notary public
on any matter before the IRS in which the practitioner is employed
as counsel or in any way has an interest. Cir. 230, § 10.26.
h. Fees.
(i) Unconscionable Fees. A practitioner may not charge an
unconscionable fee on any matter. Cir. 230, § 10.27(a).
(ii) Contingent Fee Defined. A contingent fee is defined as any
fee that is based, in whole or in part, on whether or not a
position taken on a tax return. or other filing, avoids
challenge by the IRS or is sustained either by the IRS or in
litigation. A contingent fee includes any fee arrangement
in which the practitioner agrees to reimburse the client for
all or any portion of the fee in the event that a position
taken on the tax return or other filing is challenged by the
IRS, or is not sustained, whether pursuant to an indemnity
agreement, a guarantee, rescission rights, or any other
arrangement with a similar effect. Cir. 230, § 10.27(b)(1).
This detailed definition has been added in the 2002
amendment.
(iii) The Original Tax Return or Advice. A practitioner may not
charge a contingent fee for preparing an original tax return
or for rendering tax advice in connection with a position
taken or to be taken on the original tax return. Cir. 230,
§ 10.27(b)(1).
(iv) Amended Tax Returns or Claim for Refund. A contingent
fee may be charged for the preparation of or advice given
in connection with an amended tax return or a claim for
refund (other than a claim for refund made on the original
tax return). The practitioner must reasonably anticipate at
the time of the fee arrangement that the amended tax return
or the refund claim will receive substantial review by the
IRS. Cir. 230, § 10.27(b)(3).
(v) The 2002 amendments substantially revise the rules as to
amended returns and claims for refund. Prior to 2002, the
prohibition against contingent fees related to any return.
Also under the prior regulation, in advising or preparing a
claim for refund, the practitioner was required to
reasonably anticipate that the claim would be denied and
39
subsequently litigated. The 2002 change only requires the
anticipation that there will be a substantive review by the
IRS in order to enter into a contingent fee agreement.
i. Return of Client Records.
The 2002 amendments added new § 10.28 requiring the
practitioner, upon request by the client, to promptly return all
records of the client that are necessary for the client to comply with
his or her federal tax obligations. The practitioner may retain
copies.
The existence of a dispute over fees does not relieve the
practitioner of responsibility under this section. However, if state
law permits a retention of client records then the practitioner need
only return those records that must be attached to the taxpayer's
return. Circular 230 then carefully explains that the practitioner
must provide the client with reasonable access to review and copy
any additional records retained by the practitioner under state law
that are necessary to comply with federal tax obligations.
(i) Records Defined. The records of the client include all
documents, or written or electronic materials provided to
the practitioner, or obtained by the practitioner in the
course of representation that pre-existed retention by the
client.
The term also includes materials that were prepared by the
client or a third party and provided to the petitioner with
respect to the subject matter.
It includes any return, claim for refund, schedule, affidavit,
appraisal or other document prepared by the practitioner, or
his or her employee or agent that was presented to the
client in a prior representation if the document is necessary
to comply with current federal tax obligations.
(ii) Excepted Records. The term does not include any return,
claim for refund, schedule, affidavit, appraisal or other
document prepared by the practitioner or the practitioner's
firm, employees or agents if the practitioner is withholding
such document pending the client's performance of its
contractual obligation to pay fees with respect to such
document. Cir. 230, § 10.28.
40
j. Conflicts of Interest.
(i) Prohibition. A practitioner may not represent a client
before the IRS if the representation involves a conflict of
interest, except as expressly authorized in § 10.29.
(ii) Conflict of Interest. A conflict of interest exists (1) if the
representation of one client will be directly adverse to
another client, or if (2) there is a significant risk that the
representation of one or more clients will be materially
limited by the practitioner's responsibilities to another
client, a former client or a third person, or by the personal
interest of a practitioner. Cir. 230, § 10.29(a).
(iii) Permitted Representation. Notwithstanding the existence
of a conflict of interest, the practitioner is permitted to
represent the client if (1) the practitioner reasonably
believes that he or she will be able to provide competent
and diligent representation for each affected client; (2) the
representation is not prohibited by law; and (3) each
affected client gives informed consent in writing. Cir. 230,
§ 10.29(b). Prior to the 2002 changes, Circular 230 did not
require the consent to be in writing.
(iv) Retention of Written Consent. The practitioner must retain
copies of the written consent for at least 36 months from
the date of the conclusion of the representation of the
affected clients, and the written consent must be provided
to the IRS on request. The obligation to retain the written
consent for three years and to deliver it on request were
added in 2002. Cir. 230, § 10.29(c).
k. Solicitation and Advertising.
(i) Misleading Communications. A practitioner may not use
any public communication containing false, fraudulent or
coercive statements or claims or a misleading or deceptive
statement or claim. Prior to 2002, this sentence also
prohibited "unduly influencing" or "unfair" statements or
claims. Cir. 230, § 10.30(a).
(ii) Uninvited Solicitation. A practitioner may not make
directly or indirectly an uninvited written or oral
solicitation of employment in matters related to the IRS if
that solicitation violates federal or state laws or other
applicable rules. E.g., attorney rules of professional
responsibility under state law.
41
(iii) Any lawful solicitation by or for the practitioner must
clearly identify the solicitation as such, and the source of
information used in choosing the recipient, if applicable.
(iv) The rules under Circular 230 were substantially relaxed in
2002.
(v) Disclosure of Fee Information. There are new rules
relating to the disclosure of fee information and
responsibility for costs. If a practitioner publishes the
availability of a written schedule of fees, the practitioner is
required to follow that schedule for at least 30 days after
the last date the schedule is published.
(vi) Request to Terminate Solicitation. A practitioner may not
persist in attempting to contact a prospective client if the
prospective client has made it known to the practitioner that
he or she does not desire to be solicited.
(vii) Record Retention. In the case of radio or television
broadcasting, the broadcast must be recorded and the
practitioner must retain a recording of the actual
transmission. In the case of a direct mail or e-commerce
communication, the practitioner must retain a copy of the
actual communication along with a list of the recipients for
36 months after the last transmission.
l. Negotiation of Refund Checks.
A practitioner who prepares tax returns is prohibited from
endorsing or negotiating a taxpayer refund check. Cir. 230,
§ 10.31. IRC § 6695(f) imposes a penalty of $500.00 on any
preparer who negotiates or endorses a refund check.
m. Tax Shelter Opinions.
A practitioner who provides a tax shelter opinion is required to
comply with substantial due diligence and disclosure conditions set
forth in Circular 230, § 10.33. See also ABA Formal Opinion 346
(January 29, 1982). In the 2002 amendments, the IRS intentionally
elected to defer revisions to the tax shelter opinion section. The
ABA Tax Section and other organizations have provided extensive
comments on the issue of the scope of tax shelter opinions. See
discussion in Part III of this outline.
42
n. Standards for Advice -- a Realistic Possibility of Success Standard.
(i) Signing Return. A practitioner may not sign a return as a
preparer if the practitioner determines that the return
contains a position that does not have a realistic possibility
of being sustained on its merits, unless (i) the position is
not frivolous and (ii) is adequately disclosed to the IRS.
Cir. 230, § 10.34(a)(1).
(ii) Advising the Client. A practitioner may not advise a client
to take a position on the return or prepare a portion of a
return unless:
(a) the practitioner determines that the position satisfies
the realistic possibility standard;
OR
(b) the position is not frivolous; and
(c) the practitioner advises the client of any opportunity
to avoid the IRC § 6662 accuracy related penalty,
by adequately disclosing the position, and of the
requirements for adequate disclosure. Cir. 230,
§ 10.34(a)(1).
(iii) Advising Clients of Potential Penalties. A practitioner
advising a client to take a position on a tax return, or
preparing or signing a tax return as a preparer, is required
to inform the client of the penalties reasonably likely to
apply to the client with respect to the position advised,
prepared or reported. The practitioner is also required to
inform the client of any opportunity to avoid such penalty
by disclosure, if relevant, and the requirements for adequate
disclosure.
Circular 230, § 10.34(b), explains that this rule will apply
even if the practitioner is not subject to a penalty on the
position taken. This section, as added in 2002, makes it
clear that the practitioner has a duty to advise the client of
any potential penalties.
(iv) Relying on Client Information. A practitioner may
generally rely in good faith upon information furnished by
the client, without verification. However, the practitioner
cannot ignore the implications that arose from information
furnished to or actually known by the practitioner.
43
The practitioner has an affirmative duty to make reasonable
inquiries if the information as furnished appears to be
incorrect, or is inconsistent with an important part or
another factual assumption, or is incomplete.
(v) “Realistic Possibility” Defined. There is a “realistic
possibility” of being sustained on the merits “if a
reasonable and well-informed analysis by a person
knowledgeable in the tax law would lead such a person to
conclude that the position was approximately a one-in-
three, or greater, likelihood of being sustained on its
merits.” Cir. 230, § 10.34(d).
The section explained that any authorities described in 26
C.F.R. 1.6662-4(d)(3)(iii), or any successor provision of the
substantial understatement penalty regulations may be
taken into account for purposes of satisfying the realistic
possibility standard.
The possibility that a tax return will not be audited, that an
issue will not be raised in audit, or that an issue will be
settled may not be taken into account. This sentence of
§ 10.34(d)(1) prohibits a consideration of the taxpayer
lottery.
(vi) “Frivolous” Defined. A position is frivolous if it is
“patently improper.”
o. Sanctions.
The IRS, after notice and an opportunity for a proceeding, may
censure, suspend or disbar any practitioner from practice before the
IRS if the practitioner is shown to be incompetent or disreputable,
fails to comply with any regulations in Circular 230, Part 10, or
with intent to defraud willfully and knowingly misleads or
threatens a client or prospective client. A censure is a public
reprimand. Cir. 230, § 10.50. The section proceeds to set forth 12
sets of examples of incompetence or disreputable conduct that may
lead to censure, suspension or disbarment.
D. Tax Shelter Opinions.
1. Background.
Circular 230 was first amended to provide standards of practice for
tax shelter opinions on February 23, 1984. On May 5, 2000, the IRS
requested comments regarding amendments to standards of practice
governing tax shelters and other general matters. On January 12,
44
2001, proposed revisions were first published. On July 26, 2002, final
regulations were issued incorporating non-tax shelter matters and
reserved the subject of tax opinions for later consideration. On
December 30, 2003, proposed revisions were made to Circular 230
dealing with tax shelters. The proposed revisions to §§ 10.33, 10.35,
10.36 and 10.37 are intended to become effective after final
regulations are published. The proposed regulations provide
mandatory requirements for practitioners who provide certain tax
shelter opinions.
2. Best Practice For Tax Advisors.
Circular 230, § 10.33 (Tax Shelter Opinions) has been revised to describe
best practices to be observed by all tax advisors in providing clients with
highest quality representation. The best practice requirement applies to
both providing advice and to the preparation or assisting in the preparation
of submissions to the IRS. The best practices include the following:
a. Terms of Engagement.
The practitioner is required to communicate clearly to the client the
terms of engagement and the form and scope of advice or
assistance to be rendered.
b. Establishing the Facts.
The practitioner is required to establish the relevant facts and
evaluate the reasonableness of any assumptions or representations.
(i) The practitioner is obligated to relate the applicable law,
including potentially applicable judicial doctrines, to the
relevant facts.
(ii) The practitioner needs to arrive at conclusions that are
supported by both the law and the facts.
(iii) The client is to be advised regarding the import of the
conclusions reached. This includes the subject of penalties,
such as whether the taxpayer may avoid penalties for a
substantial understatement of income tax under § 6662(d) if
a taxpayer acts in reliance on the advice.
(iv) The practitioner is required to act fairly and with integrity
in practice before the IRS.
45
3. Standards for Certain Tax Shelter Opinions. Cir. 230, § 10.35.
a. Proposed Tax Shelter Opinion Requirements.
New proposed § 10.35 provides requirements for practitioners who
provide more likely than not opinions or marketed tax shelter
opinions. The requirements are mandatory.
(i) A "more likely than not tax shelter opinion" is a tax shelter
opinion that reaches the conclusion that is at least more
likely than not with respect to one or more federal tax
issues. Cir. 230, § 10.35(c)(5).
(ii) A "marketed tax shelter opinion" is defined as a tax shelter
opinion that a practitioner knows, or has reason to know,
will be used or referred to by a person other than the
practitioner (or person who is a member of, associated
with, or employed by the practitioner's firm), in promoting,
marketing or recommending a tax shelter to one or more
taxpayers. Cir. 230, § 10.35(c)(6).
b. General Requirements.
(i) Factual Matters.
(a) The opinion must identify and consider all relevant
facts. This requires a reasonable effort to identify
and ascertain the facts, including those that may
relate to future events if the transaction is
prospective or proposed, and determine which facts
are relevant.
(b) The opinion cannot be based on any unreasonable
factual assumption that the practitioner knows or
should know is incorrect or incomplete.
The proposed revision to § 10.35(a)(1) states that it
is unreasonable to assume that a transaction has a
business purpose or that a transaction is potentially
profitable apart from tax benefits, or to make an
assumption with respect to a material valuation
interest.
The revision also explains that in the case of a
marketed tax shelter opinion, the practitioner is not
expected to identify or ascertain facts peculiar to a
taxpayer to whom the taxpayer may be marketed,
46
but the opinion must include required tax shelter
opinion disclosures discussed below (§ 10.35(d)).
(c) The opinion may not be based on any unreasonable
factual representation, statement or finding of the
taxpayer or any other person that the practitioner
knows or should know is incorrect or incomplete.
As an example, § 10.35(a)(1)(iii) states that the
practitioner may not rely on a taxpayers factual
representation that a transaction has a business
purpose, if the representation fails to include a
specific description of the business purpose or the
practitioner knows or should know that the
representation is incorrect or incomplete.
(ii) Relate Law to Facts.
The practitioner must relate the applicable law, including
any potentially applicable judicial documents, to the
relevant facts. The practitioner may not rely on any
unreasonable legal assumptions, representations or
conclusions. The opinion must not contain internally
inconsistent legal analysis or conclusions.
The practitioner may not assume the favorable resolution of
any material federal tax issues (except in the case of a
limited opinion and upon reliance of another opinion.)
(iii) Evaluation of Material Federal Tax Issues.
(a) The opinion must consider all material federal tax
issues unless the taxpayer and the practitioner have
specifically agreed to limit the scope of the opinion
to one or more specific issues. A marketed tax
shelter opinion is required to consider all material
issues.
(b) The practitioner must set forth a conclusion as to
the likelihood that the taxpayer will prevail on the
merits with respect to each material federal tax
issue.
If the practitioner is unable to reach a conclusion as
to one or more such issues, the opinion must state
that the practitioner is unable to reach a conclusion
on those issues.
47
The practitioner is required to set forth the reasons
for the conclusions, including the facts and analysis
supporting the conclusions or must describe the
reasons that the practitioner is unable to reach a
conclusion as to one or more material issues.
If the practitioner is unable to reach a confidence
level of at least more likely than not with respect to
any tax issue, the opinion must include appropriate
descriptions required in § 10.35(d) (discussed,
infra).
(c) The practitioner 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 the issue
will be settled.
(iv) Overall Conclusion.
The opinion must set forth an overall conclusion as to the
likelihood that the tax treatment of the tax shelter item or
items is the proper treatment and the reasons for that
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 practitioner's inability to reach that
conclusion.
c. Competence Requirements.
The practitioner is required to be "knowledgeable in all of the
aspects of federal tax law relevant to the opinion being rendered."
(i) Reliance on Opinion of Others.
If the practitioner is not sufficiently knowledgeable to
render an informed opinion with respect to any particular
material tax issue, the practitioner may rely upon the
opinion of another practitioner with respect to those issues,
unless the practitioner knows or should know that such an
opinion should not be relied upon.
If there is reliance on the opinion of another practitioner,
the relying practitioner must identify the other opinion and
set forth conclusions reached in the other opinion.
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The primary practitioner must be satisfied that the
combined analysis of opinions, taken as a whole, satisfies
the requirements of § 10.35.
d. Related Definitions.
(i) "Tax Shelter." The term "tax shelter" is defined to include
any partnership or any other entity, any investment plan or
arrangement, or any other plan or arrangement, a
significant purpose of which is the avoidance or evasion of
any tax imposed by the Code. A tax shelter may give rise
to one or more tax shelter items. § 10.35(c)(2). It is
noteworthy that this definition traces the broad definition
set forth in § 6662 defining tax shelters for the purpose of
substantial understatement penalties. The definition does
not include an earlier proposal that would have included
preliminary advice given pursuant to an engagement in
which the practitioner is expected subsequently to provide
an opinion.
(ii) "Tax Shelter Item." A tax shelter item is, with respect to a
tax shelter, any item of income, gain, loss, deduction, or
credit, the existence or absence of a taxable transfer of
property, or the value of property. § 10.35(c)(3).
(iii) Tax Shelter Opinion. A tax shelter opinion is written
advice provided by a practitioner concerning the federal tax
aspects of any federal tax issue related to a tax shelter item
or items. Cir. 230, § 10.35(c)(4).
(iv) "More Likely Than Not Tax Shelter Opinion." A "more
likely than not" tax shelter opinion is a tax shelter opinion
that reaches a conclusion at a confidence level of at least
more likely than not (that is, greater than 50%) that one or
more material federal tax issues would be resolved in the
taxpayer's favor.
(v) "Marketed Tax Shelter Opinion." A marketed tax shelter
opinion is a tax shelter opinion that a 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 the tax shelter to
one or more taxpayers.
(vi) "Material Tax Issue." A material tax issue is any federal
tax issue for which the Internal Revenue Service has a
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reasonable basis for a successful challenge and the
resolution of which could have a significant impact,
whether beneficial or adverse, and under any reasonably
foreseeable circumstances, on the federal tax treatment of
the taxpayer's tax shelter items.
e. Required Disclosures.
Section 10.35(d) provides disclosures that are required to be made
in the beginning of marketing tax shelter opinions, limited scope
opinions, and opinions that fail to reach a conclusion at a
confidence level of at least more likely than not. In addition,
certain relations between the practitioner and a person promoting
or marketing a tax shelter must be disclosed.
(i) The Relationship Between a Promoter and a Practitioner.
The opinion must disclose if the practitioner has a
compensation arrangement with any person (other than the
client for whom the opinion is prepared) with respect to
promoting, marketing or recommending the tax shelter
discussed in the opinion. The compensation arrangement
would include any referral fee or fee-sharing arrangement.
The disclosure must include any referral agreement
between the practitioner and another person engaged in
promoting, marketing or recommending the tax shelter.
(ii) Marketed Tax Shelter Opinions. The practitioner must
disclose that a marketed opinion may not be sufficient for a
taxpayer to use for the purpose of avoiding penalties under
§ 6662(d) of the Code. The practitioner must also state that
the taxpayer should seek the advice of their own tax
advisors. § 10.35(d)(2).
(iii) Limited Scope Opinions. The practitioner must disclose in
a limited scope opinion at the beginning that the opinion is
limited to federal tax issues agreed upon between the
taxpayer and practitioner.
It must disclose that additional issues may exist that could
affect the federal tax treatment of the tax shelter, that the
opinion does not consider or reach a conclusion with
respect to those additional issues, and that the opinion was
not written and cannot be used by the recipient, for the
purpose of avoiding penalties under § 6662(d) with respect
to those outside issues. Cir. 230, § 10.35(d)(3).
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(iv) Opinions that Fail to Reach a More Likely than Not
Conclusion. If the opinion fails to reach a conclusion at a
confidence level of at least more likely than not with
respect to any material federal tax issue addressed in the
opinion, this must be disclosed in the opinion, and that the
opinion cannot be used by the recipient for the purpose of
avoiding the substantial under-statement income tax
penalty under § 6662(d) of the Code with respect to that
issue.
(v) Effective Opinion that Satisfies the Standards.
Circular 230 cautiously explains that even though an
opinion meets the requirements of § 10.35, the
persuasiveness of the opinion with respect to the tax issues
in question and the taxpayer's good faith reliance on the
opinion will be separately determined under applicable
provisions of law and regulations. Cir. 230, § 10.35(e).
4. Procedures to Ensure Circular 230 Compliance. Cir. 230, § 10.36.
New § 10.36 has been added to provide that tax advisors with
responsibility for overseeing a firm's practice before the IRS should take
reasonable steps to ensure that the firm's procedures for all members,
associates, and employees are consistent with best practices, as described
in § 10.33. This responsibility includes overseeing the firm's practice of
providing advice or in preparing or assisting in the preparation of
submissions to the IRS.
a. Requirements for Certain Tax Shelter Opinions.
Any practitioner who has principal authority or responsibility for
overseeing a firm's practice in providing advice is required to take
reasonable steps to ensure that the firm has adequate procedures in
effect to comply with § 10.35.
(i) Discipline.
The practitioner will be subject to discipline for failing to
comply with the supervisory requirement of the section if:
(a) the practitioner through willfulness, recklessness or
gross incompetence does not take reasonable steps
to ensure that the firm has adequate procedures to
comply with § 10.35; and
(b) one or more individuals to are members of,
associated with, or employed by, the firm are or
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have engaged in a pattern or practice that fails to
comply with § 10.35; or
(c) the practitioner knows or has reason to know that
one or more individuals who are members,
associates, or employees have engaged in a practice
in connection with the firm that does not comply
with § 10.35 and the practitioner, through
willfulness, recklessness or gross incompetence,
fails to take prompt action to correct the
noncompliance. Cir. 230 § 10.36(b)(1) and (2).
5. Establishment of Advisory Committees. Cir. 230, § 10.37.
New § 10.37 authorizes the Director of Professional Responsibility to
establish an advisory committee composed of at least five individuals
authorized to practice before the IRS. The advisory committee may
review and make recommendations regarding professional standards or
best practices for tax advisors, and whether a particular practitioner may
have violated §§ 10.35 or 10.36.
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