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CURRENT
DEVELOPMENTS IN TAX
SHELTERS
By Matthew D. Lerner and Jean Baxley
Current Developments in Tax Shelters
Overview
Recent Tax Shelter Cases
What Taxpayers and Their Advisors Need to
Know About the American Jobs Creation Act
Revisions to Circular 230
IRS Requests for Tax Accrual Workpapers
Recent Developments in Privilege
2
RECENT
TAX SHELTER CASES
3
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Facts
Onslow Trading and Commercial (“OTC”), a U.K.
company, engaged in lease stripping transactions
involving the sale and leasing of computers (CHIPS)
and long-haul truck tractors (TRIPS). OTC received
tax-free prepayments of rent, which it had a future
obligation to pay to third parties.
OTC contributed its leasehold interests, the lease
payment obligations, and the prepaid rent collections
to U.S. corporations in exchange for preferred stock,
thereby purportedly giving the preferred stock a high
basis (due to the contributed rent collections) and low
value (due to the contributed lease payment
obligations).
4
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Facts (continued)
At the same time, a U.K. entity controlled by the owners of
Long-Term Capital Management (“LTCM”), i.e. LTCM-
U.K., made a $5 million recourse loan to OTC.
A foreign bank made a loan to LTCM.
LTCM contributed the loan proceeds to Long Term
Capital Partners LP (“LTCP”), a U.S. limited partnership,
in exchange for a partnership interest in LTCP.
OTC contributed the high basis preferred stock received in
the CHIPS and TRIPS transactions (and a portion of the
proceeds from the LTCM-U.K. loan) to LTCP in exchange
for a partnership interest in LTCP.
5
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Facts (continued)
LTCP contributed the preferred stock (and the proceeds
from both loans) to P, a hedge fund.
OTC sold its interest in LTCP to LTCM via the exercise of
a put option.
P sold the preferred stock, for which it claimed basis of
just over $100 million, for approximately $1 million in
cash to affiliates of Merrill Lynch, thereby triggering the
built-in losses.
6
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Facts (continued)
3
Loan
GE CHIPS Loan
1 LTCP P/S Int. UBS
OTC LTCM 3
NB TRIPS (U.K.) 4 (U.S.)
3 Loan 3
Leasehold Interests, 2 Proceeds
Preferred Preferred
Lease Obligations &
Stock Stock & Loan
Prepaid Rent Collections
Proceeds
LTCP
(U.S.)
U.S.
3
Corp. 3 Loan
Preferred Proceeds
Stock & Loan 5
Proceeds ML
P Preferred
(Cayman Stock
Islands) 7
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Arguments
The government argued that the transaction lacked
economic substance, and was merely a tax ploy to create
artificial capital losses.
The taxpayer argued that the transaction had economic
substance, and offered proof that Long-Term expected
to realize a pre-tax profit from the transaction.
8
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Outcome
The United States District Court for the District of
Connecticut disallowed the claimed capital losses, holding
that the transaction engaged in by OTC and the Long-
Term entities lacked economic substance.
The court held in the alternative that the transaction
should be recast under the step transaction doctrine and
treated as a sale of preferred stock by OTC to the Long-
Term entities, resulting in a downward adjustment to the
stock basis.
9
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Evidence of Lack of Economic Substance
The court treated the following facts as evidence of lack of economic
substance:
• The transactions were brought to Long-Term as a “tax product”
rather than as an investment.
• Long-Term’s purported primary business purpose of generating
additional investment fees from the contribution of the preferred
stock (and cash) to P was disingenuous.
• There was no reasonable expectation of profit from the
transaction.
• Several “side agreements” provided hidden fees to the parties
structuring the transactions.
• Long-Term permitted OTC to make the contribution of preferred
stock (and cash) in contravention of the taxpayer’s investing
requirements.
10
Recent Tax Shelter Cases:
Long-Term Capital Holdings v. United States
Penalties
The court upheld imposition of penalties, despite the legal opinion obtained by
Long-Term from King & Spalding. Indeed, the court stated that Long-Term
failed to satisfy its burden to establish the applicability of the reasonable cause
defense since it could not prove it received King & Spalding’s written opinion
prior to the filing of its return.
The court determined that the opinion included unreasonable factual
assumptions (e.g., it was assumed that the taxpayer had a valid business
purpose and reasonably expected to earn a material pre-tax profit), and that the
opinion contained a “selective discussion of authority . . . which bolsters its
appearance as an advocacy piece not a balanced reasoned opinion with the
objective of guiding a client’s decisions.”
The court also concluded that the taxpayer tried to hide the loss on its tax
return by combining lines of Schedule M-1, and that this demonstrated a “lack
of good faith” for purposes of the reasonable cause exception.
The penalty issue is on appeal to the Second Circuit (Case No. 04-5687, filed
October 22, 2004).
11
Recent Tax Shelter Cases:
Black & Decker Corporation v. United States
Facts
The transaction was structured in similar fashion to the listed
transaction described by the Internal Revenue Service (“IRS”) in
Notice 2001-17, 2001-1 C.B. 730. The transaction involved the
centralization of the management and administration of the taxpayer’s
employee and retiree healthcare benefit plans in a separate subsidiary.
• B&D and certain of its subsidiaries exchanged cash of
approximately $561 million for stock in a separate subsidiary,
Black & Decker Healthcare Management, Inc. (“BDHMI”), and
the assumption by BDHMI of certain employee and retiree
healthcare liabilities with a value of $560 million.
• B&D and its subsidiaries later sold stock in BDHMI in an arm’s
length sale to an independent third-party for $1 million.
• B&D claimed a $560 million capital loss, based on the position that
the cost basis of the BDHMI shares (i.e., $561 million) was
unreduced by the contingent liabilities assumed by BDHMI.
12
Recent Tax Shelter Cases:
Black & Decker Corporation v. United States
Arguments
The government argued that the transaction was merely a
tax avoidance vehicle that must be disregarded for tax
purposes.
B&D argued that the transaction had economic substance,
that its basis in the BDHMI stock was $561 million, and
that it realized a bona fide capital loss of $560 million on
the sale of the BDHMI stock. B&D conceded, for purposes
of the motion for summary judgment, that tax avoidance
was its sole motivation for the transaction.
13
Recent Tax Shelter Cases:
Black & Decker Corporation v. United States
Outcome
The United States District Court for the District of
Maryland granted summary judgment in favor of B&D
and upheld B&D’s $560 million capital loss. The court
held that the transaction “[could not] be disregarded as a
sham” and concluded that the transaction had “very real
economic implications” for the beneficiaries of B&D’s
employee benefits programs, B&D, and BDHMI.
The court applied the Fourth Circuit’s sham transaction
doctrine. In support of its analysis, the court reasoned
that "a corporation and its transactions are objectively
reasonable, despite any tax-avoidance motive, so long as
the corporation engages in bona fide economically-based
business transactions."
14
Recent Tax Shelter Cases:
Black & Decker Corporation v. United States
Evidence of Objective Economic Substance
The court found the following facts as evidence of the
objective economic substance of B&D’s transaction:
• BDHMI assumed the responsibility for the
management, servicing, and administration of plaintiff's
employee and retiree health plans;
• BDHMI considered and proposed numerous healthcare
cost containment strategies since its inception, many of
which have been implemented by B&D;
• BDHMI has always maintained salaried employees; and
• BDHMI became responsible for paying the healthcare
claims of B&D’s employees and such claims are paid
with BDHMI’s assets.
15
Recent Tax Shelter Cases:
Coltec Industries, Inc. v. United States
Facts
The transaction was structured in similar fashion
to the transaction at issue in Black & Decker.
Coltec and its subsidiary, Garlock, transferred
cash, stock of a related company, and an
intercompany note to a newly-created subsidiary,
Garrison, in exchange for Garrison’s assumption
of contingent asbestos litigation liabilities valued
at $371 million and Garrison stock. Garrison was
formed for the purpose of managing the
contingent asbestos liabilities.
16
Recent Tax Shelter Cases:
Coltec Industries, Inc. v. United States
Facts (continued)
Coltec then sold the Garrison stock received by Garlock in
the exchange to Nationsbank and First Union to establish
the market price of the stock for subsequent sales to service
providers. These sales included “put” and “call” rights
exercisable after five years; the options were never
exercised, and have expired.
Coltec claimed $370 million in capital losses from these
stock sales.
Two years later, Coltec sold additional stock in Garrison to
a select group of lawyers involved in defending its asbestos
claims to provide these lawyers an additional performance
incentive.
17
Recent Tax Shelter Cases:
Coltec Industries, Inc. v. United States
Arguments
The government argued that: (1) Garrison’s assumption of the
liabilities reduced Garlock’s basis in the Garrison stock because the
principal purpose for Garrison’s assumption of the liabilities was not a
bona fide non-tax business purpose; (2) no sale of the Garrison stock
occurred because the put and call options negated any transfer of
beneficial ownership to the banks; and (3) the transactions lacked
economic substance.
Coltec argued that: (1) the Code did not require a reduction in
Garlock’s basis in the Garrison stock for the contingent liabilities
transferred to Garrison; (2) Garlock’s transfer of Garrison stock to the
banks was a sale; (3) no separate business purpose was required for the
sale of Garrison stock to the banks; and (4) the transactions had
economic substance and were not shams because the Garrison
transaction had a legitimate business purpose.
18
Recent Tax Shelter Cases:
Coltec Industries, Inc. v. United States
Outcome
The Court of Federal Claims upheld Coltec’s $370 million
capital loss, holding that Coltec had satisfied all of the
statutory requirements for claiming a capital loss from the
stock sale (including the tests of section 357(b)).
The court declined to apply the economic substance
doctrine so as to “trump” Coltec’s compliance with the
Code. Citing Gitlitz v. Commissioner, 531 U.S. 206 (2000),
and United States v. Bynum, 408 U.S. 125 (1972).
The court determined that Coltec’s basis in the Garrison
stock that was sold to Nationsbank and First Union should
not be reduced by the amount of the contingent asbestos
liabilities transferred to the subsidiary.
19
Recent Tax Shelter Cases:
Coltec Industries, Inc. v. United States
Outcome
The court held that contingent liabilities are not “liabilities” for
purposes of reducing basis under section 358(d).
The court stated that even if section 358(d) applied to the liabilities,
section 357(c)(3) would preclude the liabilities from reducing basis
because they “would give rise to a deduction.” The court relied upon
the analysis of section 357(c)(3) in Black & Decker, which concluded
that there was no authority to limit the application of section 357(c)(3)
only to situations where the liabilities would give rise to a deduction to
the transferee (as opposed to the transferor).
The court also held that section 357(b) did not apply to reduce Coltec’s
basis in the Garrison stock, because there was a valid business purpose
for the assumption of the liabilities. In determining that there was a
valid business purpose, the court relied upon the testimony of Coltec
employees as to the non-tax purposes of the transaction.
20
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Facts
In the early 1990’s, General Electric Capital Corporation (“GECC”)
sought to reduce the risk associated with its aircraft leasing business.
GECC formed a limited liability company (“LLC”), Summer Street, that
was owned by three of its subsidiaries, TIFD III-E, TIFD III-M, and GE
Capital AG. GECC, through the subsidiaries, contributed the following
to Summer Street: aircraft worth $530 million, subject to $258 million
nonrecourse debt (net $272 million); $22 million in receivables; $296
million in cash; and 100% of the stock of another of its subsidiaries, TIFD
VI (valued at $0).
TIFD III-E, TIFD III-M, and GE Capital AG sold interests in Summer
Street worth $50 million to two foreign banks, ING Bank and Rabo
Merchant Bank (collectively, the “Banks”). This sale constituted a sale of
100% of GE Capital AG’s interest in Summer Street. The Banks
contributed an additional $67.5 million to Summer Street, bringing their
total investment to $117.5 million.
21
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Facts (continued)
• Summer Street’s name was then changed to Castle Harbour - I
LLC (“Castle Harbour”).
• As a result of these transactions, TIFD III-E and TIFD III-M
owned a combined interest in Castle Harbour of approximately 82
percent, and the Banks owned a combined interest of
approximately 18 percent.
• Under the terms of the partnership agreement, 98 percent of the
“operating income” of the partnership was allocated to the Banks.
Operating income was comprised of income less expenses.
Depreciation of the airplanes and certain guaranteed payments to
the GE entities were treated as expenses that reduced operating
income; repayments of principal on the airplane debt were not.
Since the aircraft owned by Castle Harbour had already been fully
depreciated for tax purposes prior to their contribution to the
partnership, only “book” depreciation significantly reduced
operating income.
22
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Facts (continued)
“Disposition gains and losses” from sales or distributions of assets were
allocated as follows: (1) they offset prior disposition losses/gains and/or
prior operating income/loss; (2) 90 percent of the remainder of any gain
or loss was allocated to the Banks, subject to a specified limit of
approximately $3 million; and (3) if the limit was reached, then 99
percent of the balance was allocated to the GE entities, and one percent
was allocated to the Banks.
In each year, a substantial part of the income received by the Banks
was used to “buy down” portions of the Banks’ interests, thus
decreasing their capital accounts. The goal of GE and the Banks was to
liquidate the Banks’ interests in Castle Harbour over eight-years.
The expectation of the parties was that the Banks would earn an
internal rate of return of just over 9%.
The partnership allocations reduced GECC’s tax liability with respect
to operating income by $62.2 million over the life of the partnership.
23
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Arguments
The government argued that the allocation of Castle
Harbour’s income to the Banks should be disallowed on
three grounds: (1) the overall transaction lacked
“economic substance; (2) the Banks should be treated as
lenders, not partners, for tax purposes and, therefore,
partnership income could not be allocated to them; and (3)
the manner in which the partnership income was allocated
violated the “overall tax effect” rule of section 704(b).
GECC maintained that Castle Harbour was a real
partnership, established for legitimate, non-tax business
reasons.
24
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Outcome
The United States District Court for the District of Connecticut
granted judgment in favor of the taxpayer for $62.2 million.
The court held in favor of the taxpayer on each of the arguments
raised by the government, concluding that although the transaction
“sheltered a great deal of income from taxes” it was “legally
permissible.”
The court found that the formation of the partnership had “economic
substance” under the Second Circuit Court of Appeals’ sham
transaction standard, because it had real non-tax economic effects and
a non-tax business purpose.
The court held that GECC had a legitimate business purpose for the
transaction -- to raise additional capital, and to demonstrate to
investors, rating agencies, and GECC senior management that it could
raise capital on its aging aircraft.
25
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Outcome (continued)
The Banks contributed substantial amounts of cash to the partnership,
which was used to purchase aircraft and retire debt, thus establishing
a real economic effect to the transaction.
The court declined to decide whether to apply the economic substance
test advanced by the taxpayer, i.e. that if the transaction had either a
subjective business purpose or an objective economic effect, the
transaction should be respected for tax purposes, or the test advocated
by the government, i.e. a “flexible” standard where both factors
should be considered but neither factor is dispositive. Instead, the
court determined that the transaction had both a non-tax economic
effect and a non-tax business motivation and so would pass the
economic sham test under either approach.
26
Recent Tax Shelter Cases:
TIFD-III-E, Inc. (“Castle Harbour”) v. United States
Evidence of Economic Substance
Castle Harbour received an “economically real, up-front
payment of $117 million” from the Banks;
The Banks participated in the “economically real” upside
potential of the aircraft leasing business, despite provisions
in the operating agreement that apparently guaranteed
them a certain minimum level of return on their
investment;
The arrangement allowed GECC to retire some of its
commercial paper, thus reducing its debt-to-equity ratio.
27
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Facts
After Metro-Goldwyn Mayer (“MGM”) was sold to the highest bidder,
two individuals and their related entities (collectively, the “Ackerman
Group”) attempted to acquire MGM’s parent company, Santa Monica
Holding Corporation (“SMHC”), which was owned by the creditors of
MGM, the Credit Lyonnais group (“CL Group”).
• SMHC had no valuable assets, and owed approximately $1 billion
to the CL Group. CL Group also owned stock in SMHC. CL
Group’s tax basis in the SMHC debt was approximately $1 billion,
and its basis in the SMHC stock was approximately $665 million.
The Ackerman Group (AG) formed an LLC, SMP. The CL Group
contributed the SMHC debt and the SMHC stock to SMP in exchange
for preferred interests in SMP and $5 million cash. The CL Group
acquired a put right, exercisable within five years, with respect to its
SMP interests. The put required the AG to purchase the CL Group’s
interest for $5 million, and the parties entered into a deposit account
agreement that required the $5 million purchase price to be placed in a
blocked account to be released when the put was exercised. 28
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Facts (continued)
At the earliest opportunity, i.e., just three weeks after the CL Group
made its contribution to SMP, the CL Group exercised its put rights and
received $5 million from the AG for its interest in SMP.
Under the partnership rules, the AG claimed a $1 billion basis in the
SMHC debt held by SMP, and claimed a basis of $665 million in the
SMHC stock.
In 1997, SMP sold $150 million of the almost $1 billion debt it held to
TroMetro, an LLC formed by a long-time associate of one of the
individuals who controlled the AG, for approximately $2.5 million. SMP
claimed a loss of approximately $147.5 million on the sale on its 1997
return.
In 1998, SMP sold another $81 million of the debt it held to TroMetro
for $1.4 million (i.e., cash of $150,000 and a TroMetro note). SMP
claimed a loss of approximately $80 million on the sale on its 1998 tax
return.
29
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Facts (continued)
TroMetro and SMHC entered into a distribution agreement with respect to the
film library held by SMHC. SMHC reported no income from this
arrangement.
One of the individuals who controlled the AG was on the board of directors of
Imperial Bank (“Imperial”). In 1997, Imperial realized significant capital
gains from the sale of two of its financial services companies; it was looking for
losses to offset these gains.
In November of 1997 the AG formed Corona Film Finance Fund, LLC
(“Corona”). SMP contributed $250,000 cash and a $79 million receivable in
exchange for a 99% interest in Corona.
On December 15, 1997, Imperial purchased a 79% interest in Corona from
SMP for $1.25 million, and Imperial’s agreement to pay SMP a fee of 20% of
the tax losses received from Corona. SMP claimed a capital loss of $62 million
on the sale of the Corona interest to Imperial on its 1997 tax return.
30
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Facts (continued)
On December 23, 1997, Imperial purchased an additional 14.65%
interest in Corona from SMP for approximately $200,000. SMP
claimed a capital loss of $11.6 million on the sale of the second Corona
interest to Imperial on its 1997 tax return.
Also in December of 1997, Corona sold the $79 million receivable
contributed by SMP to TroMetro for $1.1 million (i.e., $120,000 cash
and a note). Corona reported a loss of $78 million on its return for
1997. Approximately $74 million of this loss flowed through to
Imperial; $4 million flowed through to SMP and its owners.
In accordance with the original agreement between Imperial and SMP
and as a result of the $74 million loss realized by Imperial, Imperial
contributed $14.5 million cash (i.e., approximately 25% of the amount
of the tax loss) to Corona; SMP then received the cash.
31
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Arguments
The government argued that under substance over form principles, i.e. the
economic substance and the step transaction doctrines, the transactions should
be recast as direct sales of the high basis, low value assets (i.e., the receivables
and the SMHC stock) by the CL Group to the AG, resulting in no transfer of
built-in losses to SMP and no flow-through of those losses to the Ackerman
Group.
• The government argued in the alternative that, if the form of the
transaction was respected, the capital losses would still be disallowed
because SMP’s tax basis in the SMHC receivables was zero, because the
receivables were worthless at the time they were contributed to SMP by
the CL Group.
• The government did not challenge the status of SMP and Corona as bona
fide partnerships.
The taxpayer argued that SMP succeeded to the CL Group’s high bases in the
receivables and the SMHC stock when those assets were contributed to SMP,
and that subsequent transfers of the receivables generated real losses. The
taxpayer argued that the form of the transactions should be respected, because
the parties had valid, non-tax business reasons for engaging in the transactions.
32
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Outcome
The Tax Court disallowed the capital losses claimed on the sales of
receivables, holding that SMP and Corona never had any basis in the
receivables. The court concluded that: (1) the contribution to SMP of
receivables and SMHC stock by the CL Group lacked economic
substance and cannot be respected for tax purposes; (2) SMP obtained
no basis in the receivables contributed by the CL Group because the
receivables were worthless or did not represent bona fide
indebtedness; and (3) the Corona transaction lacked economic
substance.
The court concluded that the “exclusive purpose” for the formation of
SMP was to transfer to the AG “enormous” tax attributes associated
with the high-basis, low value receivables and SMHC stock.
33
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Outcome (continued)
The court concluded, based on “economic realities,” that the CL Group
entities did not become partners in SMP, but sold their high-basis, low
value assets to the AG for $10 million.
In analyzing the objective economic substance of the transaction, the
court found that the put right the CL Group obtained, and the CL
Group’s exercise of that right on the earliest date possible, negated any
economic significance that “might otherwise have attached” to the CL
Group’s joining SMP.
In analyzing the objective economic substance of the transaction, the
court found that the AG’s up-front payment of $5 million to the CL
Group for its contribution of assets (i.e., receivables and SMHC stock)
to SMP and the additional $5 million promised upon exercise of the put
option far exceeded the value of the contributed assets, and that the AG
had no reasonable expectation of recouping the $10 million.
34
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Outcome (continued)
The court assigned minimal value to the SMHC stock contributed by
the CL Group, concluded that certain securities owned by SMHC (the
“Carolco securities”) had no value; and concluded that unused net
operating losses of SMHC had little or no value.
With respect to the government’s step transaction arguments under the
“end result” and “interdependence” tests, the court stated: “[w]hether
this contention is viewed as an alternative argument, or merely as a
particularization of [the government’s] substance over form argument,
the results are identical: We disregard the [CL Group’s] purported
contribution to SMP.” Nonetheless, “for the sake of completeness,” the
court went through a step transaction analysis and concluded that the
CL Group’s contributions of SMHC receivables and SMHC stock to
SMP and the AG’s purchase of the CL Group’s interest in SMP three
weeks later should be recast as (1) direct sales of the SMHC receivables
and SMHC stock from the CL Group to the AG, followed by (2) the
AG’s contribution of the SMHC assets to SMP.
35
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Outcome (continued)
The court addressed the government’s alternative argument that SMP had a
zero basis in the SMHC receivables contributed by the CL Group because
those receivables were worthless, and held that the receivables were worthless
and, thus, did not constitute a “contribution of property” to SMP.
The court addressed the government’s alternative argument that SMP had a
zero basis in one of the SMHC receivables contributed by the CL group
because that receivable did not arise out of a bona fide debtor/creditor
relationship, and concluded that the debt was not bona fide debt.
The court concluded that, in light of the fact that SMP had a zero basis in the
SMHC assets, the contribution of those assets to Corona was “devoid of
business purpose and economic substance.”
The court rejected the government’s argument that the sales of receivables to
TroMetro should be recast as sales by SMP of an option to receive an equity
interest in SMHC. However, the court noted that this conclusion did “not
ultimately affect [its] decision” because the court had already reached the
conclusion (on other grounds) that SMP had no basis in the SMHC receivables.
36
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Evidence of Lack of Business Purpose
The CL Group had no intention of producing/distributing films with
the AG; the AG had no experience in running a film distribution
business; the CL Group contributed the film assets to SMHC and knew
they were of little value; and the parties did not actively negotiate over
the particulars re: the film business.
The AG was clearly interested in the tax attributes the CL Group had
in the MGM companies, and its due diligence activities were focused
almost entirely on obtaining assurances regarding the CL Group’s high
basis in the receivables and the SMHC stock.
The AG faxed a Wall Street Journal article to its counsel that described
a transaction similar to the proposed transaction, with a note that the
article “gives good support for our business purpose for doing the
deal.”
37
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Misstatement and Negligence Penalties
The court sustained the section 6662(h) penalty for gross valuation
misstatements, based on its determination that SMP had a zero basis
in the receivables contributed by the CL Group, concluding that
SMP’s and Corona’s claimed basis was “infinitely more than 400
percent of the amount” that the court determined to be the correct
basis in the receivables.
The court also sustained the section 6662(a)(1) negligence penalty,
observing that the principal of the AG who “personally engineered
the plan to transfer built-in losses” was a “highly educated,
sophisticated tax attorney” who had worked at a major law firm, at
the Tax Court, and at Treasury.
38
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Substantial Understatement Penalty
The court sustained the section 6662(a)(2) substantial
understatement penalty, holding that the taxpayer “cited
no substantial authority” for its position.
The court held that the transaction at issue was a “tax
shelter” for purposes of section 6662(d)(2)(C)(iii) since it
concluded that the transaction between the CL Group and
the AG lacked economic substance and, thus, that the
taxpayer must demonstrate “reasonable belief” to prevail.
The court concluded that none of the opinions purportedly
relied upon by the taxpayer reached a more likely than not
conclusion, and that the taxpayer did not reasonably rely
on such opinions.
39
Recent Tax Shelter Cases:
Santa Monica Pictures v. Commissioner
Substantial Understatement Penalty
The court analyzed separately each piece of advice the
taxpayer claimed to have relied upon, which included eight
legal and accounting memoranda, and determined that
none of the memoranda provided reasonable cause.
The court’s complaints with the opinions were that they:
• misrepresented the facts of the actual transactions;
• assumed certain incorrect facts, e.g. that there was a
business purpose for the transactions, that the taxpayer
knew were untrue;
• were based on “dubious” appraisals of assets; and
• analyzed legal issues that were irrelevant to the case.
40
WHAT TAXPAYERS AND
THEIR ADVISORS NEED
TO KNOW ABOUT THE
AMERICAN JOBS
CREATION ACT (“AJCA”)
41
American Jobs Creation Act (AJCA)
Disclosure Penalties
Section 6707A
New section 6707A imposes a penalty for failing to disclose a tax shelter
transaction.
The amount of the penalty is $10,000 for individuals, and $50,000 for all
other taxpayers for “reportable” transactions; and $100,000 for
individuals and $200,000 all other taxpayers for “listed” transactions.
Treasury has the authority to define “reportable” and “listed” transactions
in regulations under section 6011.
The penalty applies to any taxpayer who participates in a reportable
transaction. A taxpayer is a participant in a reportable transaction if his
tax return reflects the tax benefit of the reportable transaction.
The section 6707A penalty applies regardless of whether the reportable
transaction results in an understatement of tax.
42
American Jobs Creation Act (AJCA)
Disclosure Penalties
Section 6707A (continued)
The section 6707A penalty, effective for returns and statements the due date for
which is after October 22, 2004, applies in addition to any accuracy-related
penalties.
The section 6707A penalty cannot be waived for failing to report a “listed”
transaction,” but the taxpayer can argue that the transaction was not a
“substantially similar” transaction.
However, Notice 2005-11 grants the IRS authority to rescind the penalty for
failing to disclose a “reportable” transaction (other than a listed transaction)
based upon: (1) Whether the taxpayer has a history of complying with the tax
laws; (2) Whether the violation is due to an unintentional mistake of fact; and (3)
Whether imposing the penalty would be against “equity and good conscience”
There is no judicial review of the Commissioner’s determination whether to
rescind the section 6707A penalty.
43
American Jobs Creation Act (AJCA)
Disclosure Penalties
Section 6707A (continued)
Certain taxpayers have to disclose the payment of certain penalties to
the Securities and Exchange Commission (“SEC”).
The penalties which trigger this new reporting obligation are the
section 6707A penalty for failure to disclose, the section 6662A penalty
for an understatement attributable to an undisclosed listed transaction
or undisclosed reportable avoidance transaction, and the 40 percent
penalty under section 6662 for gross valuation misstatements if the 30
percent penalty under section 6662A would have applied.
Note that the failure to make the disclosure to the SEC as just
described is itself treated as a failure to include information with
respect to a listed transaction for which the penalty under section
6707A applies.
44
American Jobs Creation Act (AJCA)
Disclosure Penalties
Section 6707A (continued)
Reportable transactions include six different types of transactions.
• Listed Transactions;
• Confidential Transactions for which the taxpayer has paid an advisor a
minimum fee (i.e., $250,000 for corporations, and $50,000 for other
taxpayers);
• Transactions with Contractual Protection;
• Loss Transactions - A transaction that results in a loss of $10 million or
more in a single taxable year for corporations, or $20 million or more
in multiple years;
• Transactions with a Significant Book-Tax Difference - Transactions
with a book-tax difference of more than $10 million on a gross basis in
any taxable year are considered “significant” for these purposes; and
• Transactions Involving a Brief Asset Holding Period - Transactions are
reportable if there is a tax credit claimed that exceeds $250,000, and the
asset giving rise to the credit is held for 45 days or less.
45
American Jobs Creation Act (AJCA)
Disclosure Penalties
Section 6707A (continued)
The two types of reportable transactions that most large corporations
will face are loss transactions and transactions involving significant
book-tax differences.
For tax years ending on or after December 31, 2004, if a corporate
taxpayer is required to file the new Schedule M-3, the reporting of
book-tax differences is deemed to be satisfied by the filing of that
completed schedule.
If the Schedule M-3 is filed with the return, it does not also have to be
filed with OTSA.
If, however, the transaction has significant book-tax differences and
falls within another category of reportable transactions (for example, it
is substantially similar to a listed transaction or involves a substantial
loss), then it would not only be reported on Schedule M-3, but would
have to be reported on a Form 8886 filed with the return. A copy of the
Form 8886 would then have to be filed with OTSA. 46
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Section 6662A
In general, section 6662A provides that a 20-percent accuracy-related
penalty may be imposed on any reportable transaction understatement.
A “reportable transaction understatement” means:
• The amount of the increase in taxable income which results from a
difference between the proper tax treatment of an item and the
taxpayer’s treatment of such item (as shown on the taxpayer’s
return), multiplied by the highest rate of tax imposed by section 1
(section 11 for corporations); plus
• The amount of decrease in the aggregate amount of credits
determined under subtitle A which results from a difference
between the taxpayer’s treatment of an item to which section
6662A applies (as shown on the taxpayer’s return) and the proper
tax treatment of such item.
47
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Section 6662A (continued)
Section 6662A applies to any listed transaction and any
reportable transaction (other than a listed transaction) if a
significant purpose of such transaction is the avoidance or
evasion of Federal income tax.
The section 6662A penalty applies to any increase in
taxable income resulting from certain reportable
transactions regardless of the amount of the unreported tax
liability. This means that it applies even if the taxpayer is
in a net operating loss position.
The amount of the section 6662A penalty is 30 percent,
rather than 20 percent, if the taxpayer does not adequately
disclose the relevant facts affecting the tax treatment of the
item giving rise to the understatement. 48
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Section 6662A (continued)
The reasonable cause and good faith defense is not
available with respect to the 30-percent penalty.
Tax treatment on an amended return or a supplement to a
return is not taken into account if the amended return or
the supplement is filed after the earlier of the date the
taxpayer is first contacted by the IRS regarding an
examination of the return, or any other date specified by
the Secretary.
In general, the section 6662A accuracy-related penalty does
not apply to any portion of a reportable transaction
understatement if, pursuant to section 6664(d), it is shown
that there was reasonable cause and the taxpayer acted in
good faith. 49
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Section 6662A (continued)
The reasonable cause and good faith exception does not apply
unless:
• The relevant facts affecting the tax treatment of the item
are adequately disclosed;
• There is or was “substantial authority” for such
treatment; and
• The taxpayer reasonably believed that such treatment was
more likely than not the proper treatment. Section
6664(d)(2).
Under section 6664(d)(2), the requirement to disclose
adequately under section 6011 will be treated as satisfied even
if the taxpayer did not in fact disclose if the section 6707A
penalty is rescinded. 50
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Section 6662A (continued)
The opinion of a tax advisor may not be relied upon to establish
reasonable belief if either the tax advisor or the opinion is disqualified.
A tax advisor is a disqualified tax advisor if:
• The advisor is a material advisor and participates in the
organization, management, promotion, or sale of the transaction,
or is related to any person who so participates;
• The advisor is compensated directly or indirectly by a material
advisor with respect to the transaction;
• The advisor has a fee arrangement with respect to the transaction
which is contingent on the intended tax benefits from the
transaction being sustained; or
By regulations, the advisor has a disqualifying financial interest in the
transaction.
51
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Section 6662A (continued)
An opinion is a disqualified opinion if:
• The opinion is based on unreasonable factual or legal
assumptions (including assumptions about future
events);
• The opinion unreasonably relies on representations,
statements, findings, or agreements of the taxpayer or
any other person;
• The opinion does not identify and consider all relevant
facts; or
• The opinion fails to meet other requirements prescribed
by the Secretary.
52
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Notice 2005-12
Notice 2005-12 provides interim guidance on implementing section
6662A and the revisions to sections 6662 and 6664.
• For purposes of determining whether the 30 percent penalty
applies, the taxpayer will be treated as disclosing the relevant facts
affecting the tax treatment of the item under section 6011 if the
taxpayer filed a disclosure statement under Treas. Reg. § 1.6011-
4(d), is deemed to have satisfied its disclosure obligation under Rev.
Proc. 2004-45, 2004-31 I.R.B. 140, or satisfies the requirements set
forth in any other published guidance regarding disclosure under
section 6011.
• For purposes of determining the amount of any reportable
transaction understatement, the IRS will not take into account
amended returns filed after the dates specified in Treas. Reg.
§1.6664-2(c)(3) and Notice 2004-38, 2004-21 I.R.B. 949, which are
dates after which a taxpayer may not file a “qualified amended
return”.
53
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Notice 2005-12 (continued)
Notice 2005-12 also provides interim guidance on when a material advisor
is a disqualified tax advisor.
• A material advisor participates in the “organization” of a transaction
if the advisor devises, creates, investigates, or initiates the transaction
or tax strategy; devises the business or financial plans for the
transaction or tax strategy; carries out those plans through
negotiations or transactions with others; or performs acts related to the
development or establishment of the transaction.
• A material advisor participates in the “management” of a transaction if
the material advisor is involved in the decision-making process
regarding any business activity with respect to the transaction.
• A material advisor participates in the “promotion or sale” of a
transaction if the material advisor is involved in the marketing of the
transaction, including soliciting taxpayers to enter into a transaction or
tax strategy; placing an advertisement for the transaction; or
instructing or advising others in the marketing of the transaction.
54
American Jobs Creation Act (AJCA)
Accuracy- Related Penalties
Notice 2005-12 (continued)
Notice 2005-12 provides that a tax advisor, including a material advisor,
will not be treated as participating in the organization, management,
promotion, or sale of a transaction if the advisor’s only involvement in
the transaction is rendering an opinion regarding the tax consequences
of the transaction.
Notice 2005-12 also defines when a tax advisor will have a disqualified
compensation arrangement. Until further guidance, a tax advisor is
treated as a disqualified tax advisor if the tax advisor has a referral fee
or fee-sharing arrangement by which the advisor is compensated directly
or indirectly by a material advisor. This rule applies regardless of
whether or not the tax advisor is a material advisor.
An arrangement is a disqualified compensation arrangement if there is
an agreement or understanding (oral or written) with a material advisor
of a reportable transaction pursuant to which the tax advisor is expected
to render a favorable opinion regarding the tax treatment of the
transaction to any person referred by the material advisor.
55
American Jobs Creation Act (AJCA)
Material Advisor Rules - Changes
The AJCA made the following changes to the rules applicable to “material advisors”:
• Section 6111(a) was amended to require each material advisor with respect to a
reportable transaction to make a return (in such form as the Secretary may
prescribe) setting forth information identifying and describing the transaction;
information describing any potential tax benefits expected to result from the
transaction; and such other information as the Secretary may prescribe.
• Section 6111(b) defines a material advisor as
Any person who provides any material aid, assistance, or advice with respect
to organizing, managing, promoting, selling, implementing, insuring, or
carrying out any reportable transaction; and
Who directly or indirectly derives gross income in excess of the threshold
amount (or such other amount as may be prescribed by the Secretary) for
such advice or assistance. (The threshold amounts are $50,000 in the case of
a reportable transaction substantially all of the tax benefits from which are
provided to natural persons, and $250,000 in any other case).
56
American Jobs Creation Act (AJCA)
Material Advisor Rules
Section 6111(c) confers authority to issue regulations which provide:
• That only one person shall be required to satisfy the section 6111
requirements in cases in which two or more persons would
otherwise be required to meet such requirements;
• Exemptions from the requirements of the section; and
• Such rules as may be necessary or appropriate to carry out the
purposes of the section.
Section 6112 provides that each material advisor with respect to any
reportable transaction is required to maintain a list identifying each
person with respect to whom such advisor acted as a material advisor
with respect to such transaction; and containing such other information
as the Secretary may by regulations require.
Section 6708 provides a penalty of $10,000 per day, which is applicable
to a material advisor who fails to provide the list that is required to be
maintained under section 6112 within the prescribed time frame.
57
American Jobs Creation Act (AJCA)
Material Advisor Rules - Guidance
Notice 2004-80 provides interim guidance regarding disclosures by a
material advisor and the maintenance of lists by material advisors.
Notice 2005-17 provides an extension of the transition relief outlined
in Notice 2004-80.
Notice 2005-22 provides additional interim guidance to material
advisors, including advice regarding, among other things:
• How to complete IRS Form 8264, and when it must be filed; and
• Determining the point at which an advisor becomes a “material
advisor.”
58
American Jobs Creation Act (AJCA)
Section 6501(c)(10)
New section 6501(c)(10) changes the statute of limitations for listed transactions
by providing that if a taxpayer fails to include on any return or statement for any
taxable year any information with respect to a listed transaction which is
required under section 6011, the time for assessment of any tax imposed with
respect to such transaction shall not expire before the date which is 1 year after
the earlier of:
• the date on which the taxpayer furnishes the required information to the
Secretary, or
• the date that a material advisor provides required information relating to
such transaction with respect to such taxpayer.
New section 6501(c)(10) focuses on disclosure. The statute of limitations is only
extended if: (1) the taxpayer has not disclosed the transaction under section 6011;
and (2) the material advisor has failed to fulfill its disclosure obligation.
Revenue Procedure 2005-26 provides additional guidance on section 6501(c)(10).
59
American Jobs Creation Act (AJCA)
Section 6404(g)
The AJCA amended the circumstances under which interest which
otherwise would have been suspended by operation of section 6404(g) is
not suspended.
In general, section 6404(g) provides that, in certain circumstances,
where the Secretary does not provide a notice to the taxpayer
specifically stating the taxpayer’s liability and the basis for the liability
before the close of the 18 month period beginning on the later of the
date on which the return is filed or the due date of the return without
regard to extensions, the Secretary suspends the imposition of interest
(and other additional amounts) related to the suspension period.
Prior to the changes in the AJCA, interest would be suspended on
certain listed transactions if they were not otherwise in a category
defined in section 6404(g)(2).
60
American Jobs Creation Act (AJCA)
Section 6404(g) (continued)
The AJCA provides that, under section
6404(g)(2)(D) and (E), any interest, penalty,
addition to tax, or additional amount will not be
suspended for amounts:
• with respect to any gross misstatement;
• with respect to any reportable transaction
where section 6664(d)(2)(A) is not met; and
• with respect to any listed transaction (as
defined in section 6707A(c)).
61
American Jobs Creation Act (AJCA)
Section 163(m)
Effective for taxable years ending after October 22, 2004, newly-
enacted section 163(m) disallows a deduction for any interest payable
on an underpayment attributable to a reportable transaction as defined
by section 6662A(b) if the requirements of section 6664(d)(2)(A) are not
met.
Thus, no interest would be deductible on that part of an underpayment
attributable to a listed transaction or a reportable tax avoidance
transaction unless reasonable cause can be proved.
Reasonable cause for this purpose requires all relevant facts to have
been disclosed in accordance with the regulations under section 6011,
that there be substantial authority for the treatment of the transaction,
and that the taxpayer reasonably believes that the treatment was more
likely than not proper.
This disallowance covers interest on the deficiency, interest on any
interest payable, and interest on any penalty. 62
American Jobs Creation Act (AJCA)
Changes to Section 7525
The AJCA limits the scope of the section 7525 tax practitioner-client
privilege for communications regarding tax shelters.
In general, the change in the AJCA broadens the scope of the limitation
in section 7525(b) from communications between a federally authorized
tax practitioner and a “director, shareholder, officer, or employee,
agent, or representative of a corporation” (emphasis added) to “(A) any
person, (B), any director, officer, employee, agent or representative of
that person, or (C) any other person holding a capital or profits interest
in the person” where the communication is in connection with the
promotion of the direct or indirect participation of the person in any
tax shelter (as defined in section 6662(d)(2)(C)(ii)).
63
REVISIONS TO
CIRCULAR 230
64
Revisions to Circular 230
Background
On December 17, 2004, the U.S. Department of the Treasury
(“Treasury”) and the IRS published final regulations amending
Circular 230. These regulations were promulgated, in large part,
with the purpose of curbing the promotion of abusive tax shelters.
The regulations were revised on May 18, 2005, to respond to certain
comments by practitioners. 70 Fed. Reg. 28,824 (May 19, 2005). The
regulations provide ethical standards applicable to practitioners (i.e.
attorneys, certified public accountants, enrolled agents, and enrolled
actuaries) who provide written tax advice concerning one or more
federal tax issues. A practitioner’s failure to comply with these
regulations could result in the imposition of sanctions, which may
include censure (public reprimand), suspension, disbarment, and/or
monetary penalties.
65
Revisions to Circular 230
Applicability
The new regulations govern all written tax advice, including electronic
communications, concerning one or more federal tax issues. “Written
tax advice” means written advice concerning one or more federal tax
issues. A “federal tax issue” is a question concerning the federal tax
treatment of an item of income, gain, loss, deduction, or credit, the
existence or absence of a taxable transfer of property, or the value of
property for federal tax purposes.
Written tax advice is subject to one of two sets of rules -- the “covered
opinion” rules contained in section § 10.35, or the “other written
advice” rules contained in section § 10.37. The rules applicable to
“covered opinions” are more stringent than the rules applicable to
“other written advice.”
66
Revisions to Circular 230
Overview of Provisions
Best Practices - Broadly drafted aspirational standards.
Covered Opinions - Detailed rules applicable to written tax advice on
one or more federal tax issues arising from: (1) a listed transaction; (2)
a plan or arrangement the principal purpose of which is the avoidance
or evasion of federal tax; or (3) a plan or arrangement a significant
purpose of which is the avoidance or evasion of federal tax, if the
written advice is: (a) a reliance opinion (with a more likely than not, or
stronger, conclusion); (b) a marketed opinion; (c) subject to conditions
of confidentiality; or (d) subject to contractual protection (emphasis
added).
Other Written Advice - Rules applicable to written advice that does
not qualify as a “covered opinion.”
67
Revisions to Circular 230
Best Practices (Section 10.33)
The Best Practices standards are aspirational in nature. Best practices
include the following:
• Complying with the standards of practice provided in other sections of
Circular 230.
• Communicating clearly with the client regarding the terms of the
engagement, including the form and scope of the advice to be rendered.
• Establishing the facts, determining which facts are relevant, evaluating
the reasonableness of any assumptions or representations, relating the
applicable law (including potentially applicable judicial doctrines) to the
relevant facts, and arriving at a conclusion supported by the law and the
facts.
• Advising the client regarding the import of the conclusions reached,
including, for example, whether a taxpayer may avoid accuracy-related
penalties under the Code if a taxpayer acts in reliance on the advice.
• Acting fairly and with integrity in practice before the IRS.
• Tax advisors in supervisory roles within a tax practice are encouraged to
take reasonable steps to ensure that the tax practice’s procedures are
consistent with these best practices. 68
Revisions to Circular 230
Covered Opinions (Section 10.35)
The standards of § 10.35 apply to “Covered Opinions.” Under the
regulations, a covered opinion is written advice, including electronic
communications, concerning one or more federal tax issues arising
from:
• A transaction that is a “listed transaction” (or a transaction that
is “substantially similar” to a listed transaction) at the time the
advice is rendered.
• A partnership or other entity, investment plan or arrangement,
or any other plan or arrangement the principal purpose of which
is the avoidance or evasion of federal tax.
• A partnership or other entity, investment plan or arrangement,
or any other plan or arrangement a significant purpose of which
is the avoidance or evasion of federal tax, if the advice also
constitutes a “reliance opinion,” a “marketed opinion,” is subject
to conditions of confidentiality, or is subject to contractual
protection. 69
Revisions to Circular 230 –
Reliance Opinions Subject to Section 10.35
A “reliance opinion” is advice that concludes at a confidence level of
at least more likely than not (a greater than 50 percent likelihood)
that one or more significant federal tax issues would be resolved in the
taxpayer’s favor. A federal tax issue is “significant” if the IRS has a
reasonable basis for a successful challenge and its resolution could
have a significant impact, whether beneficial or adverse and under
any reasonably foreseeable circumstance, on the overall federal tax
treatment of the transaction(s) or matter(s) addressed in the opinion.
Note that advice that would otherwise constitute a reliance opinion is
not treated as such if: (1) it does not concern a listed transaction; (2) it
does not concern a partnership, entity, plan, or arrangement the
principal purpose of which is the avoidance or evasion of tax; and (3)
the practitioner prominently discloses in the written advice that it was
not intended or written by the practitioner to be used, and that it
cannot be used by the taxpayer, for the purpose of avoiding penalties
that may be imposed by the IRS. 70
Revisions to Circular 230 –
Marketed Opinions
Subject to Section 10.35
A “marketed opinion” is advice the practitioner knows or has reason to
know will be used or referred to by a person other than the practitioner
(or a person who is a member of, associated with, or employed by the
practitioner’s firm) in promoting, marketing or recommending a
partnership or other entity, investment plan or arrangement to one or
more taxpayer(s). § 10.35(b)(5).
Advice that would otherwise constitute a marketed opinion is not treated
as such if: (1) it does not concern a listed transaction; (2) it does not
concern a partnership, entity, plan, or arrangement the principal purpose
of which is the avoidance or evasion of tax; and (3) the practitioner
prominently discloses in the written advice that: (a) the advice was not
intended or written by the practitioner to be used, and that it cannot be
used by the taxpayer, for the purpose of avoiding penalties that may be
imposed on the taxpayer by the IRS; (b) the advice was written to
support the promotion or marketing of the transaction(s) or matter(s)
addressed by the written advice; and (c) the taxpayer should seek advice
based on the taxpayer’s particular circumstances from an independent
tax advisor. 71
Revisions to Circular 230
Exceptions to the Definition of a
“Covered Opinion”
The covered opinion rules do not apply to the following types of written
tax advice:
• Preliminary Advice – The practitioner reasonably expects to
provide subsequent written advice to the client that satisfies the
“covered opinion” requirements.
• Specified Types of Advice - Advice (other than advice with respect
to a listed transaction, or a transaction with the principal purpose
of tax avoidance or evasion) that concerns the qualification of a
qualified plan; a state or local bond opinion; and advice included in
documents required to be filed with the SEC.
• Post-Filing Advice - Post-filing advice is advice prepared for and
provided to a taxpayer, solely for use by that taxpayer, after the
taxpayer has filed a return reflecting the benefits of the
transaction.
72
Revisions to Circular 230
Exceptions to the Definition of a
“Covered Opinion” (continued)
• In-House Advice - A covered opinion does not include
written advice provided to an employer by an employee
practitioner that concerns the employer's tax liability.
• Negative Advice - Negative advice is written advice that
does not resolve a Federal tax issue in the taxpayer’s
favor, unless the advice reaches a conclusion favorable
to the taxpayer at any confidence level, e.g. not
frivolous. §10.35(b)(2)(ii)(E).
• Certain Advice Containing Prominent Disclosures -
Advice that otherwise qualifies as a reliance opinion or
marketed opinion is not a covered opinion if it contains
appropriate, prominent disclosures as described in the
regulations.
73
Revisions to Circular 230
Standards Applicable to Covered Opinions
Overview
If written advice is subject to the covered opinion
rules, the practitioner providing the advice must
• consider all relevant facts,
• relate the law to the facts,
• evaluate the significant federal tax issues, and
• provide a conclusion.
74
Revisions to Circular 230
Standards Applicable to Covered Opinions
Factual Matters
The practitioner must use reasonable efforts to identify and ascertain
the facts. The opinion must identify and consider all facts the
practitioner determines to be relevant.
The opinion must not be based on any “unreasonable” factual
assumptions.
The opinion must not be based on any “unreasonable factual
representations, statements or findings” of the taxpayer or any other
person.
The opinion may not rely on a factual representation that a transaction
has a business purpose if the representation does not include a specific
description of the business purpose or if the practitioner knows or
should know that the representation is incorrect or incomplete.
All factual representations, statements or findings of the taxpayer
relied upon by the practitioner must be identified in a separate section.
75
Revisions to Circular 230
Standards Applicable to Covered Opinions
Relating the Law to the Facts
The opinion must relate the applicable law (including
potentially applicable judicial doctrines) to the relevant
facts.
The practitioner must not assume the favorable resolution
of any significant federal tax issue, unless otherwise
permitted in the regulations, or otherwise base an opinion
on any unreasonable legal assumptions, representations, or
conclusions.
The opinion must not contain internally inconsistent legal
analyses or conclusions.
76
Revisions to Circular 230
Standards Applicable to Covered Opinions
Evaluation of Significant Federal Tax Issues
The advice must provide a conclusion as to the likelihood that the
taxpayer will prevail on the merits regarding each significant tax issue
considered in the opinion. If the practitioner is unable to reach a
conclusion regarding one or more significant federal tax issues, the
opinion must state that the practitioner is unable to reach a conclusion
regarding those issues.
A federal tax issue is “significant” if the IRS has a reasonable basis for
a successful challenge and the resolution of the issue could have a
significant impact on the overall federal tax treatment of the
transactions or matters opined on.
§ 10.35(b)(3).
The opinion must describe the reasons for the conclusions, including
the facts and analysis supporting the conclusions, or describe the
reasons that the practitioner is unable to reach a conclusion as to one or
more issues.
77
Revisions to Circular 230
Evaluation of Significant Federal Tax Issues
(continued)
If a “more likely than not” conclusion is not reached with
respect to a significant tax issue, the advice must
prominently disclose that fact and state that the taxpayer
may not use the advice to avoid penalties.
In evaluating the significant federal tax issues, the opinion
must not take into account the possibility that a tax return
will not be audited, that an issue will not be raised on audit,
or that an issue will be resolved through settlement if
raised.
78
Revisions to Circular 230
Standards Applicable to Covered Opinions
Providing an Overall Conclusion
The advice must provide an overall confidence level as to
the likelihood that the federal tax treatment of the
matter(s) that is the subject of the advice 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
inability to reach such a conclusion.
79
Revisions to Circular 230
Standards Applicable to Covered Opinions
Competence
The opinion must be rendered by a practitioner who is knowledgeable
in all of the aspects of federal tax law relevant to the opinion being
rendered. A practitioner may rely on the opinion of another
practitioner if the opinion identifies and states the conclusions reached
in the opinion relied upon. A practitioner must not rely on the opinion
of another practitioner if the practitioner knows or should know that
the opinion should not be relied upon.
If a practitioner relies on the opinion of another practitioner, the
relying practitioner must be satisfied that the combined analysis of the
opinions and the overall conclusion satisfy the covered opinion
requirements.
80
Revisions to Circular 230
Standards Applicable to Covered Opinions
Special Rules for Marketed Opinions
If the advice is a marketed opinion, the advice must provide a
conclusion at a confidence level of at least more likely than not with
respect to each significant federal tax issue and with respect to the
overall conclusion.
A marketed opinion must contain two prominent disclosures:
• The advice was written to support the promotion or marketing of
the transaction or matter addressed in the advice; and
• The taxpayer should seek advice from an independent tax advisor.
If the confidence level for a marketed opinion does not reach more
likely than not, the opinion may still be issued if, in addition to the two
required, prominent disclosures set forth in the previous paragraph,
the advice prominently discloses the following:
• The advice was not intended or written to be used, and it cannot be
used, for the purpose of avoiding penalties that may be imposed by
the IRS. 81
Revisions to Circular 230
Standards Applicable to Covered Opinions
Special Rules for Marketed Opinions (continued)
Note also that any covered opinion that fails to reach a
more likely than not conclusion with respect to a significant
federal tax issue must prominently disclose the following:
• The opinion does not reach a conclusion at a confidence
level of at least more likely than not with respect to one
or more significant federal tax issues addressed in the
opinion. With respect to those significant federal tax
issues, the opinion was not written, and cannot be used
by the taxpayer, for the purpose of avoiding penalties
that may be imposed on the taxpayer.
82
Revisions to Circular 230
Standards Applicable to Covered Opinions
Special Rules for Limited Scope Opinions
A practitioner may provide an opinion that considers less than all of the
significant federal tax issues if:
• the opinion is not an opinion with respect to a listed transaction or a
transaction that has the principal purpose of tax avoidance or evasion;
• the opinion is not a marketed opinion;
• the practitioner and the taxpayer agree that the scope of the opinion
and the taxpayer’s reliance on the opinion for purposes of avoiding
penalties are limited to the federal tax issue(s) addressed in the opinion;
and the opinion includes the following prominent disclosures:
the opinion is limited to the one or more federal tax issues
addressed in the opinion;
additional issues may exist that could affect the treatment of the
transaction or matter that is the subject of the opinion and the
opinion does not consider any such issues; and
with respect to issues not addressed in the opinion, the opinion
cannot be used for the purpose of avoiding penalties.
83
Revisions to Circular 230
Standards Applicable to Covered Opinions
Special Rules for Limited Scope Opinions (continued)
A practitioner providing a limited scope opinion may make
reasonable assumptions regarding the favorable resolution
of a federal tax issue (an “assumed issue”).
Any assumed issues must be identified in a separate section
of the opinion.
84
Revisions to Circular 230
Standards Applicable to Covered Opinions
Required Disclosures
All covered opinions must include the following disclosure
if it applies:
• The opinion must disclose the existence of any
relationship between the practitioner (or firm)
providing the opinion and a promoter of the transaction
that is the subject of the covered opinion, including any
compensation arrangement or referral agreement.
85
Revisions to Circular 230
Standards Applicable to Covered Opinions
Consistency with Disclosures
The advice contained in the covered opinion must not be
contrary to or inconsistent with any required disclosure.
86
Revisions to Circular 230
Section 10.36 -Procedures to Ensure Compliance
With the Covered Opinion Rules
Section 10.36 provides that a practitioner who has principal authority and
responsibility for overseeing a firm’s practice of providing federal tax advice
must take reasonable steps to ensure that the firm has adequate procedures in
effect for purposes of complying with § 10.35.
A practitioner who is responsible for establishing and maintaining compliance
procedures is subject to discipline in two circumstances:
• The practitioner through willfulness, recklessness, or gross incompetence,
does not take reasonable steps to ensure compliance with the covered opinion
rules, and one or more of the firm’s practitioners have engaged in a pattern
or practice of failing to comply with the rules; or
• The practitioner knows or should know of a pattern or practice of
noncompliance with the covered opinion rules, and through willfulness,
recklessness, or gross incompetence, fails to take prompt action to correct the
noncompliance.
• Note that the regulations do not provide definitions for “willfulness,”
“recklessness,” or “gross incompetence,” or give concrete examples of
practitioner conduct that would be considered willful, reckless, or grossly
incompetent in this context.
87
Revisions to Circular 230
Standards Applicable to
“Other Written Advice”
The standards of Section 10.37 apply to written tax advice that does not
constitute a “covered opinion.”
Section 10.37 states that a practitioner must not:
• Base advice on unreasonable factual or legal assumptions
(including assumptions as to future events);
• Unreasonably rely upon representations, statements, findings or
agreements of the taxpayer or any other person;
• Fail to consider all relevant facts that the practitioner knows or
should know; or
• In evaluating a federal tax issue, take into account the possibility
that a tax return will not be audited, that an issue will not be raised
on audit, or than an issue will be resolved through settlement if
raised.
88
Revisions to Circular 230
Standards Applicable to
“Other Written Advice” (continued)
All relevant facts and circumstances, including the scope of
the engagement and the type and specificity of the advice
sought by the taxpayer, will be considered in determining
whether advice complies with this standard.
If the practitioner knows or has reason to know that the
advice will be used or referred to by someone outside the
practitioner’s firm in promoting, marketing or
recommending to one or more taxpayers a partnership,
entity, plan, or arrangement a significant purpose of which
is the avoidance or evasion of federal tax, the practitioner’s
conduct will be judged using a “heightened standard of
care.”
89
Revisions to Circular 230
Sanctions and Penalties for Noncompliance
Section 10.52 of the Circular 230 regulations provides that a
practitioner may be sanctioned by censure (public reprimand),
suspension, or disbarment, for willful violation of the regulations (other
than § 10.33); or for recklessly or through gross incompetence
violating, among others, the covered opinion provisions and other
written advice requirements.
Monetary penalties against a practitioner who violates Circular 230 are
permitted under section 822(a)(1) of the recently enacted AJCA. Such
penalties may be imposed on firms and entities on behalf of which the
practitioner may be acting if the firm or entity knew or reasonably
should have known of the practitioner’s conduct. Any penalty imposed
shall not exceed the gross income derived (or to be derived) from the
conduct giving rise to the penalty and may be in addition to, or in lieu
of, any suspension, disbarment, or censure of the practitioner. 31
U.S.C. § 330(b) (as amended by the AJCA). The new regulations do not
address this recent change in the law.
90
IRS REQUESTS FOR
TAX ACCRUAL
WORKPAPERS
91
IRS Requests for Tax Accrual Workpapers
Contents of Tax Accrual Workpapers
Tax accrual workpapers include documentation of the
company’s analysis of tax contingencies and reserves
reported on financial statements, including roll-forwards of
changes to the reserves. The workpapers may include
memoranda, analyses and schedules that reflect the
company’s hazards-of-litigation determinations.
The workpapers may be prepared by company attorneys,
company accountants, and other company personnel, and
by outside legal or accounting advisers. The workpapers
may be reviewed by or provided to various persons, both
inside and outside the company.
92
IRS Requests for Tax Accrual Workpapers
IRS’s Position Re: Disclosure
In United States v. Arthur Young & Co., 465 U.S. 805 (1984), the
Supreme Court held that tax accrual workpapers enjoy no special
protection against disclosure to the IRS. Nevertheless, in
Announcement 84-46, 1984-18 IRB 18, the IRS stated that it would
demonstrate “administrative sensitivity” and generally would not
request tax accrual workpapers. Until 2002, the IRS generally
requested tax accrual workpapers only in unusual circumstances.
In 2002, responding to tax shelter developments, the IRS adopted a new
tax accrual workpaper policy, under which workpapers will be
requested from taxpayers that engage in “listed transactions.” The new
policy was initially set forth in Announcement 2002-63, 2002-2 CB 72,
was augmented in Large and Midsized Business (“LMSB”) Questions
& Answers and in Chief Counsel Notice 2004-010, and was finally
memorialized in Internal Revenue Manual section 4.10.20. The new
policy is in keeping with the IRS’s emphasis on “transparency.”
93
IRS Requests for Tax Accrual Workpapers
IRS’s Position Re: Disclosure (continued)
Under the new guidelines, if a taxpayer engages in one
listed transaction, and properly discloses that transaction,
the IRS will request only the portion of the tax accrual
workpapers concerning that transaction. However, the IRS
will request all tax accrual workpapers if:
• The listed transaction is not properly disclosed; or
• The taxpayer engages in multiple listed transactions; or
• There are reported financial irregularities regarding
the taxpayer.
This new policy applies to tax returns filed after July 1,
2002 (some returns filed earlier also may trigger a request,
if listed transactions were not disclosed).
94
IRS Requests for Tax Accrual Workpapers
Asserted Protections From Disclosure
Taxpayers and the IRS have disagreed on whether certain protections apply to
shield tax accrual workpapers from disclosure to the IRS. Taxpayers have
asserted that the following protections apply to shield workpapers from disclosure
to the IRS:
• Attorney-Client Privilege – Protects confidential communications made by a
client, or by a person seeking to be a client, to an attorney, or made by the
attorney to the client outside the presence of third parties with an expectation
of confidentiality for the purpose of securing legal services, unless the
privilege has been waived.
• Work Product Doctrine – Protects documents prepared “in anticipation of
litigation” or for trial by or for another party, or by or for that other party’s
representative. The doctrine protects mental impressions of, and facts
gathered by, attorneys and other representatives. A document may be
prepared “in anticipation of litigation” even though litigation is not currently
ongoing or imminent. A document prepared for “dual” legal and business
purposes may, or may not, be entitled to work product protection.
95
IRS Requests for Tax Accrual Workpapers
Asserted Protections From Disclosure (continued)
Code Section 7525 Tax Practitioner-Client Privilege – Created by statute,
protects not only communications between tax attorneys and clients, but
between other tax practitioners and their clients. Applies to
communications made after July 22, 1998, between “federally authorized
tax practitioners” and clients.
• The privilege applies in a manner similar to the attorney-client
privilege.
• The privilege does not apply to “tax shelter” transactions (i.e.
transactions with a “significant” purpose of tax avoidance or evasion).
• For communications prior to October 15, 2004, the privilege does not
apply to “corporate” tax shelters. For communications after October
15, 2004, the privilege does not apply to any tax shelter.
• The privilege does not apply to criminal matters. The privilege may
only be asserted in matters before the IRS and in Federal tax litigation.
96
IRS Requests for Tax Accrual Workpapers
Are Tax Accrual Workpapers Privileged?
The IRS’s position is generally that tax accrual workpapers are not
privileged.
In United States v. El Paso Co., 683 F. 2d 530 (5th Cir. 1982), the Fifth
Circuit said it “would be reluctant to hold that a lawyer’s analysis of the
soft spots in a tax return and his judgments on the outcome of litigation on
it are not legal advice.” However, the court held that disclosure of
workpapers to outside auditors waived any privilege. (The case was decided
before the enactment of Code section 7525).
In United States v. Rockwell Int’l, 897 F. 2d 1255 (3d Cir. 1990), the Third
Circuit held that the determination of whether a tax reserve analysis is
protected by the attorney-client privilege is dependent on several factors:
(1) does it represent legal advice, or business advice, of an attorney? (2)
Who was involved in its preparation? (3) Who has control of the file? (4)
Was it intended to be disclosed to third parties, such as an independent
auditor? (5) Was it actually disclosed to a third party?
97
RECENT DEVELOPMENTS
IN PRIVILEGE
98
Recent Developments in Privilege
Legal Opinions
In the context of legal opinions, the IRS has asserted that work product
protection is waived when the taxpayer places advice “in issue,” e.g.
offers a short opinion for penalty protection purposes. This view was
rejected in Black and Decker v. United States, 219 F.R.D. 87 (D. Md.
2003), where the court refused to find a broad subject matter waiver
and allowed the “long” tax opinion prepared by an accountant to
remain protected.
The IRS has argued that documents (including legal advice) drafted by
outside attorneys for an accounting firm client that promoted tax
shelters are not protected by the attorney-client privilege because the
law firm and the accounting firm were “co-promoters” of shelters and,
thus, all communications were business advice, not legal advice. This
position was rejected due to lack of proof in United States v. BDO
Seidman, 2003-1 USTC ¶50,255 (N.D. Ill.).
99
Recent Developments in Privilege
Section 7525 Privilege
In the tax shelter context, the IRS has asserted that the section 7525
privilege does not encompass an “identity” privilege for clients of an
accounting firm who have engaged in potentially abusive tax shelters. This
position was successfully asserted by the government in United States v.
BDO Seidman, 337 F.3d 802 (7th Cir. 2003) and United States v. Arthur
Andersen, 2003-2 USTC ¶50,624 (N.D. Ill. 2003).
Based upon one court’s analysis, tax opinion letters prepared by
accountants may not be protected from disclosure by the accountant-client
privilege. In United States v. KPMG, LLP, 237 F. Supp. 2d 35 (D.D.C.
2003), the court concluded that the tax opinion in issue, which was
prepared by accountants, was not protected by the accountant-client
privilege because the analysis in the opinion letter was “prepared in
connection with preparation of a tax return” as the opinion related to a
transaction to be disclosed on the taxpayer’s tax return. Compare KPMG
with United States v. Adlman, 134 F.3d 1194 (2d Cir. 1998), where the
Second Circuit held that certain tax opinion letters prepared by
accountants may be protected from disclosure to the IRS by the work
product doctrine. 100
Circular 230 Disclosure
Internal Revenue Service Circular 230 Disclosure:
As provided for in Treasury regulations, advice (if
any) relating to federal taxes that is contained in
this communication (including attachments) is not
intended or written to be used, and cannot be used,
for the purpose of (1) avoiding penalties under the
Internal Revenue Code or (2) promoting,
marketing or recommending to another party any
plan or arrangement addressed herein.
101
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