An analysis of SSTS interpretation no. 1-2.

• Author: Gardner, John C.
• Position: Part 2 - Statements on Standards for Tax Services

EXECUTIVE SUMMARY

* Illustrations 8 and 9 involve a member's reliance on assumptions about residual value in equipment leasing transactions.

* Illustrations 13-16 present situations in which a member is considering whether to rely on an attorney's opinion in applying the realistic possibility standard to a client's proposed transaction.

* The remaining illustrations in Interpretation No. 1-2 focus on a member's reliance on taxpayer and third-party representations, reliance on taxpayer instructions, rendering oral versus written advice and responsibilities in formulating tax advice.

Interpretation No. 1-2 is a guide to responsible tax planning for AICPA members and an interpretation of Statements on Standards for Tax Services Nos. 1 and 8. This two-part article discusses how it applies to tax planning and tax shelters. Part II covers Illustrations 8-20 of the Interpretation, reviews some significant tax shelter cases and provides recommendations.

AICPA members are working in a very litigious environment and are under scrutiny by regulators, the public and parties to various business and personal transactions. To avoid problems, this two-part article analyzes Interpretation No. 1-2, "Tax Planning," of Statements on Standards for Tax Services (SSTS) No. 1, which offers guidance on AICPA member responsibilities in tax planning and tax shelters. Part I, in the July 2004 issue, discussed the background on Interpretation No. 1-2, and analyzed the general interpretations and the first seven illustrations. Part II, below, will discuss the remaining illustrations and some leading case law in this area and provide general recommendations.

Illustrations 8-20

Interpretation No. 1-2 includes illustrations that provide members with guidance on prudent steps to take in the tax planning process. Illustrations 8-20 cover issues such as reliance on assumptions and representations, responsibilities in formulating tax advice, taxpayer instructions and oral advice.

Reliance on Assumptions

Illustrations 8-9: Illustration 8 is a leasing transaction in which the tax consequences depend on whether the leased property is reasonably expected to have a residual value of 15% of its value at the beginning of the lease. A member relied on the taxpayer's instructions to use a particular assumption about the residual value. Such reliance may be appropriate when the assumption is supported by (1) the CPA's review of information provided by a third party or the taxpayer, (2) the member's own analysis or knowledge or (3) the taxpayer's expertise.

Illustration 9 involves a taxpayer receiving assistance from a member in an evaluation of a proposed equipment leasing transaction. Again, critical to the lease's tax consequences is the equipment's estimated residual value at the lease's end. However, in this illustration, the broker, who is arranging the lease transaction, has prepared an analysis that explicitly describes an assumption about such value. The illustration's conclusion is that the member assisting the taxpayer (and giving advice) should consider whether it is appropriate to rely on the broker's assumption instead of performing other procedures to validate the estimated residual value or obtaining a representation from the broker about such residual value. The member should consider such factors as the broker's methodology, whether alternative information sources are reasonably available and the broker's experience in such transactions.

Tax shelters have often been established in the equipment leasing area. This may raise concerns about economic substance and business purpose, the reputation of the brokers and promoters and the level of due diligence required for such transactions. Further, tax advisers may be subject to liability claims if a court subsequently rules that they did not follow professional standards (e.g., Interpretation No. 1-2), or sufficiently document or exercise the necessary care in evaluating these transactions.

Legal authority: Both Illustrations 8 and 9 are similar to Rice's Toyota World, Inc., (19) in which the court makes clear that a taxpayer should not rely on information from those who have a vested (and, thus, biased) interest in the transaction. Thus, a member should make an independent investigation of the facts and reach an independent conclusion, using independent experts, if needed, to help make that determination. This is the minimum requirement in a due diligence review.

Rice's Toyota World involved a purchase-and-leaseback arrangement between Rice's Toyota World and a computer equipment leasing company. The taxpayer purchased a computer and leased it back to the computer company. The purchase price was $1,455,227--paid with a four-year, $250,000 promissory note and two other nonrecourse notes payable over eight years. The computer company claimed that the monthly rental would cover the amortization of the nonrecourse notes and generate a $10,000 annual cashflow to the taxpayer. However, no attempt was made to independently verify that claim.

Rice's accountant looked at information about the transaction, including a document entitled, "Rules of Thumb for Pricing Used Computers" prepared by the Stanford Research Institute. He "determined that the $10,000 yearly cash flow made good economic sense. In his analysis, he assumed some residual value, and he also considered the possibility of releasing the property at the end of the lease." Despite this review, the Tax Court decided that the transaction was a sham; the Fourth Circuit...