Getting an opinion? Make it a double! - The implications of privilege protection on penalty avoidance.

• Author: Abernethy, John

Senior Tax Executives (STE) should seriously consider obtaining two independent and distinct professional tax advisers' opinions, one before a transaction is consummated and one before filing the return, regarding the tax treatment of any potentially controversial transactions (1) they are contemplating. The two opinions satisfy differing needs of the STE and Senior Management.

Divergent motivations exist for the STE and Senior Corporate Management as they complete the due diligence necessary to make the decision to enter into a potentially controversial transaction. Information must be gathered to make a sound business decision; steps must be taken affirmatively to avoid penalty exposure; and financial reporting concerns must be addressed.

First, the STE gathers information and evidence to assist Senior Management in making the business decision regarding the transaction, including the risks (such as potential litigation costs and reputation effects) and the potential outcomes of a tax controversy. While the STE may have become very comfortable with the transaction, both the STE and Senior Management are protected from second-guessing by obtaining contemporaneous evidence before entering the transaction, in which independent tax experts examined all facts and relevant law and reached a conclusion about the most likely ultimate outcome of a potential controversy. A conclusion about the probability of an ultimate outcome will often state all "bad facts" and evaluate them, as well as any technical weakness of arguments, to weigh the risks and hazards of litigation necessary for Senior Management's decision-making. Opinions are often sought from tax counsel and are referred to hereinafter as Tax Legal Opinions (TLO). TLO that are prepared in anticipation of litigation are protected by the attorney work product privilege against disclosure. TLO may also be privileged if considered confidential by the taxpayer and confidentiality is maintained. TLO that discuss the risks and hazards of litigation contain information that should be protected from waiver by the taxpayer and its advisers.

Second, the STE is motivated to preclude the assessment of penalties. One avenue of defense against the accuracy related penalty of section 6662(b) is disclosure of the transaction in detail (by filing Form 8275 or Form 8275-R or utilizing the provisions of Rev. Proc. 94-69). (2) If the transaction is determined to have a significant purpose of tax avoidance, however--and many controversial transactions may be held to have such a significant purpose--then disclosure is not available as a means to avoid the section 6662(b)(2) penalty (3). Absent disclosure as a means of penalty protection, the best defense (4) is to rely in good faith on the opinion of a professional tax adviser who is competent, has sufficient expertise, and to whom all necessary and accurate information has been given. (5) In Perrah, the Tax Court stated:

A taxpayer may avoid the application of the accuracy-related penalty by proving that he or she acted with reasonable cause and in...