Sharpen Your Pencil - the New Circular 230 Regulations

• Jurisdiction: United States,Federal
• Author: By Thomas W. Shaver, Esq.
• Publication year: 2005
• Citation: Vol. 11 No. 2

SHARPEN YOUR PENCIL - THE NEW CIRCULAR 230 REGULATIONS

By Thomas W. Shaver, Esq.^*

I. INTRODUCTION

In December 2004 the Internal Revenue Service issued final regulations that significantly change the scope of tax practitioner ethical standards.¹ In response to concerns broadly expressed in the tax practitioner community, the Internal Revenue Service significantly revised the December regulations in May 2005.² Generally, the new regulations, as revised, will apply to written advice rendered after June 20, 2005. The final regulations are incorporated into Circular 230 issued by the Treasury Department to govern the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service (IRS). In Janury 2003 the IRS established the Office of Professional Responsibility to administer the regulations set forth in Circular 230.

The Circular 230 Regulations were proposed in December 2003.³ The preamble to the proposed regulations discussed standards and requirements for tax shelter opinions, including marketed tax shelter opinions and opinions that reach a conclusion of at least "more likely than not" for one or more material federal tax issues. The reference to tax shelter opinions would indicate that the new regulations were intended to curb over-aggressive tax strategies by major accounting firms and corporations of the Enron stripe. Nevertheless, the language of the final regulations omits the reference to tax shelter opinions and is expansive enough to cover many tax planning strategies, however legitimate or routine.⁴ Practitioners took considerable relief from the May 2005 revisions to the final regulations. Nevertheless, even as revised the new Circular 230 Regulations cover the waterfront of estate planning practice.

This article discusses two branches of analysis required under the new regulations:

• Is the written advice covered?
• If covered, what standards must be met?

Specific applications to estate planning practice will be reviewed in the context of the new regulations. Finally, the article offers thoughts on the effect on the attorney-client relationship in light of the new regulations.

In studying the new regulations and understanding the standards for practice before the Internal Revenue Service, the careful practitioner should give close attention to the requirements for factual investigation. The regulations impose on the practitioner first the duty to investigate the facts and then the duty to relate those facts to applicable federal tax law. General discussions of the operation of federal tax law and tax consequences of a hypothetical transaction will not be sufficient. The duty of factual investigation applies to all written advice, not just to "covered opinions." The standards for factual investigation under the new regulations will require the most significant retooling of a typical estate planning practice.

II. COVERED OPINIONS

The Circular 230 Regulations introduce a new term of art: covered opinions.⁵ A covered opinion must meet the heightened tax practitioner standards set forth in the final regulations. Covered opinions include both written advice and electronic communications.⁶ The advice subject to the new regulations includes:

• Listed Transactions determined under Treasury Regulations (Regs.) § 1.6011-4(b)(2),⁷ or substantially similar transactions;
• "Any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement the principal purpose of which is avoidance or evasion of any tax" (emphasis supplied);⁸ and
• "Any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement a significant purpose of which is avoidance or evasion of any tax" (emphasis supplied), if the written advice falls within certain categories further defined in the Regulations.⁹

A. Investment Plan or Arrangement

The Circular 230 Regulations offer no guidance on what constitutes an investment plan or arrangement. The language is broad enough to include routine and long-established tax savings strategies such as estate planning trusts, corporate reorganizations and exchanges of like kind property. This is not your father's tax shelter. When the IRS issued final regulations in December 2004 careful tax practitioners were justifiably concerned that overbroad scope of covered opinions would require that routine transactions be subject to the new restrictive practitioner standards. The May 2005 revisions to the Circular 230 Regulations partly alleviate those concerns.

B. Principal Purpose Tax Avoidance Transactions

The May 2005 revisions responded to practitioner concerns regarding the lack of definition of principal purpose. The revised regulations incorporate a definition of principal purpose similar to Treasury Regulations § 1.662-4(g) (ii). Tax avoidance or evasion

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is the principal purpose of a partnership or other entity, investment plan or arrangement if that purpose exceeds any other purpose. Nevertheless, the principal purpose is not to avoid or evade federal tax if the partnership, entity plan or arrangement "has as its purpose the claiming of tax benefits in a manner consistent with the statute and Congressional purpose."¹⁰ Estate planners take comfort in this language to exclude from the scope of the new regulations routine planning vehicles such as irrevocable life insurance trusts and grantor retained annuity trusts.

Two words of caution are appropriate. First, there are routine planning strategies that the IRS has never accepted as consistent with statutory purpose despite consistent court approval, such as Crummey withdrawal powers and intentionally defective grantor trusts. Second, the facts surrounding a transaction can determine whether it falls within the statutory purpose. A self-canceling installment note is sanctioned by the Internal Revenue Code, but a self-canceling installment note that is administered with complete disregard of legal formalities might not be.¹¹ The IRS recognizes buy-sell agreements as determining fair market value for estate and gift tax purposes, but not if that agreement is a testamentary substitute.¹²

The definition of covered opinions might discourage some tax practitioners from rendering written advice because it appears that oral advice is not within the scope of the regulations. In effect, the regulations penalize the conscientious and careful practitioner who lays out the anticipated tax benefits of a proposed transaction in a letter for the review and understanding of the client. Oral advice may allow the practitioner to avoid the reach of the Circular 230 regulations at the risk of misunderstanding and eventual liability to clients who heard what they meant to have the practitioner communicate to them.

The significance of principal purpose tax avoidance transactions in the Circular 230 Regulations extends beyond the definition of a covered opinion. The regulations provide limited relief in terms of certain exclusions, exceptions or allowances discussed later in this article. Consistently, the regulations exclude principal purpose tax avoidance transactions from the application of such relief.

C. Significant Purpose Transactions

With respect to plans or arrangements that have a significant purpose of tax avoidance, the Circular 230 Regulations establish four subcategories of covered opinions:

• Reliance opinions that conclude that one or more significant federal tax issues would more likely than not be resolved in taxpayer's favor;¹³
• Marketed opinions that will be used in promoting, marketing or recommending a partnership, investment plan or arrangement;¹⁴
• Opinions subject to conditions of confidentiality in which the tax practitioner imposes restrictions on disclosure of tax advice to protect confidentiality of the practitioner's tax strategies;¹⁵
• Opinions subject to contractual protection when the tax practitioner's fees will be refunded if intended tax consequences are not sustained or those fees are contingent on the tax result.¹⁶

1. Reliance Opinions.

The Circular 230 Regulations define a reliance opinion as written advice that concludes at a confidence level of at least more likely than not that one or more significant federal tax issues would be resolved in the taxpayer's favor.¹⁷ In an excess of regulatory zeal the Regulations provide a definition of both a federal tax issue and significant. The definition of "federal tax issue" encompasses any item of income, capital gain, loss, deduction or credit, taxable transfers and valuation of property for federal tax purposes.¹⁸

The regulatory definition of "significance" is its own mine field. For purposes of the Circular 230 Regulations a federal tax issue is significant if the IRS has a reasonable basis for a successful challenge.¹⁹ This definition burdens the tax practitioner with analyzing not only the likelihood of sustaining the anticipated tax benefits, but also the reasonable likelihood of a successful challenge by the tax authorities. Potentially, only a narrow range of federal tax issues are significant: those reporting positions that the IRS could reasonably challenge but that the practitioner is more confident than not of sustaining. Nevertheless, a careful practitioner may be inclined to interpret generously the likely success of an IRS challenge, given the possible sanctions for failure to comply with the new regulations.

Furthermore, a federal tax issue is significant if the beneficial or adverse resolution of the issue would have a significant impact on the transaction or matter covered in the opinion "under any reasonably foreseeable circumstance." The quoted language typifies the approach of the new regulations. The language appears to be intentionally drafted to test the reasonable limits of ethical requirements for tax practitioners. In attempting to curb sharp practice, the Circular 230 Regulations effectively burdens conscientious and careful tax practitioners who will find the scope...