Will a tax opinion still prevent penalties?

• Author: Rosenthal, Steven M.

The U.S. Department of the Treasury and Internal Revenue Service recently limited the use of tax opinions to avoid penalties. First, under new regulations, the government provided that a taxpayer may use a tax opinion to defend against penalties only if the taxpayer disclosed the underlying transaction appropriately. Second, the IRS announced a new penalty policy under which a taxpayer may use the tax opinion to avoid penalties only if the adviser (i.e., the opinion-writer) is independent from any promoter of the transaction. Given the IRS's current hostility toward tax shelters and those connected with them, taxpayers should expect the IRS to enforce these deterrent measures aggressively. As a result, taxpayers must select their advice, and their advisers, carefully to avoid penalties.

This article describes the new rules for tax opinions and suggests how taxpayers may best use tax advice to avoid penalties. After summarizing the Internal Revenue Code's accuracy-related penalties and the Treasury Department's current disclosure rules, the article describes the new penalty regulations and policy. Next, the significance of the new rules to taxpayers is analyzed. Finally, the article concludes with a description of several penalty proposals that are pending in Congress.

Penalties and Defenses

Taxpayers are subject to an "accuracy-related" penalty for understatements under section 6662 of the Code. (1) Negligence or disregard of the tax laws, as well as a substantial understatement of income tax, triggers the penalty. (2) For corporations, an understatement, which is the difference between the correct amount of tax due and the amount of tax actually paid, is substantial if the understatement exceeds the greater of 10 percent of the annual tax due or $10,000. Whatever the cause of the penalty, i.e., negligence, substantial understatement, or both, the amount of the accuracy-related penalty equals 20 percent of the understatement.

A taxpayer that demonstrates reasonable cause and good faith for the underpayment may avoid the accuracy-related penalty. (3) Establishing reasonable cause is a facts-and-circumstances determination. The most important factor is the taxpayer's efforts to ascertain its correct tax liability. According to the Internal Revenue Manual, the IRS generally grants "reasonable cause relief" from penalties when the taxpayer "exercises ordinary business care and prudence," which the IRS determines by reviewing (i) the taxpayer's reason for the underpayment, (ii) the taxpayer's history of tax payments, (iii) the duration of time between the underpayment and subsequent correct payment of tax, and (iv) whether circumstances beyond the taxpayer's control caused the underpayment. (4)

A taxpayer also may use a tax opinion to satisfy the reasonable cause exception. (5) Under the regulations, the taxpayer must, at a minimum, disclose all relevant facts to the adviser. In addition, the adviser must base the opinion on the relevant facts and law and must not rely on unreasonable factual or legal assumptions or taxpayer representations. Under the case law, a factor to determine whether a taxpayer reasonably relied on tax advice is whether the adviser was financially independent from the promoter. (6)

Finally, last year, the Treasury promulgated final regulations (under section 6011) to require taxpayers to disclose "reportable transactions" on their tax returns. (7) The six categories of report able transactions are (i) transactions identified by the IRS as tax avoidance transactions ("listed transactions"), (ii) confidential transactions, (iii) transactions with contractual protection (of the purported tax benefits), (iv) loss transactions (for a corporation, a transaction with more than a $10 million loss in a single year), (v) transactions with a significant (i.e., greater than $10 million) book-tax difference, and (vi) transactions involving a brief asset holding period. These categories are surprisingly broad. Fortunately, there has been some disclosure relief (described in the accompanying story) for routine commercial transactions. There currently are no statutory penalties for a taxpayer that fails to disclose a reportable transaction. (8)

New Regulations and Policy

At the end of 2003, the IRS issued final penalty regulations, which...