THE RISE OF LAW AND THE FALL OF CIRCULAR 230: TAX LAWYER PROFESSIONAL STANDARDS, 1985-2015.

• Author: Hatfield, Michael

1. INTRODUCTION 830 II. POSITION STANDARDS: 1985-2015 832 A. 1986: Tax Section and Treasury in Reaction 834 1. Congress: Substantial Authority and Reasonable Basis 834 2. ABA Reacts: Realistic Possibility 840 3. Treasury Reacts: Substantial Authority 846 B. Congress and Treasury Follow ABA's Lead 855 1. Congress Modifies [section] 6694: Realistic Possibility 856 2. [section] 6694 Regulations Follow Tax 861 Section's Opinion Task Force 3. Circular 230 Incorporates [section] 6694 and 869 Realistic Possibility C. Substantial Authority Wins 872 1. Reasonable Basis--Again 873 2. Penalty Studies--Again 875 3. Surprise: More Likely Than Not 879 D. Circular 230 Loses 885 III. TAX SHELTERS 890 A. The First Wave of Tax Shelters 891 B. The Second Wave of Tax Shelters 893 1. 1994-1997: Congressional Response 894 2. 2000: Treasury Advances 896 3. 2004: American Jobs Creation Act and Circular 230 901 4. The Fall of Circular 230? 905 5. The Tax Shelter War Is Over 909 IV. CONCLUSION 916 A. Looking Back 917 B. Moving Forward 926 On my second day as Director, I met with then-Commissioner-Shulman. He asked me what the "plan" was. I told him I would like to scrap Circular 230 and start over. He thought I was kidding. Karen Hawkins, Director (2009-2015), IRS Office of Professional Responsibility (1) I. INTRODUCTION

   This Article is third in a series exploring the development of professional responsibility standards for tax lawyers, beginning in 1945. (2) This Article concludes the series with a focus on 1985-2015. While tax lawyers face the same professional ethics issues as all lawyers, such as duties of competence and confidentiality, and though they face some important and unique issues, such as advising a client when a mistake is discovered on an already filed return, the issues that dominated their professional responsibility discussions from 1985-2015 are return position standards and tax shelter opinions. The return position issue is as to when a return with a questionable position may be filed without disclosing the questionability to the Internal Revenue Service (IRS). Presuming all tax advice will be reflected on a return eventually, the answer is relevant not only if the lawyer is literally preparing the return (which is not usually the work of tax lawyers) but also to the lawyer's pre-return transaction planning. The tax shelter opinion issue involves the substance of written opinions covering unusual tax minimization plans most assuredly to be rejected by the IRS if detected. Unlike written advice for usual tax planning, tax shelter opinions are not provided to help the taxpayer understand the plan but rather to provide a defense from penalties if the plan is rejected not only by the IRS but the courts.

   The first article in this series covers the 1945-1965 period, which was one in which tax lawyers writing about their professional duties invoked Cold War patriotism and concerns about communism, consumerism, and the commercialization of the profession. (3) They wrote about natural law and tax jurisprudence as well as client and competitive business pressures. (4) They called for the moral improvement of both tax lawyers and their clients. (5) They pondered the relationship of their duties to their clients and their duties to the tax system. (6) Most importantly, in retrospect, the members of the Section of Taxation (Tax Section) of the American Bar Association (ABA) appointed a committee to study their various ethical questions. (7) That committee, the Committee on Standards of Tax Practice, then posed the return position question to the ABA Committee on Ethics and Professional Responsibility (PR Committee). (8) In 1965, the PR Committee responded by translating the question into the vocabulary of the ABA canons of ethics and answering it from an advocacy-oriented perspective. (9) Twenty years on, with pressure from Congress, Treasury, and the tax bar, the PR Committee replaced that opinion with one updated in vocabulary but not perspective. (10) Part II of this Article picks up the development of the return position issue at the time of that second opinion, 1985.

   The second article in this series covered 1965-1985, including the intensification of the government's war on tax shelters. (11) In 1980, Robert Mundheim, the Treasury General Counsel, targeted tax shelter opinions. (12) He said the opinions helped promote shelters to investors on the theory that the tax opinion provided the investor assurance that a negligence or fraud penalty would not be assessed even if the anticipated tax benefits were disallowed. (13) His aim was to limit the unprofessional conduct of the tax lawyers who provided the opinions. (14) In a short period, both the PR Committee and Treasury developed strategies to constrain that conduct. (15) In 1982, the PR Committee issued Opinion 346 setting forth the requirements for a professionally responsible tax shelter opinion. (16) In 1984, Treasury mirrored the same requirements in regulations. (17) This was the first instance in which Treasury claimed the right to regulate the substance of tax lawyering, and it generated resistance from some tax lawyers who doubted Treasury had the legal authority and were sure it had a conflict of interest. (18) Part III of this Article picks up the tax shelter opinion issue after the ABA and Treasury issued guidance.

   With reference to the history covered in the prior two articles, Part IV of this Article notes the most significant elements of the 1985-2015 period, such as the rise of legal standards and the fall of Treasury as the primary regulator of tax professionals. It also suggests the way to guide the future development of professional standards is empirical research into the diversity of the tax bar and the variations in practices across the country in order to develop better strategies for articulating professional standards and better strategies for supporting lawyers in meeting those standards.

2. POSITION STANDARDS: 1985-2015

   Between 1985 and 2015, the Tax Section, Treasury, and Congress proposed, commented, acted, and reacted on return position standards with considerable frequency. (19) One can only speculate as to the number of work hours put into their projects. In 1985, the ABA PR Committee reacted to congressional penalties by issuing Opinion 85-352, which announced the "realistic possibility of success" standard for return positions. (20) Not entirely happy with the PR Committee's opinion, in 1986 a task force of the Tax Section (the "Opinion Task Force") issued an interpretation that the realistic possibility of success standard could be quantified at about a one-in-three chance of success on the merits. (21) Also not entirely happy with Opinion 85-352, in 1986 Treasury proposed amending Circular 230 to use the realistic possibility standard as a default for tax return preparation but require that the "substantial authority" position standard be met in many, if not most situations. (22) After a series of hearings and reports, Congress changed the penalty statutes and followed the ABA's lead by adopting the realistic possibility standard for preparers, setting into motion Treasury issuing penalty regulations and Circular 230 modifications to reflect the quantified meaning of realistic possibility of success. The regulations were finalized over the tax bar's objections to the quantified approach, despite the approach having originated with the Tax Section's Opinion Task Force. Nevertheless, by the end of 1989, the realistic possibility of success standard had prevailed: it was the preparer standard not only for legal ethics purposes but as a matter of statute and two sets of regulations. It remained in these places until Congress, after ignoring penalty studies it mandated, suddenly raised, without consultation with the tax bar or Treasury, the preparer position standard to more likely than not in 2007. Though it had resisted the substantial authority standard for decades, confronted with the suddenly enacted more likely than not standard, the tax bar united behind substantial authority and convinced Congress to enact it in 2008 with retroactive effect. Thus, in 2008, the preparer standards for lawyers were much as Treasury had first proposed in 1986. Though Treasury then seemed largely successful in the long-term negotiations over the standards, its move in 2011 to subject commercial return preparers to the same standards under Circular 230 backfired, not only knocking out Treasury's claim to regulate those preparers but also knocking out its claim to regulate lawyers who were not representing clients in IRS proceedings.

   1. 1986: Tax Section and Treasury in Reaction

      By 1986, Congress had enacted statutory penalties on both taxpayers and tax return preparers for inappropriate return positions. In 1985, the ABA PR Committee issued its second formal opinion in 20 years on the appropriate tax return position standard for tax lawyers. (23) This Opinion 85-352 did not align the professional standards for tax lawyers with the penalty standards for return positions. The Tax Section reacted by appointing the Opinion Task Force to interpret Opinion 85-352, which it did, also suggesting that Congress and Treasury use the Opinion Task Force's interpretation for modifying the return preparer position penalty statute and Circular 230. Treasury reacted by asserting its claim on regulating the return positions of tax lawyers by proposing to align the professional standards of Circular 230 with the penalty standard. The proposal was not well received by the tax bar.

      1. Congress: Substantial Authority and Reasonable Basis

         Through penalty sections in the Internal Revenue Code (I.R.C.), Congress has legislated return position standards for both taxpayers and return preparers. Under current law, though the penalties are separate, the standards are the same for both taxpayers and return preparers. Both [section] 6662 for taxpayers and [section] 6694 for...