Stricter rules for the written advice practitioners give taxpayers

Why has Circular 230–a set of regulations for individuals who practice before the IRS–been such a hot topic lately? Because on June 20, much stricter rules governing the written advice that practitioners (accountants, attorneys, enrolled agents) give to taxpayers will go into effect.

The following revisions to Circular 230, potential ramifications of the changes, and current controversy surrounding the modified rules will affect anyone who issues written advice concerning certain tax-favored transactions.

Until fairly recently, disclosure of participation in tax shelters rarely occurred because penalties for nondisclosure were nonexistent. And the list of shelters that were required to be registered under the prior version of the Code was also fairly narrow. Prior to the enactment of the American Jobs Creation Act of 2004 (AJCA), taxpayers involved in tax shelters played the audit lottery and usually avoided detection by the IRS. Opinion letters buttressed the growth of tax shelters under the old version of Circular 230.

After years of hemorrhaging lost tax revenue (potentially billions of dollars) due to ineffective laws, the IRS started fighting back by expanding its shelter-fighting staff and issuing lots of guidance targeting a much broader scope of transactions (e.g., listed transactions, which are transactions identified by the IRS as tax avoidance transactions in nature).

Under AJCA (enacted in October 2004), Congress not only subjected a broader scope of transactions to mandatory disclosure, but most importantly, enacted stiff new monetary penalties for nondisclosure as well. One new penalty applies to individuals even if there is no understatement of income, and amounts to $10,000 or $100,000–depending on whether the undisclosed transaction is simply a reportable transaction or has been classified as a listed transaction.

Although the revised version of Circular 230 does not directly impact agents (unless they fall into one of the categories stated above), they need to be aware of the pending changes that may significantly affect the scope and nature of the covered opinions (and other written advice) their clients may be receiving–and perhaps paying larger fees to obtain.

What is a “covered opinion”? Under the final version of Circular 230 (issued in December 2004) a “covered opinion” means written advice (including e-mails) that concerns one or more federal tax issues arising from a listed transaction. The term “covered opinion” also includes any plan or arrangement the principal purpose of which is avoidance or evasion of any tax. But perhaps most notable–and most unsettling, especially with respect to estate and gift planning–is the fact that a “covered opinion” as that term is currently worded also applies to any plan or arrangement a significant purpose of which is the avoidance or evasion of tax if the written advice is:

(1) a “reliance opinion” (advice that concludes that one or more significant federal tax issues would be resolved in the taxpayer’s favor at a confidence level of more likely than not–in other words, greater than a 50% likelihood);

(2) a “marketed opinion” (the practitioner knows that the written advice will be used or referred to by a person other than the practitioner in promoting, marketing or recommending);

(3) subject to confidentiality; or

(4) subject to contractual protection.

Written advice will not be treated as a reliance opinion if the practitioner prominently discloses that the written advice was not written to be used, and cannot be used, for the purpose of avoiding penalties. Similarly, written advice generally will not be treated as a marketed opinion if it does not concern a listed transaction or a plan or arrangement having the principal purposes of avoidance or evasion of tax and the written advice contains this disclosure.

In a covered opinion, the practitioner must, among other things, state the facts being relied on, relate the law to the facts, provide an overall conclusion, and also disclose fee arrangements between promoters and practitioners.

In recent weeks, practitioners have vociferously argued that the final rules were much too broad in scope, conceivably encompass almost every type of tax advice and transaction–whether abusive or not–and basically render opinion letter writing unworkable. Even though no estate planning techniques have been categorized as listed transactions to date, practitioners are nevertheless concerned that the overly broad language of Circular 230 may pull in large numbers of what now are considered to be legitimate planning techniques.

The furor over the controversial Circular 230 rules as currently phrased had escalated to the point that the Director of the Office of Professional Responsibility announced on April 28 that further revisions would be made to Circular 230 and that such changes would be released before the Circular 230 regulations go into effect.

On May 19, 2005, the IRS clarified and narrowed the application of the previously published final regulations in response to comments that the rules were too broad.

The IRS clarified that:

o The “principal purpose” of a partnership, investment plan or arrangement (or other plan or arrangement) is the avoidance or evasion of any tax imposed by the Internal Revenue Code if that purpose exceeds any other purpose.

o The “principal purpose” of a partnership, investment plan or arrangement is not to avoid or evade federal tax if that partnership, entity, plan or arrangement has as its purpose the claiming of tax benefits in a manner consistent with the statute and congressional purpose.

o A partnership, entity, plan or arrangement may have a significant purpose of avoidance or evasion even though it does not have the principal purpose of avoidance or evasion.

Sonya King, J.D., LL.M., is an assistant editor of Tax Facts, a National Underwriter Company publication. She can be reached at sking@nuco.com.