Amendments to Circular 230 (Part II)

This two-part article analyzes additions and amendments to the Circular 230 regulations adopted in 2004 and 2005. Part II examines the requirements for covered opinions and other written advice.

John C. Gardner, Ph.D., CPA
Professor of Accountancy
University of Wisconsin–La Crosse
La Crosse, WI

Barbara J. Eide, Ph.D., CPA
Associate Professor of Accountancy
University of Wisconsin–La Crosse
La Crosse, WI

Joseph T. Kastantin, MBA, CPA
Associate Professor of Accountancy
University of Wisconsin–La Crosse
La Crosse, WI

Editor’s note: Dr. Gardner is a member of the AICPA Tax Divisions Tax Executive Committee.
Authors’ note: The authors wish to thank the reviewers for their insightful comments.

Executive Summary

• Section 10.35(c) is critical in establishing the facts, in relating the
  law to the facts and in evaluating significant Federal tax issues.

• Section 10.37 is important for tax practitioners issuing written advice that is not a covered opinion.

• Practitioners should carefully consider the new and amended terms and standards established by the modifications to Circular 230.

This two-part article reviews the recent amendments to the Treasury Circular 230²⁴ regulations, which govern tax practice before the IRS by CPAs, attorneys, enrolled agents, enrolled actuaries and appraisers.²⁵

Part I, in the January 2006 issue, analyzed best practices and the definitions relevant to covered opinions. Part II, below, focuses on the requirements for covered opinions and other written advice, as well as compliance provisions and the establishment of an advisory committee to the Office of Professional Responsibility (OPR).

Requirements

Exhibit 1 is a summary of the requirements for covered opinions under the amended Circular 230 regulations.

Factual Matters

Section 10.35(c)(l), Factual matters, is critical in establishing the facts. An opinion cannot be based on unreasonable factual assumptions, and practitioners must consider all the facts they deem relevant. This would seem to tie their efforts to due diligence under Section 10.22. Practitioners should also examine case law on unreasonable factual assumptions and the efforts to be undertaken to establish which facts are relevant. Thus, documentation is critical in demonstrating compliance with the requirements to ascertain the facts. An examination of tax shelter case law will reveal situations in which courts have held that a practitioner did not act with due diligence in ascertaining the facts. Additional guidance may be found in Interpretation No. 1-2, Tax Planning, of Statements on Standards for Tax Services (SSTS) No. 1, Tax Return Positions,²⁶ which contains examples of tax planning and tax shelter situations.

One sentence in the new regulations has the potential to provide very useful guidance in fully understanding some troublesome parts of this law. The preamble²⁷ states, [t]he final regulations provide that a practitioner providing a covered opinion, including a marketed opinion, must not assume that a transaction has a business purpose or is potentially profitable apart from tax benefits, or make an assumption with respect to a material valuation issue. Section 10.35(c)(1)(ii) states, it is unreasonable to assume that a transaction has a business purpose or that a transaction is potentially profitable apart from tax benefits. This might be interpreted to mean that it is unreasonable to assume that any transaction has a business purpose (i.e., the business purpose must always be clearly established).

Likewise, it is unreasonable to assume that a transaction is potentially profitable; potential profitability must always be clearly established. Further, if a transaction is not expected to be profitable apart from its tax benefits, an opinion rendered on such a transaction would not be permitted. In other words, if covered opinions cannot assume that the business purpose of a transaction is to secure tax benefits, and if the only potential profitability expected to arise from a transaction is the tax benefits, then no covered opinion may be issued.

Relating Law to Facts

Section 10.35(c)(2) states, the opinion must relate the applicable law (including potentially applicable judicial doctrines) to the relevant facts. This is a very broad and comprehensive statement. What is applicable law? What about potentially applicable judicial doctrines? Such doctrines are critical, given the discussions in numerous tax shelter cases over the past decade that addressed business purpose, sham transactions and economic substance.²⁸ A review of these and similar cases (especially on economic substance) is critical. Congress has persistently considered defining economic substance statutorily, but has not yet adopted such a rule.²⁹ The phrase potentially applicable judicial doctrines is troubling for practitioners, because what is potentially applicable may not be as clear when a practitioner is preparing an opinion, as compared to when the opinion comes under OPR scrutiny. Who is to determine what is potentially applicable? Will CPAs have to obtain an outside review of all opinions to determine whether all potentially applicable judicial doctrines have been considered?

Depending on a transactions materiality, practitioners may want to consider whether they are competent to advise clients on how legal doctrines, such as economic substance, apply to transactions. Importantly, they must demonstrate that they consulted the professional tax literature or received an opinion from another competent tax professional.

An example of what not to do (and what would be forbidden) under Section 10.35s covered opinions may be found by examining Long-Term Capital Holdings.³⁰ This decision was a victory for the IRS. It is very detailed and provides a good discussion of problems with tax opinions considered inadequate by the district court and that would be inadequate under Section 10.35. A summary of this case would be a useful tool for training staff. It could be the basis for a discussion of what constitutes a covered opinion under Section 10.35 (even though that was not the issue in the case).

Evaluating Federal Tax Issues

What is a significant tax issue? Section 10.35 provides no guidance on how to determine whether every significant tax issue has been covered in an opinion. Will it be necessary, for example, to have either an internal or external review of the situation described in the advice, to ensure that every significant tax issue is covered? This would be expensive, especially when there are informal communications (e.g., normal business and tax planning advice), as well as uncertainty as to whether a covered opinion exists.

One commentator concluded³¹ that the concept behind a limited scope opinion is that routine advice and answers do not need to rise to the level of time-consuming, expensive and full-blown formal opinions. These opinions may allow a practitioner and a taxpayer to agree that the opinions provide penalty protection. However, a limited scope opinion may not include marketed opinions, listed transactions, or situations in which the transactions principal purpose concerns tax evasion or avoidance. It is also difficult to determine when such a limited scope opinion might be applicable, as there is little guidance on what constitutes the principal purpose and any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement. These phrases are not adequately defined. This precludes issuing a limited scope opinion, because of doubt as to whether this language applies.

Section 10.35(c)(4)Overall Conclusion

Section 10.35(c)(4) is an omnibus provision. It requires practitioners, after satisfying the requirements for each covered opinion in written advice, to collectively consider the overall conclusion, to ensure that it also separately satisfies Section 10.35s requirements. This is analogous to an auditors obligation under International Standards on Auditing 320.7 concerning materiality issues arising from an audit engagement. First, an auditor has to deal with each material issue separately. Then, another assessment is required to determine whether the materiality threshold has been collectively reached, before the auditor can render an opinion on the clients financial statements.

Section 10.35(d)Competency

The concept of practitioner competency was already built into Circular 230; see Exhibit 2 . It requires practitioners to be knowledgeable in all of the aspects of Federal tax law relevant to the opinion, which is unrealistic. Additionally unrealistic is a practitioner relying on another practitioners opinion, unless the practitioner responsible for the overall opinion knows or should know the unreliability of the other practitioners opinion. The verb knows implies actual knowledge, while should know is undefined and could vary with the circumstances. Documentation of due diligence regarding an opinion of another individual (e.g., a member of ones own firm or an external consultant) will help protect against charges that the practitioner is not competent. Due diligence is already required by Section 10.22 and by professional ethical responsibilities outlined in the SSTSs (including the two interpretations).³²

Section 10.35(e)Required Disclosures

Section 10.35(e) includes disclosure requirements for all opinions, and special rules for marketed opinions, limited scope opinions and opinions that fail to reach a more-likely-than-not conclusion, see Exhibit 3.

Section 10.35(f)Effect of opinion

Despite an opinions formal adherence to Section 10.35(c)(e), Section 10.35(f) requires a separate determination of the opinions persuasiveness regarding the tax issues in question, as well as the taxpayers good faith reliance on the opinion; see Exhibit 4. Thus, Section 10.35(f) gives the government two final, undefined standards to determine whether any covered opinion meets Section 10.35s requirements. According to several commentators, even if an opinion meets the detailed standards of Section 10.35(a)(e) (discussed above), its persuasiveness and the taxpayers good faith reliance will be determined separately under applicable provisions of the law and Regulations, including particularly sections 6662, 6664, and new 6707A.³³ Thus, it is imperative for CPA tax practitioners to examine these Code sections, including changes made by the American Jobs Creation Act of 2004.

Section 10.36Procedures to Ensure Compliance

AICPA comments³⁴ on the December 2003 proposed amendments to Circular 230 centered on steps that tax advisors could take to ensure compliance with the best practices described in Section 10.33. This would involve adherence to an appropriate quality-control guide or similar document. The AICPA issued a Tax Practice Quality Control Guide in 2002 to assist CPA tax practitioners. It is also considering whether to prepare other guidance for its members on quality control in tax practice and how firms may best adhere to quality-control standards and comply with Sections 10.35 and 10.37. The comment letter also encouraged the Service to note that the scope and formality of any such guide must be scaled to the size of the particular practitioners practice. Additionally, the comments called for Section 10.36 to encourage firms to adopt either internal or external review programs.

According to Section 10.36(a), any practitioner who has (or practitioners who have or share) principal authority and responsibility for overseeing a firms practice of providing advice concerning Federal tax issues must take reasonable steps to ensure that the firm has adequate procedures in effect for all members, associates, and employees for purposes of complying with Section 10.35; see Exhibit 5. The practitioner or group of practitioners covered by Section 10.36 would only be subject to discipline if through willfulness, recklessness, or gross in-competence, there are no adequate procedures in place and one or more associates, firm members or employees are, or have, engaged in a pattern or practice, in connection with their practice with the firm, of failing to comply with 10.35.

Second, the practitioner(s) will be subject to Section 10.36 if they know or should know that one or more firm members, employees or associates have, or are now, engaged in a pattern or practice that is not in compliance with Section 10.35 and that the practitioner(s) charged with Section 10.36 responsibilities through willfulness, recklessness, or gross incompetence, fail[s] to take prompt action to correct the noncompliance. Unfortunately, the Service has not provided guidance on reasonable steps or adequate procedures for Section 10.36 purposes.

The terms willfulness, recklessness and gross incompetence are connected with Sections 10.51(l) and 10.52(a)(1) and (2). These procedures (and compliance) seemingly cover all of a firms members, because they include employees, which could include other professionals (e.g., an in-house appraiser) or nonprofessional personnel. However, the assertion of potential disciplinary charges would only be permitted in more extreme cases involving recklessness, willfulness and gross incompetence tied to a pattern of misconduct or practice. This language implies, of course, that an isolated error or practice, detected by the practitioner(s) responsible for Section 10.36 compliance and promptly corrected, would not be subject to Circular 230 discipline. It seems to target the most egregious conduct (which is consistent with the material discussed in Sections 10.35 and 10.37), rather than typical misconduct due to error or ignorance. Unfortunately, Section 10.36 contains no guidance on adequate procedures, nor a timeframe for prompt action to ensure compliance by those within the firm.

Section 10.37Requirements for Other Written Advice

Section 10.37 (see Exhibit 6) is also important, because many CPA tax practitioners will not be issuing covered opinions that meet the more-likely-than-not standard required under Section 10.35, and the Sec. 6662 standard for tax shelters. Section 10.37 is fraught with peril, because Section 10.35(f) states, a practitioner who provides written advice that is not a covered opinionis subject to the requirements of Section 10.37. Potential problems immediately arise, as it may not be possible to ascertain whether a particular piece of written advice is covered by Section 10.35 or 10.37. Further, practitioners will have to be careful about any opt-out for penalty protection under Section 10.35.

Practitioners also need to remember that Section 10.37 (unlike the Section 10.35 significant purpose provisions) applies not only to significant tax issues, but also covers one or more Federal tax issues. Also, like Section 10.35, it covers all Federal taxes, not just income taxes. A practitioner will not be able to provide a client with a written opinion if it is based on unreasonable legal or factual assumptions (including those about future events). However, unreasonable is not defined for Section 10.37 purposes.

Also, a practitioner must not unreasonably rely on representations, agreements, assumptions or statements of the taxpayer, or any other person in the written advice. All relevant facts that the practitioner knows, or should know about, must be considered; further, he or she must not take into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be resolved through settlement if raised. The phrase knows or should know is vague at best; there is no guidance about the level of due diligence that the advisor must engage in to ascertain the representations, agreements, assumptions or statements that may be relied on as a basis for the written advice. A practitioner may look, however, to Section 10.34(c) for guidance. It states, in part, that:

[A] practitionermay rely in good faith without verification upon information furnished by the client. The practitioner may not, however, ignore the implications of information furnished to, or actually known by, the practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete.

The language should know is not adequate, because it would seem to allow for the Service to second-guess the practitioner after the fact, when the written advice might be examined as part of an audit. Tax practitioners might want to consult International Accounting Standard 38.BC97, which discusses the issue of hindsight.

The discussion on the audit lottery in Section 10.37 is consistent with the coverage of the topic in SSTS No. 1, which states in part that an AICPA member should not prepare or sign a return or recommend a tax return position that the member knows exploits the audit selection process of a taxing authority. But, if a member has a good faith belief that more than one tax return position meets the standards of SSTS No. 1, then that member may include a discussion of the likelihood that such position might or might not cause the taxpayers tax return to be examined and whether the position would be challenged in an examination. SSTS No. 1 thus provides a supplementary gloss on the ambiguous language contained in Section 10.37.

Finally, all facts and circumstances, including the scope of the engagement and the type and specificity of the advice sought by the client will be considered in determining whether a practitioner has failed to comply with this section. Unfortunately, this statement will potentially allow the OPR to reach its own conclusions based on an ambiguous (and unexplained) facts-and-circumstances test. Thus, practitioners should maintain detailed records about how the advice was created and communicated to the client.

Marketing advice: Marketing advice not covered by Section 10.35 falls within the ambit of Section 10.37(a). The language regarding marketed opinions would again (as under Section 10.35) protect written advice by the practitioner or someone who is associated with, employed by or is a member of the practitioners firm. But if the written advice involves marketing by someone other than a protected person (e.g., the practitioner or someone in the firm) and is used for marketing, promoting or recommending to other taxpayers a plan, partnership, arrangement or investment plan tied to a significant purpose of tax evasion or avoidance, the determination of whether a practitioner has failed to comply with this section will be made on the basis of a heightened standard of care because of the greater risk caused by the practitioners lack of knowledge of the taxpayers particular circumstances. This language does not provide the practitioner with any realistic guidance about what constitutes a heightened standard of care, because there are no examples. Practitioners should examine case law about marketed opinions in the tax shelter area for examples that might be analogous to those potentially covered by Section 10.37.

Section 10.38Establishment of Advisory Committees

The advisory committees, authorized under Section 10.38, will not be permitted to participate in specific disciplinary matters regarding individual practitioners. Instead, an advisory committee may review and make general recommendations regarding professional standards or best practices for tax advisors, including whether hypothetical conduct would give rise to a violation of Sections 10.35 or 10.36; see Exhibit 7.

Conclusion

Many facets of Circular 230 represent uncharted territory for practitioners. They include undefined critical terminology and significantly higher standards of tax practice, without the benefit of precedents or other research interpretation. Thus, tax advisers should exercise caution and carefully review the new or modified terms and the higher standards to which they are now held, as the law took effect on June 21, 2005. Exhibit 8  is an application chart useful in identifying specific requirements of Circular 230.

It will be important for both Treasury and professional organizations, like the AICPA, to provide guidance and to educate practitioners on how to comply with revised Circular 230. As adherence to Circular 230 is complex and the potential for sanctions so potentially catastrophic, clarity and timeliness in providing guidance is essential.