Amendments to Circular 230 (Part I)

This two-part article analyzes additions and amendments to the Circular 230 regulations adopted in 2004 and 2005. Part I covers rules on best practices and the definition of covered opinions.

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 Division’s TEC.

Authors’ note: The authors wish to thank the reviewers for their insightful comments.

Executive Summary

• A regulation on best practices for tax advisors was added to restore, promote and maintain the public’s confidence

• Circular 230’s definition of a covered opinion raises several complicated issues on the significant and principal purpose of written advice.

• The May 2005 amendments increased the number and scope of exclusions from covered opinions.

Amendments to the Treasury Circular 230¹ regulations, which govern tax practice before the IRS by CPAs, attorneys, enrolled agents and enrolled actuaries, were proposed on Dec. 30, 2003.² They were approved in December 2004,³ after receiving comments approved by the AICPA Tax Division’s Tax Executive Committee (TEC),⁴ the American Bar Association (ABA) Tax Section, other professional organizations and associations, and interested parties. The new regulations involve an aspirational call for best practices (revised Section 10.33); standards governing covered opinions (new Section 10.35); steps to ensure compliance (Section 10.36); standards governing other written advice (Section 10.37); and provisions for the creation of an advisory committee to the Office of Professional Responsibility (OPR), to review and recommend professional standards for Circular 230 (new Section 10.38).

This two-part article explores the Circular 230 amendments and identifies potential challenges for CPA tax practitioners subject to them. Additionally, it raises practical issues and makes some suggestions that will help CPAs to serve as client advocates, while still adhering to the highest professional standards.⁵ Part I, below, analyzes best practices and the definitions relevant to covered opinions. Part II, in the February 2006 issue, will examine the requirements for covered opinions and other written tax advice.

Background

During the past decade, tax shelters and tax advocacy have been continually discussed in the media, in Congress and by professional organizations, such as the AICPA and ABA.⁶ This attention ran parallel with the auditor independence issues addressed in the Sarbanes-Oxley Act of 2002 (SOA).⁷ Companies such as Enron and a few CPA and law firms have been cited in court documents, as well as in Congressional hearings, for eroding the tax base due to their participation in tax shelters. Congress held hearings on the perceived problems of tax shelters, and introduced legislation in both houses that addressed tax shelters and the practitioner and promoter communities. Regulations dealing with potentially abusive tax shelters were thought to be the catalyst behind the long-awaited proposed modifications to Circular 230 in 2001.⁸ However, the final rules,⁹ adopted in July 2002, contained no changes on tax shelter opinions. The 2001 proposed changes on these opinions were withdrawn in December 2003, when the new proposal¹⁰ was published. The Service received comments during spring 2004 and published the new final regulations on December 17 of that year.¹¹ Treasury issued additional clarifications on May 18, 2005,¹² and the rules became enforceable on June 21, 2005.

Circular 230

Circular 230 governs tax practice before the Service by CPAs, attorneys, enrolled agents and enrolled actuaries. “Practice,” as defined in Section 10.2(d), encompasses “all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a taxpayer’s rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service.” The term “presentation” includes, but is not limited to, preparing and filing documents and communicating and corresponding with the Service, in addition to representing clients at hearings, conferences and meetings.

Circular 230 is administered by the OPR, which has the authority to impose sanctions on practitioners who violate it. According to Section 10.50, sanctions may range from a private reprimand to more serious consequences, including public censure, suspension or disbarment. Suspended or disbarred practitioners are not permitted to practice before the Service while suspended and are subject to OPR conditions designed “to promote high standards of conduct.” These conditions may be imposed for a reasonable period, depending on the gravity of the violation. Disbarred practitioners are not permitted to practice before the IRS unless the OPR (after a five-year period of disbarment) is satisfied that they will not violate Circular 230 and that reinstatement is not contrary to public interest. Suspended or disbarred practitioners may also lose their licenses to practice at the state level, depending on the state’s disciplinary rules. In addition, liability claims may be filed against a practitioner based on the conduct giving rise to the suspension or disbarment. Thus, due to the possibility of such sanctions, it is essential for CPAs in tax practice to be aware of the amendments and additions to Circular 230 and to take the necessary steps to ensure that they comply with them.¹³

AJCA

In addition, American Jobs Creation Act of 2004 (AJCA) Section 822, specifically established statutory authority for censure (that was already provided under Circular 230). The OPR may now impose monetary penalties on practitioners. Additionally, if the representative is acting on behalf of an employer or other entity, the Secretary may impose a monetary penalty on the employer or other entity if it knew, or reasonably should have known, of the conduct.¹⁴ This penalty may be in addition to one imposed on the practitioner. Financial penalties may also be in lieu of, or in addition to, any suspension, censure or disbarment. According to AJCA Section 822, monetary penalties are not fixed dollar amounts, but are “not to exceed the gross income derived (or to be derived) from the conduct giving rise to the penalty.” Thus, the OPR has additional weapons in its arsenal to regulate and sanction practitioners and their firms.

Section 10.33—Best Practices

Importantly, “best practices” were added to the regulations to “restore, promote, and maintain the public’s confidence”; see Exhibit 1 for a summary of Section 10.33. Practitioners may justifiably presume that the public’s confidence in tax advisors was shaken due to revelations of malfeasance among some well-known players. At one point during the Congressional investigation into the independence of certain auditors that led to the SOA, a proposal was drafted that would have prohibited audit firms from serving as tax advisors to their publicly traded audit clients. Although the proposal failed, a failure on the part of tax advisors to “restore, promote and maintain the public’s confidence” may result in it being reconsidered. Indeed, the Public Company Accounting Oversight Board (PCAOB) submitted new rules to the Securities and Exchange Commission (SEC) for approval, limiting the types of tax services that independent audit firms can provide to audit clients that are listed companies.

PCAOB Rules

On July 26, 2005, the PCAOB adopted certain independence rules on services provided by auditors to their listed audit clients.

Three specific provisions indicate that certain services would impair auditor independence. Rule 3521 provides that contingent fee arrangements with listed audit clients impair independence. It does not specifically mention contingent fees for tax services but, rather, all contingent fee arrangements. Rule 3522(a) states that several tax services impair auditor independence as to listed audit clients. These include:

• Marketing, planning or opining in favor of tax treatment of a confidential transaction as defined by Rule 3501;
• Marketing, planning or opining in favor of aggressive interpretation of applicable tax laws; and
• Marketing, planning or opining on any listed transaction (discussed in more detail below).

Rule 3523 extends the impairment of independence to auditors providing tax services to certain management members engaged in both financial reporting oversight for the listed company, and tax services to such members’ immediate family. The proposed rules will not take effect until approved by the SEC.

These specific provisions are followed by additional prohibitions and admonitions on independence as to all listed audit clients. Rule 3524 strengthens the extant pre-approval requirement for documented tax services rendered to such clients. The pre-approval must include discussions with the listed company’s audit committee about the potential effects of such services on auditor independence.

Rules 3502 and 3520 further strengthen the independence rules. Rule 3502 prohibits audit firms and any associated members from (1) causing the firm to violate any relevant laws, rules or professional standards due to an action or omission and (2) recklessly not knowing about such laws, rules or professional standards. Rule 3520 also requires audit firms and all associated members to remain independent of their listed clients during an audit and engagement period.

Client Engagements

The 2002 version of Circular 230 did not mention client engagements per se. Guidance now appears in Sections 10.33 and 10.37. As with audit services, the client engagement letter is the first formal acknowledgement of the terms, expectations and conditions under which services will be provided to the client. The addition of client engagement guidance further aligns Circular 230 with certain provisions of both the SOA and generally accepted auditing standards.

AICPA Comments

An adherence to best practices will help ensure tax system integrity when tax professionals provide advice or assist a client in preparing a submission to the IRS. In a comment letter¹⁵ to the Service on the December 2003 proposed amendments, the AICPA expressed both support for, and concerns about, the proposed changes to Circular 230. First, it supported “the concept of ‘best practices’ for tax advisors as a central component” of the proposed amendments. Second, it approved the statement in the preamble that the proposed changes to Circular 230 “are limited to practice before the IRS and do not alter or supplant other ethical standards applicable to practitioners.” This statement recognizes the critical role played by professional ethical standards (such as the AICPA Code of Professional Conduct and the Statements on Standards for Tax Services) in establishing ethical CPA behavior.

The AICPA further noted that, because the Circular 230 standards on best practices are aspirational (and in light of potential liability claims), the phrase “highest quality representation” should be replaced with “high quality representation.” This “should create a realistic goal for practice before the IRS while providing reasonable protection from unwarranted civil malpractice litigation.” Unfortunately, this suggestion was not adopted by the Service, thus creating a real danger that liability claims might be filed if a practitioner does not adhere to so-called “aspirational” Section 10.33.

The AICPA offered a final caution on Section 10.33’s aspirational aspects. It noted that a practitioner should not be subject to the sanctions identified in Section 10.52 “for mere ‘shortfalls’ in meeting the ‘best practices’” in Section 10.33. This recommendation was adopted in the regulation’s final version.

Covered Opinions

Section 10.35 describes the responsibilities of practitioners providing “covered opinions” and sets forth requirements, including certain disclosures. (The definitions pertinent to covered opinions are discussed below; the requirements will be discussed in Part II, in the February 2006 issue.)

Section 10.35(b)(2) and (3)

Section 10.35(b)(2) and (3) provide the basic definitions of covered opinion, written advice, excluded advice and Federal tax issues; see Exhibit 2 .

Written advice: One issue is what constitutes written advice. Potentially, it includes all written communications between clients and their advisors, not simply prospective planning. Practitioners have also suggested that text messages on cell phones may be written advice.

Query: Does written advice include a document that merely discusses several possible strategies or the tax treatment of several possible alternative strategies, but which does not reach any conclusion or make any recommendation? This may be partially answered in Section 10.35(b)(2), which defines a covered opinion as written advice (including electronic communications) by a practitioner concerning one or more Federal tax issues arising from certain transactions. Additional exceptions were added in the May 2005 revisions, as noted in Exhibit 2 and discussed below.

Listed transactions will receive particular scrutiny by the Service. The IRS’s website (www.irs.gov) has the most current information. Failure to check this information could potentially lead to penalties, possible sanctions under Circular 230’s due diligence provisions (Section 10.22) and liability claims.

Principal purpose: Transactions with a principal purpose to avoid or evade taxes are also critical under Section 10.35. The term “principal purpose” was formerly used to define tax shelters under Sec. 6662, but that definition was amended by the Taxpayer Relief Act of 1997.

The May 2005 additions to Circular 230 define the meaning of principal purpose in Section 10.35(b)(10) (see Exhibit 3), which states, “the principal purpose of a partnership or other entity, 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.” However, the principal purpose rules are not to evade or avoid taxes “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…” (e.g., the low-income housing credit, which is designed to accomplish a specific Congressional goal). Finally, an entity, plan, arrangement or partnership may have a “significant purpose” of tax avoidance or evasion, even though “it does not have the principal purpose” outlined in Section 10.35(b)(10) (discussed below).

Other areas needing IRS guidance include the meaning of the phrase “any partnership or other entity, any investment plan or arrangement.” This language applies to both “the principal purpose” and “a significant purpose” under Section 10.35. A taxpayer and practitioner should not have to speculate as to whether such language applies to the taxpayer.

Commentators wanted the term “principal purpose of tax evasion and avoidance” to be clarified and wanted to know whether the definition contained in Regs. Sec. 1.6662-4(g)(2)(i) and (ii) was being incorporated into Section 10.35. The definition of principal purpose is similar to that contained in the Sec. 6662 regulations, which have not yet been updated to reflect the new “significant purpose” definition of “tax shelter” under Sec. 6662. According to Regs. Sec. 1.6662-4(g)(2)(i)(C):

The principal purpose…is to avoid or evade Federal income tax if that purpose exceeds any other purpose. Typical of tax shelters are transactions structured with little or no motive for the realization of economic gain, and transactions that utilize the mismatching of income and deductions, overvalued assets or assets with values subject to substantial uncertainty.

Regs. Sec. 1.6662-4(g)(2)(ii) also states in part that “the principal purpose…is not to avoid or evade Federal income tax if…the claiming of exclusions from income, accelerated deductions or other tax benefits” is undertaken by the entity, arrangement or plan “in a manner consistent with the statute and Congressional purpose” (e.g., taking accelerated depreciation under Sec. 168 or expensing tangible property under Sec. 179).

Significant purpose: Importantly, the phrase “a significant purpose” applies to reliance opinions, marketed opinions, and advice subject to confidentiality or contractual protection. This phrase is drawn from the 1997 tax changes and has not yet been defined in the Sec. 6662 regulations. Some guidance may be found in Regs. Sec. 301.6111-2(b)(3), which states in part that a significant purpose activity is one that “has been structured to produce Federal income tax benefits that constitute an important part of the intended results of the transaction.” Regs. Sec. 301.6111-2(b)(3)(i) further states there would be no significant purpose if the transaction was “in the normal course of its business in a form consistent with customary commercial practice” and there “is a generally accepted understanding that the expected Federal income tax benefits from the transaction…are properly allowable under the Internal Revenue Code for substantially similar transactions.”¹⁶

Despite this guidance, several complicated issues are raised by the significant-purpose language. First, what is the difference between a significant-purpose and a principal-purpose transaction? Clearly, normal tax practice (e.g., claiming accelerated depreciation) should not be covered by either set of rules. The Sec. 6662 regulations imply that a principal purpose exists “if that purpose exceeds any other purpose.” But what about a significant purpose? Does it include normal tax planning (e.g., whether to do business as a C or an S corporation)? This term needs to be defined for purposes of both the Sec. 6662 regulations and Section 10.35. Further, it might be advisable for the Service to eliminate the significant-purpose language that the AICPA objected to in earlier comments on proposed amendments to Circular 230. However, if this language is not dropped, Treasury still needs to clarify and define the differences in language consistent with current explanations contained in the Sec. 6111(d) regulations.¹⁷

The category of “covered opinions” for transactions with “a significant purpose” of tax avoidance is complex. In addition to “a significant purpose,” the opinion has to be either a reliance or a marketed opinion. In addition to the exclusion noted, written advice that would be a “covered opinion” only under the “significant purpose” category is excluded if it concerns the qualification of a qualified plan, is a “state or local bond opinion” or is included in documents required to be filed with the SEC.¹⁸

Other exclusions: The number of exclusions increased as a result of the May 2005 additions to the amendments. First, Section 10.35(b)(2)(ii)(C) states in part that a covered opinion does not include written advice both prepared for and provided to a taxpayer, which is only for that taxpayer’s use after the taxpayer has filed a return with the Service “reflecting the tax benefits of the transaction.” However, this exclusion does not apply:

[I]f the practitioner knows or has reason to know that the written advice will be relied upon by the taxpayer to take a position on a tax return (including for these purposes an amended return that claims tax benefits not reported on a previously filed return) filed after the date on which the advice is provided to the taxpayer.

This addition to Circular 230 was added based on commentators’ expressed concern that:

[A]dvice given after a tax return is filed, in particular advice given in the context of an IRS examination or litigation, might constitute a covered opinion within the meaning of the Final Regulations.¹⁹

Commentators also expressed concern that written advice by an in-house counsel to an employer while determining the employer’s tax liability could be covered advice and raise many issues. Section 10.35(b)(2)(ii)(D) now excludes “written advice provided to an employer by a practitioner in that practitioner’s capacity as an employee of that employer solely for purposes of determining the tax liability of the employer.” The language of this addition is broader than in-house counsel (presumably, an attorney) and would cover any practitioner under Section 10.2(e) that worked for an employer in this situation. The excluded written advice of such a practitioner for covered opinion purposes would still fall under Section 10.37 (other written advice). This change would not affect other circumstances, such as whether the written advice of a practitioner “might be relevant to determining the employer’s good faith and reasonable cause” (e.g., under Sec. 6664(c) for purposes of the accuracy-related penalties under Sec. 6662).

The final addition covers negative advice under Circular 230. Section 10.35(b)(2)(ii)(E) excludes written advice “that does not resolve a Federal tax issue in the taxpayer’s favor, unless the advice reaches a conclusion favorable to the taxpayer at any confidence level.” The confidence levels include standards drawn from the Sec. 6662 (e.g., substantial authority) and the Sec. 6694 regulations (e.g., the realistic possibility of success standard). If the written advice involves two or more Federal tax issues, all of the Federal tax issue conclusions included in the opinion must likewise meet the requirements of the language quoted above, or the entire opinion must comply with Section 10.35(c).

The preamble provides a detailed discussion of the negative advice section. Both the Service and Treasury want to encourage practitioners to advise taxpayers that (1) one or more Federal tax issues will not be resolved in favor of the taxpayer or (2) the transaction itself is not appropriate. However, they are concerned about written advice that could be construed as encouraging taxpayers to take aggressive tax return positions (even while giving them negative advice under Section 10.35(b)(2)(ii)(E)), but also reaching a favorable conclusion at any confidence level. Negative advice under Section 10.35, which contains such penalty protection under Section 10.37, would not be excluded from the Section 10.35 provisions for reliance-opinion purposes.

Federal tax issue: The phrase “Federal tax issue” is critical. The word “tax” covers all taxes ranging from income tax to gift and estate taxes.²⁰

Written advice on one or more Federal tax issues must be significant in relation to a reliance opinion (but only need be a Federal tax issue if the opinion describes either a listed or principal-purpose transaction). Section 10.35(b)(3) states that a Federal tax issue is significant if:

[T]he Internal Revenue Service has a reasonable basis for a successful challenge and its resolution could have a significant impact, whether beneficial or adverse and under any reasonably foreseeable circumstance, on the overall Federal tax treatment of the transaction(s) or matter(s) addressed in the opinion.

Unfortunately, reasonable basis is not defined. However, it is defined for negligence purposes in Regs. Sec. 1.6662-3(b)(3), which states, in part:

Reasonable basis is a relatively high standard of tax reporting, that is significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in 1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard.

Note: “reasonable basis” for Sec. 6662 purposes applies to taxpayers.

Section 10.35(b)(4)—Reliance Opinion

Section 10.35(b)(4) defines a reliance opinion; see Exhibit 4. A reliance opinion will only be covered if it does not contain a red herring legend.²¹ But, what if the reliance opinion does not include it? What if a client e-mail discusses a transaction and the practitioner wrote back that the only proper way to handle it was in a particular way? That response would seem to assume (even if implicitly) that the answer met the more-likely-than-not standard, which Section 10.35 defines as “a confidence level…greater than 50 percent likelihood.” In fact, one could even argue that the answer assumes a 100% likelihood of success. Practitioners will need to be careful of language used in both formal and informal client communications, to avoid having a particular communication come within Section 10.35.

Certain normal tax planning engagements may not be covered by Section 10.35, even if they do provide penalty protection. For example, a practitioner is asked to opine in writing as to whether there is substantial authority for a particular transaction under Sec. 6662, to avoid the 20% substantial understatement penalty. This type of formal or informal communication would appear to be covered by Section 10.37 (to be discussed in Part II, in the February 2006 issue), rather than Section 10.35.

The preamble stresses that written advice will not be considered a reliance opinion if the tax practitioner discloses that it “was not written to be used and cannot be used for the purposes of avoiding penalties.” Written advice generally will not be classified as a marketed opinion if it does not concern an arrangement or plan that has a principal purpose of evading or avoiding tax or if it is not a listed transaction. The advice must also prominently disclose that it cannot be used by any taxpayer to avoid penalties.

Accuracy-related penalties are among the most significant penalty provisions for taxpayers under Sec. 6662. The preamble states that Treasury and the IRS intend to amend Regs. Sec. 1.6664-4 “to clarify that a taxpayer may not rely upon written advice that contains this disclosure to establish the reasonable cause and good faith defense to the accuracy-related penalties.”

Two commentators believe that practitioners should not issue indiscriminate penalty waivers in all written communications.²² They stress that if a written communication is not covered by Section 10.35 (i.e., it does not meet the more-likely-than-not standard under Sec. 6662), a taxpayer should be able to rely on penalty protection from the practitioner preparing the return. Written tax advice not covered by Section 10.35 will be covered by Section 10.37 (see Part II, in the February 2006 issue).

Section 10.35(b)(5)—Marketed Opinion

One commentator noted that marketed opinions do not cover opinions prepared and sold by accounting firms. The key language contained in Section 10.35(b)(5) states: “used or referred to by a person other than the practitioner (or a person who is a member of, associated with, or employed by the practitioner’s firm) in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayer(s)”; see Exhibit 5. This would exempt self-marketing of a CPA firm’s tax planning strategies by its members.²³

Section 10.35(b)(6)–(9)—Conditions of Confidentiality and Other Definitions

Section 10.35(b)(6)–(9) defines conditions of confidentiality, contractual protection, prominent disclosure and state or local bond opinion for Section 10.35 purposes; see Exhibit 6.

Situations involving conditions of confidentiality or contractual protection will be less important for many small to medium-sized practice units. The final regulations set forth specific requirements for covered opinions; most of them reflect good practice when preparing a formal opinion.

Under Section 10.35(b)(8), an item is prominently disclosed for purposes of Section 10.35 “if it is readily apparent to a reader of the written advice.” The facts and circumstances surrounding the written advice will be used to determine whether the disclosure is readily apparent. Factors used in this determination include (but are not limited to) both the written advice’s length and the taxpayer’s sophistication. At a minimum, for an item to be prominently disclosed, it “must be set forth in a separate section (and not in a footnote) in a typeface that is the same size or larger than the typeface of any discussion of the facts or law in the written advice.”

The prominent disclosure changes were designed to minimize the burden of compliance on practitioners, while ensuring “transparency between taxpayers and practitioners and to provide taxpayers with notice of any limitation on their ability to rely on written advice.” This section seems more of a consumer protection provision rather than one actually needed for Section 10.35 purposes.

Conclusion

Part II, in the February 2006 issue, will analyze covered opinion requirements under the revised Circular 230 regulations. In addition, an application chart will be used to illustrate the requirements for tax advice under the amended Circular 230 rules.