Tax Opinion Confidence Levels

When a professional tax adviser provides a formal opinion on the merits of a taxpayer's return position, the adviser usually expresses it in terms of where the position falls along a hierarchical spectrum of "tax opinion confidence levels."

In the most basic iteration of the hierarchy, the meaningful confidence levels range upward from:

1. Not frivolous;

2. Reasonable basis;

3. Realistic possibility of success;

4. Substantial authority;

5. More likely than not; and

6. Should.

Although the "should" standard is not directly related to the Code or the regulations, it is not coincidental that the other five standards correspond with particular statutory or regulatory safe harbors from penalties.

Protection from Penalties

Adequately disclosing a return position generally affords protection against (1) a return-preparer penalty under Sec. 6694 (as long as the position is not frivolous) and (2) the Sec. 6662 substantial-understatement and intentional-disregard accuracy-related penalty (as long as a reasonable basis exists for a position that is not a tax shelter).

Even without adequate disclosure, if a realistic possibility of success (defined by the regulations as at least a one-in-three chance) exists that the return position will be sustained on its merits if challenged, neither (1) the return-preparer penalty nor (2) the accuracy-related penalty imposed for taking a position contrary to a revenue ruling or a notice (but not a regulation) will be applied. The substantial-understatement component of the Sec. 6662 accuracy-related penalty also does not apply to an undisclosed-return position for which there is substantial authority, provided that the position is not a tax shelter.

When there is substantial authority for a return position that is not a tax shelter, the taxpayer's reasonable belief that its treatment of the item is more likely than not the proper treatment will bring a noncorporate taxpayer within the statutory safe harbor of Sec. 6662(d)(2)(C). This will also satisfy the "authority" and "belief" requirements imposed on corporate taxpayers seeking to avoid the substantial-understatement penalty on a reasonable-cause basis. Satisfying these requirements, however, is not dispositive of reasonable cause for this purpose. Moreover, the Service and Treasury have proposed to make the reasonable-cause provisions inapplicable to undisclosed transactions reportable under Sec. 6011.

Other Confidence Levels

Whether in response to client requests or as a natural consequence of analyzing and opining on a broad array of potential return positions, tax advisers have added other levels of confidence or assurance to the top end of the hierarchy (i.e., after "should"), including (in ascending order):

1. Although not free from doubt (the taxpayer's position should prevail);

2. Although not entirely free from doubt (the taxpayer's position should prevail); and

3. The taxpayer's position "will" prevail (i.e., there is no reasonable argument that supports a contrary conclusion).

Under the current penalty regime, these additional standards may be characterized as superfluous or perhaps even irrelevant, as none of them provides the taxpayer with any greater degree of penalty protection than would a "more likely than not" opinion.

Additional attention to the upper end of the confidence-level spectrum, however, may be warranted in light of rigorous new or proposed standards against which corporate tax shelters are (or may be) judged. For example, under Temp. Regs. Sec. 1.6011-4T(b)(3)(ii)(C), a taxpayer will not have to report a transaction for Sec. 6011 purposes if it reasonably determines that no reasonable basis exists under the tax law for denial of any significant portion of the transaction's expected tax benefits. (Note: The Service and Treasury have proposed to eliminate this exception.) In addition, a recent study by the Joint Committee on Taxation included a recommendation that would eliminate the substantial-understatement penalty attributable to corporate tax shelters only if the corporate participant is "highly confident" (i.e., reasonably believes at least a 75% chance exists that the tax treatment would be sustained on the merits).

It is uncertain exactly where the "no reasonable basis to deny" standard relating to reportable transactions fits in the hierarchy of tax opinion confidence levels, especially in relation to the "should" (i.e., usually "should prevail") standard. In part, that is because neither the "reasonable basis" standard (the polar opposite of no-reasonable-basis-to-deny) nor the should-prevail standard has been quantified definitively. For the should-prevail standard, there would be little reason for the IRS to quantify a standard that is neither derived from nor directly related to the Code.

Measuring the Higher Standards

In April 2000, an IRS representative stated that a "should" opinion would not be sufficient to satisfy the no-reasonable-basis-to-deny standard. Although that representative did not disclose the thought process leading to that conclusion, a logical starting point for an attempt to quantify the no-reasonable-basis-to-deny standard would be Regs. Sec. 1.6662-3(b)(3), which provides that reasonable basis "is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper."

Generally, reasonable basis falls below the realistic-possibility-of-success standard, which is quantified as a one-in-three chance of being sustained on the merits. However, if a return position must have a 25% chance of being sustained on its merits to satisfy the reasonable-basis standard, then for there to be no reasonable basis to deny a taxpayer the benefits of a return position, the position presumably must have at least a 75.1% chance of being sustained. Reasonable people might disagree, however, as to whether the should-prevail standard meets or exceeds that threshold. Commentators or practitioners who equate a "should" opinion with a 75%-or-higher confidence level clearly may disagree with the IRS representative's conclusion.

Under Regs. Sec. 1.6662-3(b)(3), the existence of a reasonable basis for a return position depends more on whether it is supported by one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii) than on whether its chance of being sustained on the merits exceeds some percentage threshold. That approach implies that the no-reasonable-basis-to-deny standard is a lofty one, presumably met only if no authority (or only authorities of questionable relevance or persuasiveness) supports a contrary position.

From Michael A. Urban, J.D., M.L.T., Washington, DC