Tax opinions may be harder to get from US tax advisers in the future in tax shelter transactions under new rules the Internal Revenue Service proposed in January. The new rules are part of a government campaign against aggressive tax planning.

“Tax shelter” is a somewhat nebulous term that catches many transactions that are done at least partly to reduce federal income taxes.

The new rules are guidelines that US tax advisers must follow when giving any written advice about tax shelter transactions. The aim is to prevent tax advisers from leaving the impression that such transactions work by assuming away inconvenient facts or by failing to flag all the legal issues.

They will have two main effects. One is to force the law and accounting firms rendering such opinions not only to go into greater detail about why they concluded the transaction works, but also to recite the facts on which the opinion writer is relying. Short-form opinions that merely recite the documents the opinion writer reviewed and his conclusion will no longer be permitted. They will also require tax advisers to inquire more deeply into whether the taxpayer has a meaningful business purpose for the transaction or expects any real economics apart from tax benefits and bar reliance on outside appraisals that seem questionable.

Tax partners at law and accounting firms face public reprimands from the IRS — and possibly even suspension or disbarment from practice before the IRS — unless they take steps to ensure their firms are complying.

The rules are merely proposed. The agency has scheduled a hearing on them for May 2.

Tax Shelter

The new guidelines apply to any written advice on the consequences of a “tax shelter” transaction. Written advice includes not only formal opinion letters and tax discussions in offering circulars, but also legal memoranda.

The words “tax shelter” have not been clearly defined. The new guidelines adopt the same definition for the term as in section 6662(d)(2) of the US tax code. The words are defined there as any transaction or entity that has as “a significant purpose” the “evasion or avoidance of Federal income taxes.” Thus, a big-ticket leasing transaction or a tax structure to defer US taxes on an outbound investment is potentially a tax shelter. However, the implication is that the taxpayer aims not simply to reduce his taxes, but to do so in a way that is arguably aggressive. IRS regulations under section 6662 say the following:

“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, certain nonrecourse financing, financing techniques that do not conform to standard commercial business practices, or the mischaracterization of the substance of a transaction. The existence of economic substance does not of itself establish that a transaction is not a tax shelter if the transaction includes other characteristics that indicate it is a tax shelter.”

This is a broader concept of tax shelter than the IRS used in regulations last year that require any corporation participating in a “reportable transaction” to attach a form with the details of the transaction to its tax return for each year the transaction affects its US tax position.

Law firms are likely to be conservative. The new rules are guidelines for anyone who wants to practice before the IRS. The IRS drew up the rules; it can interpret them as broadly as it wants. This is not a case where the tax adviser can argue that the IRS is misreading what Congress said in the tax law.

Opinions

Opinions about tax shelters will have to explain in a lot more detail in the future why these transactions work.

Different rules apply to opinions that conclude a tax shelter has a better than even chance of working than to weaker opinions. What follows is a description of the rules for opinions that conclude a transaction is at least more likely than not to work.

Under the new rules, the opinion will have to recite all the material facts of the transaction. The tax adviser cannot assume facts. However, he can ask the taxpayer to represent certain things and rely on those representations as long as what is being represented sounds reasonable “based on all the facts and circumstances” and the person making the representation is in a position to know the inside story.

For example, the tax adviser can rely on a credible representation that the transaction serves a real business purpose. However, the representation must explain the business purpose. He can rely on a representation that the taxpayer expects a profit from the transaction apart from tax benefits. However, the taxpayer must provide credible factual backup to support it.

Appraisals and financial projections may be relied on only if they appear sensible and the person doing them is “reputable and competent.” The tax adviser must inquire behind any appraisal of the fair market value of assets to make sure the appraiser used an acceptable approach for determining market value.

Turning to the legal discussion, only “reasoned” opinions will be allowed in the future; the opinion cannot simply state a conclusion without explaining why. It must address every tax issue on which there is a reasonable possibility of challenge by the IRS. It must state the likelihood that the taxpayer will prevail on each issue individually, and also give a bottom-line conclusion on the entire transaction. The opinion must also state that

“the practitioner has considered the possible application to the facts of all potentially relevant judicial doctrines, including the step transaction, business purpose, economic substance, substance over form, and sham transaction doctrines, as well as potentially relevant statutory and regulatory anti-abuse rules, and the opinion must analyze whether the tax shelter item is vulnerable to challenge under all potentially relevant doctrines and anti-abuse rules.”

If the tax adviser is relying on an opinion from another law firm, he must identify the firm, give the date of the opinion, and describe its conclusions.

Taxpayers sometimes ask for an opinion only on a narrow issue. A tax adviser will be able to give such an opinion in the future only if someone else competent is opining on the broader issues. He should see the broader opinion.

Penalties

Tax advisers who violate the new rules face public reprimands and possibly even suspension or disbarment from practice before the IRS.

Other tax partners at the same law or accounting firm are also at risk if the government can show that the firm has engaged in a pattern or practice of failing to comply. However, the government is expected to take this action only against any tax partner who knew of the violations and failed “consistent with his or her authority” within the firm to rectify the situation.

Contingent Fees

Some law and accounting firms collect fees based on the amount their advice saves the taxpayer. The new rules bar fees in the future that are tied wholly or partly to success in sustaining a position with the IRS or in litigation. The ban extends to indemnity agreements, guarantees, rescission rights and other arrangements where the taxpayer would be entitled to some money back if the position is not sustained.

However, the ban applies only to fees for advice about positions the taxpayer plans to take on an original return, and not to fees for refund claims or positions on amended returns if the refund claim or amended return is expected to receive “substantive review” by the IRS.

by Keith Martin, in Washington