By now, corporate taxpayers will have noticed a change in much of the written tax advice they have received from their outside tax advisers after June 20, 2005. This change is the immediate result of new regulations the U.S. Treasury has issued to regulate advisers who provide U.S. federal tax advice. The Treasury issued these regulations (which are referred to as "Circular 230") under its statutory authority to regulate those who are authorized to practice before the Treasury and the Internal Revenue Service. The 2004 Tax Act specifically ratified the Treasury's authority to issue such regulations and authorized stiff monetary penalties, as well as other sanctions, against practitioners and firms that show a pattern or practice of noncompliance with the regulations. The intended and practical effect of these regulations, as well as the potential penalties that back them up, is that written U.S. federal tax advice issued after June 20, 2005, either must be much more elaborate and discursive in its form and content than was previously the case or must prominently display certain disclaimers prescribed in the regulations.
These regulations are a direct outgrowth of Treasury's attack on the abusive tax shelters that were widely marketed with the participation of some prominent tax advisers over the past decade and that have attracted a great deal of adverse publicity in recent years. Those tax shelters were frequently marketed in conjunction with tax opinions that purported to protect the taxpayer from penalties in the event the tax shelter proved to be ineffective. On close analysis, Treasury concluded that many of such tax opinions did not reflect appropriate professional standards, and this has led Treasury to require that all written tax advice (which specifically includes electronic mail) that is intended to provide penalty protection to taxpayers include both a detailed analysis of all significant tax issues in the transaction and an extensive discussion of relevant legal issues, and be preceded by substantial due diligence verification of all pertinent facts.
With respect to most major transactions, these additional requirements should not ordinarily affect the time and effort that reputable tax lawyers have long put into more formal written tax opinions prepared for clients, because much of the substantive work that the new regulations require has long been routine for most tax advisers of that stripe. However, these requirements may well affect the time, effort, and thus cost to the clients of rendering more routine advice - unless the clients are willing to forego the ability to use such advice for penalty protection purposes, as discussed below. In addition, as also discussed below, these requirements may well affect the form that such opinions take and, more fundamentally, the ability of clients to maintain the privileged status of some of the work that their tax counsel perform for them. Moreover, in the absence of some accommodation, these requirements could effectively foreclose the ability of all tax advisers to provide less formal written tax advice, such as by electronic mail, without investing substantial time and effort that may be difficult to justify in light of the amount of tax involved or the purpose for which the client is seeking the advice.
In recognition of the fact that clients may well need tax guidance in some situations that will not economically justify the cost of such a "full blown" tax opinion, with all the formalities and diligence that the new regulations now require, the regulations offer advisers the option, in certain limited circumstances, of providing taxpayers with informal written tax advice, but only if that advice is accompanied by a disclaimer - or, as some advisers call it, a "legend" - that meets guidelines detailed in the regulations and that advises the taxpayer that it cannot rely on such informal advice for penalty protection purposes. In addition, if the written advice is used for the purpose of promoting, marketing, or recommending a transaction to other persons, the regulations require a more elaborate disclaimer. The precise content of the disclaimers is prescribed in the regulations and will be discussed below. But first let's explore what the use of a disclaimer will and will not accomplish under the new regulations.
Under the regulations, whenever the written advice relates to a so-called "listed transaction" or a transaction that has as its principal purpose the evasion or avoidance of U.S. federal tax, there is effectively no way for a tax practitioner to provide written tax advice without satisfying the elaborate requirements of Circular 230. "Listed transactions" are a series of tax strategies that the Internal Revenue Service ("IRS") has identified in revenue rulings as "blacklisted" transactions that are highly suspect and thus are virtually guaranteed to receive careful governmental scrutiny. Thus, with respect to either listed transactions or "principal purpose" transactions, Circular 230 effectively precludes a tax adviser from advising with respect to U.S. federal tax issues unless the adviser renders a "full blown" tax opinion that satisfies the elaborate requirements of factual diligence and detailed analysis of both fact and law that are prescribed in Circular 230. The option of giving informal written advice with one of the required disclaimers is not an available option with respect to such transactions.
Likewise, if the practitioner imposes on the taxpayer an obligation, whether or not legally enforceable, to maintain the confidentiality of the tax advice, or if the practitioner's fee is conditioned on the realization of the desired tax benefits, the regulations will not permit the tax adviser to provide written tax advice without complying with all of the formal requirements imposed by the regulations. Here again, the disclaimers authorized in the Circular 230 regulations will not serve to waive the formal requirements that the regulations impose on the written tax advice.
Thus, the only circumstances where the new regulations permit the use of disclaimers to waive the satisfaction of the regulatory requirements are where the saving of federal tax is at most a significant purpose of the transaction or arrangement, which likely encompasses a very substantial segment of business transactions, and there is no confidentiality condition or contingent fee arrangement. Only in those circumstances do the regulations permit a practitioner to avoid satisfying the elaborate requirements of the regulations if the practitioner "prominently discloses" in the written advice a disclaimer, or "legend," that itself satisfies requirements set forth in the regulations.
For this purpose, the regulations prescribe two forms of disclaimer, depending on the reason for which the written communication is made. First, if the communication serves only to provide advice to the taxpayer to which it is addressed and concludes at a confidence level of "more likely than not" or higher that one or more significant federal tax issues would be resolved in the taxpayer's favor if challenged by the IRS, the advice will be a so-called "reliance opinion." Such a reliance opinion can be excepted from the most stringent Circular 230 requirements if the adviser prominently discloses in the advice a disclaimer, or "legend," that is prescribed in the regulations. An example is the legend that my own law firm has excerpted from the regulations for this purpose, which includes the following language, "To comply with U.S. Treasury Regulations, we advise you that any U.S. federal tax advice included in this communication is not intended or written to be used, and cannot be used, to avoid any U.S. federal tax penalties." In addition, because the regulations require a more extensive disclaimer if the written advice is to be used to market a transaction or structure to persons other than the client who receives the advice, many practitioners, including my own firm, have appended the following additional language in order to be sure that the more elaborate disclaimer for so-called "marketed opinions" is not required, "or to promote, market, or recommend to another party any transaction or matter."
Second, if the written advice is intended to be used to promote a transaction or arrangement to persons other than the person originally receiving the advice, then the written advice is a so-called "marketed opinion" for which the regulations require a more extensive disclaimer. As an example of that disclaimer, my own firm has distilled the following language from the regulations, "To comply with U.S. Treasury regulations, we advise you that any U.S. federal tax advice included in this communication (1) is not intended or written to be used, and cannot be used, to avoid any U.S. federal tax penalties, and (2) was written to support the promotion or marketing of the transaction or matter addressed by this communication. Any taxpayer should seek advice from an independent tax advisor based on the taxpayer's particular circumstances."
As is readily apparent, the regulations require both disclaimers to state that the written advice cannot be used for penalty protection. But, is that an accurate statement? If the disclaimer is in fact attached to the advice, it probably is an accurate statement of the law. For most purposes, the question of whether professional advice provides penalty protection will be governed by section 1.6664-4(c) of the Treasury Regulations, which, inter alia, requires that the taxpayer relied on the advice in good faith. However, if the advice specifically instructs the taxpayer that it cannot use the advice for penalty protection, then it would seem difficult for the taxpayer to rely on the advice for that purpose in good faith. The Treasury has indicated that it plans to specifically amend this regulation to correspond with the requirements of the new Circular 230 regulations, but, until it does so, the requirement that the disclaimer be included in the informal advice probably serves to bootstrap the result that the Treasury wants - i.e., denying taxpayers the ability to claim penalty protection from such informal written advice.
On the other hand, if the disclaimer is not included in the advice, the taxpayer may then still be able to assert that it relied in good faith on such advice and thus is entitled to penalty protection under the section 6664 regulation referenced above. While failure to attach the disclaimer could expose the tax adviser to sanctions under the Circular 230 regulations, it should not affect the taxpayer's ability to rely on the advice in good faith. Thus, if the written advice qualifies for one of the exceptions that the regulations prescribe, it is still possible for a tax adviser to deliver informal tax advice that can both comply with Circular 230 and provide the taxpayer with a basis for penalty protection. Examples at opposite ends of the spectrum are a reliance opinion at a "substantial authority" level (because it does not reach a "more likely than not" conclusion) and a reliance opinion at a "will" level of confidence (because it implicitly concludes that the IRS does not have a reasonable basis to challenge the tax position, and thus there is not a "significant federal tax issue," as the regulations define it, addressed by the advice).
Other exceptions embedded in the regulations include reliance or marketed opinions that are included in materials required to be filed with the SEC (unless the advice relates to a listed transaction or a "principal purpose" transaction) and written advice that the tax adviser reasonably expects to be followed by subsequent written advice that satisfies the requirements of Circular 230. Thus, the new regulations still have room for tax advisers to issue written advice that does not satisfy the formal requirements of Circular 230 and yet can keep both the adviser and the taxpayer free from penalties.
Although much of the public discourse has centered on the extra effort and cost that the new regulations will require for Circular 230-compliant opinions and on the disclaimers or legends that must be attached to certain informal tax advice, relatively little discussion has been focused to date on what some believe is the most negative effect that the new regulations will have on taxpayers. This is the disclosure that the regulations may require of the analysis by which the tax adviser reached his or her conclusion in the advice rendered to the taxpayer. In the past, it was common for tax advisers to bifurcate their advice into 1) a short-form opinion that recounted the relevant facts and then stated the adviser's legal conclusions regarding the federal tax consequences that would attend those facts; and 2) a background "work product" memorandum Only the short-form opinion was disclosed to the IRS for penalty protection. The "work product" memorandum discussed the issues that the adviser anticipated the IRS might raise to challenge the tax treatment and the responsive arguments that the adviser intended to make to counter those challenges. Although the conclusion was never tested in court, many legal advisers felt that there was good judicial authority to support the view that the short-form memo could be disclosed to the IRS without waiving the work product privilege that attached to the background memo. Circular 230 has the potential to change all of that and to give the IRS access to the analysis and issue-spotting for which the taxpayer has paid its adviser. In effect, the IRS will be taking for its own use the expert advice and analysis that only the taxpayer paid for. A cynic might even suggest that was Treasury's objective.
If that in fact is the end result of new Circular 230, that does not seem fair to the taxpayer. The IRS is justified in assuring that the taxpayer obtains competent and independent tax advice on which it relies for penalty protection. But how and why can the IRS justify demanding the benefit of the issue-spotting and analysis that the adviser undertook on the taxpayer's behalf and at its expense? In short, why should we not expect the IRS personnel to do their own work for which the public pays them instead of appropriating the work of the taxpayer's adviser? The answer may well turn out to be that Circular 230 does not necessarily require such an unfair conclusion. Even if the result of the new regulations is to require the adviser to bring forward from the background memo much of the analysis that previously appeared only there and to insert it into the opinion that is disclosed to the IRS, there may yet be room to hold back in the work product memo much of the more sophisticated issue-spotting and analysis undertaken by the adviser without violating Circular 230. Moreover, there may even be room under new Circular 230 to preserve without major change the two-part approach that many tax lawyers have long used in the opinion process, as long as the work product memo itself is given to the taxpayer after the short-form opinion and the content of the memorandum is by itself sufficient to satisfy the requirements of Circular 230. In that event, both the short-form opinion that the IRS will see and the work product memo that follows the short form memo - and that the IRS will not see - will be Circular 230-compliant.
The IRS may well find that situation to be objectionable, particularly since it would frustrate what may well have been one of their unstated objectives from the new regulations. If so, look for this to become one of the major flash points in the days to come between the IRS, on one hand, and taxpayers and their advisers, on the other, over the ultimate effect of the regulations. How this plays out may well determine the degree to which the regulations can require taxpayers to pay for the development of arguments that the IRS will then use against them.