The tax departments of most law firms have had a bad run over the last ten years, losing market share and top talent to accounting firms, but there is evidence that change is afoot.
To understand the problems facing law firm tax lawyers, you have to understand the market for tax services for large corporations. Traditionally, accounting firms did the tax returns and law firms handled the tax aspects of transactions. Over time, tax services became increasingly sophisticated, to the point where virtually all corporate activities now have some aspect of tax planning.
As accounting firms became more and more aggressive in expanding the services they provided, they offered more and more in the way of tax planning that competed directly with the services provided by tax lawyers.
In many respects, it was easier for the big accounting firms to market tax services to large corporate clients. First, the largest purchasers of tax services in a corporation -- CFOs and tax directors -- were usually trained by one of the big accounting firms, had stronger relationships with accounting firms, and were more likely to identify with accountants than with lawyers. In contrast, a law firm's strongest relationships are typically with the general counsel's office. While the general counsel will sometimes have authority over tax planning, this is more the exception than the rule.
Second, an accounting firm engaged to audit a corporation's books is often in the best position to spot tax planning opportunities. Even if the idea comes from another source, the audit firm can usually make a case that it would be able to provide the services more cheaply than another provider because it already has the basic numbers at hand.
And finally, some believed that tax planning and tax products would be unlikely to be second guessed if the tax services and audit work were done by the same firm.
Until recently, the result was that accounting firms had a significant share of the market for corporate tax planning. Indeed, many tax lawyers gave in and joined the large accounting firms.
Now, perhaps, the playing field has tilted away from accounting firms, and in two significant ways. First, Sarbanes-Oxley has dramatically changed how a public corporation can obtain tax services. Second, after a long internal reorganization, it now appears that the IRS will aggressively fight corporate tax shelters.
Anyone reading this publication has already been inundated with summaries of the Sarbanes-Oxley Act (SOX), the proposed SEC regulations under SOX, and the final regulations. So let's skip the pre-show. Under the final regulations, an auditor cannot perform "tax services" unless the audit committee gives prior approval. While the preamble states that the "Commission reiterates its long-standing position that an accounting firm can provide tax services to its audit clients without impairing the firm's independence," some observers believe that for a variety of reasons audit firms will be engaged to do less tax planning as a result of SOX.
First, the regulations do not define "tax services." The preamble indicates that this means "tax compliance, tax planning, and tax advice," but specifically warns against treating a prohibited service as within this exception just because some aspect of it involves taxes. The blanket term "tax work" or "tax services" connotes a continuum of activities that range from simple tax compliance to sophisticated legal analysis and litigation. Accordingly, a proposal to carry out "tax services" can involve -- in substance -- legal or expert services, or other services that audit firms are prohibited from performing. A risk-averse audit committee could decide to refuse to engage audit firms to carry out work that could reasonably be seen as a prohibited service.
Second, the preamble appears to sound the death knell for the type of ready-made tax products that have been aggressively marketed by some accounting firms. Specifically, the preamble states "audit committees also should scrutinize carefully the retention of an accountant in a transaction initially recommended by the accountant, the sole business purpose of which may be tax avoidance and the tax treatment of which may be not supported in the Internal Revenue Code and related regulations."
Third, SOX changes who has final say on purchasing tax planning services. Even if accounting firms could provide exactly the same services as pre-SOX, the final decision on purchasing such services is made by the audit committee, not the CFO. This is viewed by some law firm tax attorneys as an enormous leveler.
And fourth, some feel that the expanded disclosure of tax fees will put the more modest pricing of law firm tax services in a more favorable light. In addition, the public disclosure of high amounts of tax fees for accounting firms may suggest aggressive tax planning and draw IRS scrutiny.
Corporate Tax Shelters
While SOX could level the market for tax services going forward, the IRS is in the midst of a long battle against corporate tax shelters marketed by accounting firms in the past and is engaged in a variety of efforts to stop the on-going marketing of such shelters.
On the litigation front, the IRS has prevailed in some cases, but has also suffered some setbacks. Of greater import, however, is that some courts have now adopted an "economic substance" doctrine that can be used by the IRS to successfully attack corporate tax shelters. And if the IRS is able to prevail, then corporate tax shelters may go the way of the personal tax shelters sold in the 1970s and 1980s. The implications, however, may extend beyond that. Specifically, corporations may consider whether to place tax planning under the general counsel's office, and, if the corporation is saddled with a failed tax shelter, whether to sue the promoter.
If the IRS is serious about attacking aggressive tax arrangements, corporations may need to re-think where in the organization chart the tax planning function should be performed. If enough tax shelters are challenged, there may be a movement to put tax planning under the control of the general counsel. Many of the most aggressive shelters should have been vetted by legal counsel, but often were not. If they had, they may have been aborted.
Shifting tax planning to the general counsel's office may also be advantageous because of the attorney-client privilege and the work-product doctrine. Much tax planning in the CFO's office is carried out with little regard for potential litigation and, consequently, little of it is privileged. Moreover, aggressive tax planning by accounting firms typically is not protected, notwithstanding the 1998 creation of the "accountant" privilege. Although Congress attempted to extend the attorney-client privilege to accountants, the courts and the IRS have interpreted this effort narrowly, it does not apply to tax shelters, and it does not create a work-product privilege. Moreover, if it exists at all, it applies only to federal taxes. Therefore, state tax authorities give no deference to it.
Another consequence of the IRS' crack-down on tax shelters may be litigation against promoters. If a corporation has a tax shelter, it needs to figure out what to do with it. If the IRS has attacked it and has filed a notice of deficiency, the corporation will need to evaluate its chances of prevailing against the IRS, whether settlement is possible, and whether an action for damages against the promoter may lie. Indeed, litigation against accounting firm tax shelter promoters may be the only viable form of mitigation in some cases. Such litigation raises several issues.
First, many accounting firms specifically limited their liability in the engagement letters they had their tax shelter clients sign. Attorneys, of course, are prohibited from putting such language in engagement letters. Interestingly, if the accounting firm was engaged in the unauthorized practice of law (see below), then a court might determine that the same standards should apply, on the principle that a malfeasor should not benefit from his actions.
Second, prevailing in a malpractice action is not as simple as showing that the tax shelter did not work. Professional malpractice actions are difficult to win, and the ones that do succeed often involve an objective failure, such as missing a filing deadline, or violating an ethics rule. In some jurisdictions the doctrine of "negligence per se" applies whenever a defendant violates a law or regulation. In this regard, state laws against unauthorized practice of law may be very helpful. While many jurisdictions permit some tax planning to be conducted by non-lawyers, the type of analysis required for corporate tax shelters will necessarily involve interpretation of statutes, regulations and cases. Some would argue that this type of interpretation constitutes the practice of law.
Finally, even if these obstacles can be overcome, the measure of damages for a faulty tax shelter is probably less than the amount the corporation ultimately pays to the IRS. Tax shelter promoters will argue that in the absence of entering into the shelter the corporation would have paid the taxes anyway. With respect to the interest component of the deficiency, the government's interest rate is often less than the corporation's internal cost of borrowing, so the promoter will argue the corporation hasn't suffered any damages. However, in the case of a substantial understatement the interest rate can be bumped 200 basis points. In addition, damages should include any penalties assessed by the IRS. This is not inconsiderable: the substantial understatement penalty alone is 20%. Finally, any litigant should include the fees paid for the shelter. Some accounting firms charged very high fees, sometimes based on a percentage of the tax benefit, and these could constitute the largest portion of damages.
At this point, it is not clear that either SOX or the potential of recoupment litigation against the big accounting firms will ultimately prove advantageous to law firm tax lawyers. However, these developments do suggest that corporations need to re-examine their existing procedures for obtaining tax planning services.