The revised Circular 230 Rules of Practice Before the Internal Revenue Service are in full force starting June 20, 2005. The revised rules are a reaction to practitioner complicity in - or at least acquiescence to - abusive tax techniques within the period ranging roughly between 1996 and 2003.
The new rules try to correct taxpayer behavior by monitoring more closely the actions and advice of tax advisors. While no one in the government believes that tax abuses are as rampant now as they had been in the past, the presumption is that the mindset of the tax department as profit center still exists sufficiently to trigger a return to bad habits if too much slack is given.
Most practitioners are of the opinion that only a relatively few bad apples are to blame for the excesses of the past. However, the fallout - in the form of revised Circular 230 - affects everyone.
The IRS Office of Professional Responsibility, the enforcer of Circular 230, says in all sincerity that it will apply the revised rules reasonably. Its staff even promises to treat Circular 230 as a dynamic document that will be subject to further refinements if necessary. However, many firms cannot afford to chance stumbling into a Circular 230 violation of any kind, only to depend upon IRS largesse. Since a violation can affect an entire tax department's right to practice before the IRS, not to mention that of a key member, adherence to a strict construction of the rules appears to be the only course of action that tax practitioners should take at this time.
If something goes awry with a particular tax strategy, the IRS can choose not only to attack the transaction through examination of the taxpayer. It also now has the authority through revised Circular 230, and the means through increased funding, to examine if the taxpayer's practitioner may also be at fault as the facilitator of the transaction. If the practitioner did not follow Circular 230 procedure, the honest intentions behind the transaction itself may be overshadowed or ignored.
The bottom line
Basically, what the revision to Circular 230 does is to force the practitioner to tell the client in most cases that any advice short of that based on exhaustive, time-intensive (and expensive) research and explanation may not be relied on for penalty protection. The practitioner is backed into a corner by having the same standards applicable to formal tax opinions carry over to less formal written communications and routine tax advice. While disclaimers may be common enough on amusement park tickets or packs of cigarettes, it will be a bit of a shock for clients to see one on correspondence that they receive from their tax professional.
The IRS claims that the delayed effective date from adoption of the regs in December 2004 was longer than usual and was done specifically to allow practitioners to draft new procedures memoranda for staff, educate their clients on the opinion-writing standards, and adjust their clients' expectations going forward. These standards clearly will have an impact on the way a practitioner provides advice.
The prevailing opinion is that the IRS will interpret the rules liberally in favor of practitioners at first, for most practitioners. However, if it believes that it can combine civil and criminal proceedings against a particular practitioner as a tax shelter promoter or other participant more effectively by also proceeding under Circular 230, it may do so.
Yet the conventional wisdom is also that the IRS sees an advantage to using Circular 230 as a way to mold practitioner behavior and to "persuade" the practitioner to be less of a facilitator of aggressive tax planning. As a result, some practitioners will be prosecuted as examples to others.
While maintaining a relatively tough public stand on Circular 230 enforcement, however, the IRS is also likely to continue to soften some edges. It did so recently by issuing IR-2005-59, which contained a number of concessions. In that IR, the IRS announced five major revisions to its opinion-writing standards in response to what it characterized as protests from many practitioners and professional groups. Three of the revisions expanded the scope of "excluded advice." The remainder tried to refine "principal purpose" and relax certain disclaimer requirements.
* Excluded advice. Under Circular 230, a "covered opinion" is written advice regarding listed transactions, transactions for which the principal purpose is to avoid or evade taxation, or certain other advice-based transactions.
In writing a "covered opinion," practitioners are expected to disclose any relationship that they have with promoters of the shelter, any compensation the practitioner will receive, and that the opinion may not be adequate for the taxpayer to avoid penalties. Written advice can encompass something as informal as an e-mail.
While the May revisions to the rules do not give even casual, conversational e-mails a free pass from all the Circular 230 requirements, they do add three situations to excluded communications:
1. Written advice prepared for and provided to a taxpayer after the taxpayer has filed a return for the transaction;
2. Advice from in-house counsel to an employer for determining the employer's tax liability; and,
3. "Negative advice" from a practicioner that concludes that a tax issue will not be resolved favorably for the taxpayer or will not result in the intended tax benefit.
Of course, to contain the exceptions to their intended purpose, several "exceptions to the exceptions" were made. If the practitioner knows or has reason to know that the taxpayer will use the covered opinion advice for a return in the future, the standards must be met. If the practitioner is not acting in the capacity as an employee, the exception doesn't apply. Finally, if the practitioner reaches a favorable conclusion for the taxpayer at any level of confidence with respect to that or any issue in the case of multiple tax issues, Circular 230 applies.
* Principal purpose. The IRS also tried to clarify what is meant for a transaction to have as its "principal purpose" tax avoidance or evasion for purposes of the covered opinion standards. A transaction will have the principal purpose of avoidance or evasion if avoidance or evasion exceeds any other purpose. The revised rules clarify that avoidance or evasion may be a significant purpose but not rise to the level of principal purpose. The new revisions also clarify that a principal purpose does not include one that is consistent with the code and congressional intent.
OPR director Cono Namorato has emphasized that this standard is intended to catch "fringe behavior." Nevertheless, the "principal purpose" test continues to generate the most confusion and dissatisfaction among practitioners, mainly because "principal purpose" has been a term of art used in different ways in different situations. The actual language in the revised rules still may be read as encompassing much more that "fringe behavior."
* Disclosure. For a practitioner to opt out of having an opinion subject to the Circular 230 requirements, the disclaimer to the client must be "prominently disclosed." Under the earlier rules, the disclaimer had to be placed near the top of the correspondence in bold type larger than the body of the message.
Since many practitioners complained, especially on the logistics of including it in e-mail, the IRS changed the standard. At a minimum, the disclaimer must be "readily apparent" to the reader. While this assumes some leniency that will allow many disclaimers to be placed at the end of the correspondence in a position not as jarring to the eye, it cannot, in fact, be "fine print." Nor can the body of the correspondence impliedly contradict the disclaimer.
Internal compliance programs, whether they be in the form of education, set procedures, checklists, review mechanisms or e-mail templates, or the general identification and adoption of best practices, should be initiated by all practitioners in response to revised Circular 230.
As to what language needs to appear in a disclaimer, practitioners are officially on their own, at least for now. While Circular 230 appears to force practitioners to include disclaimers in routine correspondence with clients on tax matters, it offers no help in coming up with acceptable language for the disclaimer. The OPR argues that a "one size fits all" disclaimer would not recognize the varied circumstances in which client communications are undertaken.
Revised Circular 230 has clearly "federalized" tax practice. While asking whether the rules of tax practice now rival the complexity of the Tax Code would perhaps be disingenuous for the moment, the cost of providing written advice to clients clearly will increase because of the Circular 230 restrictions and, arguably, the overly broad "smell test" that the IRS is using to interpret them.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
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