New regulations to Circular 230 calling for "highest quality representation" may encourage malpractice litigation involving tax advisors, according to some observers.

The new regs were issued as part of an ongoing effort to improve ethical standards for tax professionals and to curb abusive tax avoidance transactions.

Circular 230 is applicable to attorneys, accountants and other tax professionals who practice before the Internal Revenue Service. The revisions are meant to ensure that tax professionals do not provide inadequate advice, and increase transparency by requiring tax professionals to make disclosures if the advice given is incomplete.

"These new standards send a strong message to tax professionals considering selling a questionable product to clients," said IRS Commissioner Mark W. Everson. "The new provisions give us more tools to battle abusive tax avoidance transactions and to rein in practitioners who disregard their ethical obligations."

The rules include a list of best practices that practitioners should adhere to when providing advice, including communicating clearly with the client regarding the terms of the engagement; establishing the facts and evaluating the reasonableness of any assumptions; advising the client about the significance of any conclusions; and acting fairly and with integrity in practice before the IRS.

The regulations specify that the best-practices rules are aspirational, and that a practitioner who fails to comply with best practices will not be subject to discipline. However, the regs state: "Although best practices are solely aspirational, tax professionals are expected to observe these practices to preserve public confidence in the tax system."

"Good firms already follow those practices," observed Chris Rizek, tax partner at Washington-based Caplin & Drysdale. "But one of the concerns is that even though they're aspirational, they are likely to be looked to by courts seeking a standard of what tax practice should be. The failure to meet the best-practices standard could be deemed negligence."

Tom Ochsenschlager, vice president for taxation at the American Institute of CPAs, agreed. "It's one thing to say they're aspirational, and another thing for an attorney to ask you in court, 'These are best practices - did you do that?' It will put the tax advisor on the defensive almost immediately."

"On the other hand," he said, "I'm happy they are merely aspirational, since the advisor has the opportunity to defend himself by saying that he usually follows these practices, but it wasn't necessary in this particular circumstance."

Although the rules call for communicating clearly with the client, Ochsenschlager observed that clients don't always understand the reasons behind the advice.

"Some tax advice is so complicated that you can give the client a view from 10,000 feet, but the nuance is beyond most clients' comprehension," he said. "In theory, if every client understood tax well enough to follow your best-practices advice, they wouldn't need you as a tax advisor."

Ensuring that attorneys, accountants and other tax practitioners adhere to professional standards and follow the law is one of the IRS's top four enforcement goals. The revisions to Circular 230 represent a key component of the strategy to achieve this goal, according to Cono Namorato, the director of the IRS Office of Professional Responsibility.

The OPR investigates allegations of misconduct by tax practitioners and enforces the standards of practice in Circular 230. Everson and Namorato have taken a number of steps to increase the effectiveness of the OPR, including doubling the size of its staff.

"The playing field for tax advisors has changed with these standards for tax opinions, the new penalties that Congress recently enacted and other steps the IRS has taken to detect and deter abusive transactions," said Namorato. "Most professionals share our concern about the egregious behavior of some of their colleagues, and we appreciate the efforts of responsible practitioners to promote ethical practice. We are taking steps to ensure that all practitioners live up to their professional obligations."

In addition to the best-practices standards for all tax advisors, the new regulations provide mandatory requirements for written advice that presents a greater potential for concern, and minimum standards for other advice. The mandatory requirements for written advice that present a greater potential for concern prohibit practitioners from providing advice that, for example, relies on incorrect factual assumptions or representations, does not consider all relevant facts, or fails to analyze important legal issues. The minimum standards for other advice will give practitioners flexibility to exercise professional judgment to meet specific client needs.

The regulations subject "covered opinions" to specific standards of practice. A covered opinion includes written advice concerning a federal tax issue arising from a plan or arrangement, the principal purpose of which is the avoidance or evasion of any tax.

"It's good that they changed 'substantial' to 'principal' in the definition," Ochsenschlager said. "Almost every piece of tax advice has a substantial purpose of tax avoidance. But they left in the 'substantial' standard where the opinion will be a reliance opinion or a marketed opinion. This means that a client can ask for advice on a transaction, and if your memo is not meant to protect him or what he's asking you to opine on doesn't have a principal purpose of avoidance, then the opinion can be more casual. So it facilitates the efficient practice of tax consulting."

"Historically, the IRS couldn't put anyone on the hook," explained Ochsenschlager. "The taxpayer said, 'You can't hit me with penalties because I, as a reasonable person, relied on the opinion of my attorney or CPA.' Now the taxpayer cannot rely on that opinion unless the opinion is specifically for that purpose, and if it is, they have to go through stringent requirements or the opinion will not serve to protect the taxpayer from potential penalties."

"These revisions to Circular 230 strike an appropriate balance between tightening practitioner standards and minimizing the burden on everyday advice," said acting assistant secretary for tax policy Greg Jenner. "These rules target the types of written advice that present a significant cause for concern and avoid undue interference with the practitioner-client relationship."

The Treasury Department and the IRS also issued separate proposed regulations regarding written advice concerning tax-exempt bonds that are similar to the standards for written advice in the final regulations. The proposed standards take into account the special characteristics of the market for tax-exempt bonds, while ensuring that professionals who provide advice concerning tax-exempt bonds adhere to standards of practice that are comparable to the standards applicable to other tax professionals.

Until the proposed regulations are finalized, practitioners providing advice concerning tax-exempt bonds will be subject to certain minimum standards.

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