As the Internal Revenue Service continues to labor to finalize Circular 230 on the requirements for tax shelter opinions and when they may be relied on, a recent court decision may have already done a significant portion of its work.

The court not only rejected the taxpayer's reliance on a tax shelter opinion, but also gave the government the 40 percent penalty that it requested for such misplaced trust.

Unfortunately, the old saying, "Bad cases make bad law," may hold true here. Good tax planning requires a degree of certainty. The latest IRS victory, although arguably "just" under the circumstances, raised anew doubts over what will constitute reasonable reliance.

Background

Throughout much of the 1990s, tax shelters were marketed by promoters as a "no lose" proposition for potential corporate clients. The tax losses afforded by the tax shelter were the subject of tax shelter opinions, upon which the taxpayer could reasonably rely to avoid accuracy-related penalties. Even if the position taken on the return was eventually reversed on audit, the taxpayer was only out the tax deduction and related interest, which would leave the taxpayer as well off as if the transaction had never been undertaken in the first place.

The tax shelter opinion would prevent the assessment of the tax penalties that could make the effort not worth the economic risk. There were, of course, the promoter's fees out of pocket, but the potential tax savings were hard for many corporate taxpayers to resist, especially when being promoted by people with such excellent credentials.

For many taxpayers, things have not quite worked out in the way that they envisioned. The IRS has identified many of these marketed tax shelter transactions as lacking business purpose and economic substance, and has further asserted accuracy-related penalties contending that the tax shelter opinions were tainted and reliance upon them was not reasonable.

Long-Term Capital Holdings

Long-Term Capital Holdings, decided by the U.S. District Court in Connecticut on Aug. 27, 2004, was just such a case. Long-Term Capital Holdings involved lease-stripping transactions utilizing either a master lease or a wrap lease structure or a sale/leaseback structure. The structure involved prepaid rental income allocated to a foreign entity not subject to U.S. tax, and rental deductions being allocated to U.S. corporations seeking deductions to offset other taxable gains. To preserve the U.S. tax treatment, the foreign entity exchanged its leasehold interest for preferred shares issues by the U.S. corporate taxpayers in a transaction designed to be a tax-free Sec. 351 exchange.

The preferred shares and the related basis held by the foreign entity as a result of these transactions were then transferred to Long-Term Capital Management, a hedge fund whose partners were attracted to the idea of generating tax losses. The foreign entity exchanged the preferred shares it had acquired for a partnership interest in LTCM. The foreign entity also put in cash loaned to it by LTCM and received a put option to transfer back its partnership interest, which was later exercised. The final transaction was for LTCM to sell the preferred shares that it had received for $1 million and claim a loss on the sale allocated to its partners of over $100 million.

The court found that the transactions, which were claimed to result in the dramatic increase in the preferred stock's basis, lacked economic substance and should be disregarded for tax purposes. The court concluded that the economic costs of the transaction were not justified by the reasonable expectations of economic return.

Alternatively, the court also held that, applying the step transaction doctrine, the transactions could be treated as a sale of preferred stock by the foreign entity to LTCM, which would result in an adjustment of the basis in the preferred stock to the amount of LTCM's purchase price, eliminating the claimed loss.

Finally, the court upheld accuracy-related penalties of 40 percent for gross valuation misstatements and 20 percent for substantial understatements, on the basis that LTCM did not meet the reasonable reliance exception for avoiding the penalties. The court found that LTCM lacked a reasonable belief that the basis it claimed for the stock was valid. The court also found that LTCM did not have substantial authority for its return position because there was not reasonable reliance on a tax shelter opinion either in terms of credibility or timing. The tax shelter opinion upon which LTCM purportedly relied did not constitute substantial authority due to defects in the opinion itself.

There were two tax-shelter opinions involved in the case: one addressing the basis in the preferred shares of the foreign entity resulting from the Code Sec. 351 exchange, and the other examining the ability of the LTCM partners to claim losses using the transferred basis. The court found that the opinions could not be reasonably relied upon because the LTCM partners' loss opinion was written after the tax return was filed, was based on assumed facts rather than the actual facts of the transaction, and LTCM concealed the loss through netting on the tax return rather than disclosing the transaction and its reliance on substantial authority.

Perhaps of most concern to taxpayers and tax practitioners was that the court seemed to be saying that the taxpayer's in-house tax expert failed to study the opinion and evaluate whether it could be properly relied upon.

Good-faith reliance requires that the taxpayer not know or have reason to know that a representation or assumption is unlikely to be true. Good-faith reliance would not appear to require that the taxpayer investigate the legal conclusions of the opinion to determine if they were properly arrived at. It may be that the court was saying that, in this case, the in-house tax expertise was sufficient that there was reason to know that the legal conclusions were not likely to be true.

While the case is likely to be appealed by the taxpayer, the government claimed a significant victory in its efforts against corporate tax shelters and their promoters.

Circular 230

Proposed Circular 230 would revise the requirements for the issuance of tax shelter opinions as a protection from accuracy-related penalties. The taxpayer can rely on the opinion only if the drafter adheres to the proposed standards and observes the due diligence and disclosure requirements.

There are new requirements for factual due diligence and legal analysis. The opinion must accurately and completely describe all material facts, including assumptions and representations. An assumption is unreasonable if the tax practitioner knows, or has reason to believe, that a factual assumption or presentation is incorrect, incomplete, inconsistent or implausible. A representation is incomplete if it claims that a transaction is potentially profitable but fails to give an adequate factual foundation.

For a more-likely-than-not opinion, the opinion author must conclude unambiguously that the treatment of a tax shelter item is more likely than not the proper treatment. For a marketed opinion, the practitioner must weigh the typical investor's tax and non-tax purposes for entering into a transaction. For a limited-scope opinion, the writer must state that there may be additional tax issues that may bear on the shelter that were not considered and that no penalty protection is provided as to those items. Some in the IRS are debating whether any penalty protection should be given for a marketed tax shelter opinion.

The Long-Term Capital Holdings decision raised the issue of whether a taxpayer who had no reason not to know that the opinion issuer failed to comply with the Circular 230 requirements for reliance nevertheless may have failed in a duty to investigate to satisfy itself that the opinion complied with Circular 230 standards for good-faith reliance.

The IRS had hoped to finalize Circular 230 with respect to tax shelter opinions by the end of the year, but there is some uncertainty now as to whether that goal can be met.

Summary

The Long-Term Capital Holdings case will help the IRS in asserting accuracy-related penalties by providing several grounds for attacking the reasonable reliance of the taxpayer on tax shelter opinions.

Revised Circular 230 is designed to help accomplish the same thing for transactions going forward. Taxpayers who lose on the reasonable reliance argument may well turn to the opinion writers for recovery of the penalties paid.

Needless to say, practitioners will be watching the progress of the Long-Term Capital Holdings appeal very closely.

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 Co.

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