Circular-230 2005-06

June 20, 2005

CCH Tax Briefing: CONTROVERSIAL CIRCULAR 230 RULES OF PRACTICE NOW EFFECTIVE Special Report

New Rules For Tax Advice ✔ ✔ ✔ ✔ ✔ ✔ ✔ ✔

Covered Opinions Reliance Opinions Marketed Opinions “Legend Out” Disclosures Confidence Levels Best Practices OPR Enforcement June 21st Effective Date

Inside Reaction ............................. 1 Covered Opinions .............. 2 Standards for Covered Opinions .............. 4 Exclusions from Covered Opinions .............. 5 Practitioners and Promoters .................... 6 Bond Opinions ................... 6 Legends Out ....................... 6 Best Practices .................... 8 Other Circular 230 Standards ........................... 8 Enforcing Circular 230 ..... 10 Sample Client Letter ........ 11

New IRS Rules For Giving Tax Advice— Are You In Compliance?

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fter years of proposals, debate, commentary and more debate, final Circular 230, Rules of Practice before the IRS, have taken effect. The final regs turn the old rules upside down. Many practitioners are still struggling to understand the full scope and consequences of new Circular 230. Because the new regs are such a change from the old ones, many consequences are unknown. This CCH TAX BRIEFING highlights the key features of new Circular 230 to keep practitioners in compliance. Final Circular 230 regs were issued in December 2004. The IRS revised them, reacting to practitioner concerns in May 2005. Many concerns remain. Key parts of the new regs on how tax advice is given are mandatory and failure to follow them could bring about significant penalties, including being barred from practice before the IRS and, in some cases, having an entire firm sanctioned. Other parts of the new regs are not mandatory, such as the “best practices” aspirations designed by the IRS. However, it’s clear that the IRS expects practitioners to abide by the highest ethical standards of client service. To prevent a small group of tax shelter advisors and promoters from acting badly, all are effectively punished, complain many practitioners. “Like using a harpoon to kill a goldfish,” or “a sledge hammer to kill a fly,” say others. Treasury and IRS officials informally have said, “We hear you,”

and call Circular 230 a “living document” subject to adjustment and also subject to administrative interpretation on the enforcement side. So far, however, no changes have been announced since the few revisions in May. The IRS reports that it is sticking to its deadline applicable to all written advice rendered after June 20, despite pleas for practitioners to do otherwise.

REACTION Tax practitioners are facing a brave new world that requires them to comply with rules of practice for tax shelter opinions, and they’re not happy about it. They believe the Circular 230 regs are vague and overly broad. To avoid the reach of the new law, firms are developing disclaimers, which they intend to include with most, if not all, communications sent outside the firm. The IRS’s Office of Professional Responsibility has been telling practitioners at public forums that it will apply new Circular 230 “reasonably.” Many practitioners, however, are not comforted by the IRS’s good intentions. They would rather have the literal language of Circular 230 corrected to ensure “reasonable interpretation.” Many tax attorneys and accountants are also sending letters to their clients, alerting them to the new practice of putting disclaimers, or “legends,” on letters,

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2005 Practice Update e-mails, and other written communications that give tax advice (see page 11 of this Briefing for a sample client letter). The alternative to putting a disclaimer on outside communications is to comply with the comprehensive requirements for “covered opinions” under new Circular 230. In most cases, practitioners caution that the fees for providing a covered opinion for routine tax advice would be substantially disproportionate to the benefits to the client. Michael Desmond, Treasury’s deputy tax legislative counsel (legislative affairs) recently observed that new Circular 230 has two purposes: to regulate tax shelter opinions provided for penalty protection, and to issue standards for these opinions. Putting a disclaimer on every communication defeats the purpose of the regs to ensure that clients are well informed. “Legends,” by default, create an opt-in dynamic for applying the rules, which was not intended by Treasury, Desmond said. New Circular 230 applies to electronic communications as well as written communications. Oral communications are not covered.

The new standards for written tax advice also may serve to lose clients at the examination stage based on a conflict of interest. The same practitioner who advised the taxpayer about a tax planning strategy must help the taxpayer defend against a penalty assessment on examination of that transaction on a later IRS audit. Not defending vigorously against the penalty using a reliance defense, when the defense would open up to scrutiny (and possible IRS censure) the practitioner’s written advice procedures, appears to be

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enough of a possibility that a conflict of interest would be present.

COVERED OPINIONS The most controversial provisions in new Circular 230 deal with tax shelter-type opinions, which the IRS calls “covered opinions.” Written advice that is a “covered opinion” must follow heightened standards of detail and thoroughness in making factual and legal assumptions.

“Key parts of the new regs…are mandatory and failure to follow them could bring about significant penalties”

Practitioners have complained that a lot more than traditional tax shelter situations are included in the new Circular 230 language defining a “covered opinion.” When read literally, it covers many “routine advice” situations. Requiring “full-blown” advice in each of these situations effectively rules out dispensing “routine advice,” which traditionally anticipates considerably less formal and less time consuming process. Many practitioners see no safe alternative “legend out” language to every written client communication, except in those instances in which full-blown advice is given. A “covered opinion” under Circular 230 is any written advice about a: “Listed transaction (or a transaction substantially similar);” Any plan or engagement which has as its principal purpose tax avoidance or evasion; or Any plan or engagement which has tax avoidance or evasion as a sig-

nificant purpose if the written advice is: A reliance opinion; A marketed opinion; Subject to conditions of confidentiality; or Subject to contractual protection. “Listed transactions.” These are transactions that the IRS has identified as patently abusive tax avoidance transactions. The IRS has labeled 31 transactions as “listed transactions.” Examples are Son of BOSS, abusive lease stripping, contingent liability and basisshifting transactions, and schemes using Roth IRAs to shelter business income. Principal purpose of tax avoidance or evasion. A transaction will have the principal purpose of avoidance or evasion if avoidance or evasion exceeds any other purpose. A transaction structured to claim tax benefits in a manner intended by the Tax Code and Congress will not be deemed to have the principal purpose of avoiding or evading tax. A transaction can be a “listed transaction” or have the significant purpose of tax avoidance even if it lacks the principal purpose of tax avoidance. Reliance opinions. Written tax advice is a reliance opinion if it concludes at a confidence level of more likely than not that one or more significant federal tax issues could be resolved in the taxpayer’s favor. Given the definition of a “reliance opinion,” one way to make certain that advice is not considered a reliance opinion is to state that “because of varying interpretation of the law, the advice at this point on a confidence level scale is less than ‘more likely than not’ that one or more significant federal tax issues would be resolved in the taxpayer’s favor.” An opinion that is otherwise considered a “reliance opin-

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Critical Definitions Part of the problem with complying with new Circular 230 is in the ambiguity of the terms used. In the end, an evaluation of the confidence level in which advice is influenced by subjective factors that may put certain advice in one category or another. A client may interpret the description of advice differently from what the practitioner intends in using such “confidence level” terms of art in correspondence to the client. “Substantially similar.” Advice related to a transaction “substantially similar” to a listed transaction is automatically considered a covered opinion. “Substantially similar” is not defined. “Principal purpose.” Advice related to a plan or arrangement, the “principal purpose” of which is the avoidance or evasion of any tax imposed under the Code, is automatically considered a covered opinion. A principal purpose exceeds any other prupose and does not include claiming tax benefits in a manner consistent with the Code and congressional intent. “Significant purpose.” Advice is also considered a covered opinion if related to a plan or arrangement, the “significant purpose” of which is the avoidance or evasion of any tax imposed under the Code (and is either a reliance opinion, a marketed

opinion, subject to confidentiality, or subject to contractual protection). While this “confidence level” is greater than “more likely than not,” precisely how much greater remains a subject of concern. Does the dollar amount involved make an issue more significant? It also requires an evaluation that the transaction does not have “a significant purpose of tax avoidance or evasion.” As a result, assuming that advice for all tax opinions must pass the “more-like-thannot” confidence level (see “reliance opinion,” immediately below) appears to be the more cautious approach. “More likely than not.” Advice given at a confidence level of “more likely than not” to prevail is defined as “a greater than 50 percent likelihood of the position being upheld.” “Significant federal tax issue.” An issue is no longer an issue that is subject to a covered opinion if the conclusion is that the IRS has no reasonable basis for challenge. However, the “Other Written Advice” standards still must be met. “Substantial authority.” Not in Circular 230 at all, but very relevant to the client is an additional criteria for advice, “substantial authority” for purposes of avoiding the substantial underpayment of income tax penalty. The regs under Code Sec. 6662 state, “The substantial authority standard is less strin-

gent than the more likely than not standard (the standard that is met when there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard as defined in §1.6662-3(b)(3).” “Reasonable basis.” A position that is not a covered opinion still must have a reasonable basis behind it. A “reasonable basis position” has a 10 to 25 percent likelihood of success; under Reg 1.6662-3(b) it is a “relatively high standard” significantly higher than “not frivolous.” For purposes of the negligence penalty, the reasonable basis standard is not satisfied by a return position that is “merely arguable” or that is “merely a colorable claim.” “Realistic possibility.” A position is considered to have a “realistic possibility” of being sustained if it has approximately a one in three or greater likelihood of being sustained on its merits. Under Circular 230, section 10.34, a practitioner may not advise a taxpayer to take a position on a tax return unless the position satisfies the “realistic possibility” standard or the position is not frivolous and the practitioner advises the client to adequately disclose the position on the return.

ion,” however, can also escape being considered if the practitioner properly notifies the client in the written advice that the advice is designated as a type that cannot be relied on to protect against any IRS penalties for negligence, substantial understatement of income or the like. For details on how this socalled “legend out” disclaimer works, see page 6.

ommend a partnership or other entity, investment plan or arrangement, the written advice is a marketed opinion. The same rule applies if the practitioner should have known his or her written advice would be used in promotion.

confidentiality.” One suggested clause reads, “this advice is intended solely for your use and may not be relied on by third parties; however, you may freely share this tax advice with third parties.”

This category is broad and may trap any advice that the taxpayer expected to pass along to a third party. However, in protecting against falling into this category, the practitioner also needs to guard against the advice being subject to “conditions of

If the advice concerns other than a “listed transaction” or a transaction that has the principal purpose of tax avoidance or evasion, the practitioner can treat what would otherwise be a marketed opinion as a non-marketed opinion by adding a “legend out” notice of no penalty protection. The legend out process

Marketed opinions. If a practitioner knows that his or her written advice will be used to promote, market or rec-

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2005 Practice Update can be used to avoid reliance opinion status, and is explained further on page 6. Individuals also must be advised to seek advice from an independent tax advisor. The IRS warns that if a practitioner is unable to reach a “more likely than not” conclusion, he or she must not provide the marketed opinion at all, under penalty of suspension or disbarment. Many practitioners worry that advice that may be passed along to any third party, not necessarily in the tax shelter setting, can literally be considered a marketed opinion subject to new Circular 230’s heightened standards. Confidentiality. This attribute looks at disclosure and protection of confidentiality of tax strategies. If written advice limits disclosure to protect the practitioner’s tax strategies, this is a condition of confidentiality. It does not matter if the limitation on disclosure is legally binding. A claim that a transaction is proprietary or exclusive may not necessarily be considered a limitation on disclosure. To be safe, however, a practitioner might confirm to all recipients that there is no limitation on disclosure and this confirmation would override any claim that a transaction is proprietary or exclusive. Contractual protection. A covered opinion exists if a client has the right to full or partial refund of fees if all or some of the intended tax consequences addressed in the written opinion are not sustained. Contractual protection is also present if fees are contingent on the realization of tax benefits. Designating fees as other amounts will not discourage IRS scrutiny. The IRS warned that it will

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look at all the facts and circumstances to determine if a fee is refundable or contingent, including the right to reimbursement of amounts not specifically designated as fees.

REQUIREMENTS FOR COVERED OPINIONS Circular 230 describes in detail the requirements practitioners must follow for covered opinions. These requirements address idnetifying of facts and issues, applying assumptions, relating the law to the facts, and reaching conclusions. A practitioner giving written advice that is a covered opinion must now give details and extensive analysis that no longer likely fits into a client’s idea of what is an informal opinion or one that carries a modest fee. These requirements force the practitioner to spend a great deal of time making sure that the long list of mandatory considerations is covered. Practitioners say that this will force any advice that is a covered opinion to cost significantly more, paid for by surprised clients or absorbed by overworked practitioners. Factual matters. The facts of a transaction must be laid bare. The opinion must identify and consider all relevant facts. Moreover, opinions must not be based on unreasonable factual assumptions. All factual assumptions must be identified in a separate section of the opinion. Similarly, practitioners must ignore unreasonable factual representations, statements or findings by the taxpayer or others. Factual representations also must be identified in a separate section of the opinion. “To require practitioners to exercise due diligence in

identifying and understanding all the facts, relating the law to the circumstances and requiring a competent and thorough evaluation of federal tax issues in rendering formal opinions should be an expectation,” the National Association of Tax Professionals told CCH INCORPORATED. Reaching a conclusion. The opinion must relate the law and judicial doctrines to the facts and consider all significant federal tax issues. Practitioners must come to some conclusion about the likelihood of the taxpayer prevailing. If the practitioner concludes the taxpayer will prevail, he or she must set forth the reasons. The same is true if the practitioner concludes the taxpayer will not prevail. If the practitioner is unable to reach a conclusion, he or she must explain why no conclusion is reached. Whenever a practitioner relies on the opinion of another practitioner, he or she must expressly identify the other opinion and the conclusions in that opinion. An opinion that does not conclude that the taxpayer will more likely than not prevail must prominently disclose this conclusion. It must be readily apparent to the reader. Limited scope opinions. New Circular 230 offers ‘limited scope opinion” rules as a solution to having to provide extensive analysis on all related issues when giving advice in writing. While these rules allow more likely than not opinions selectively on the significant federal tax issues that are addressed (and which are not marketed opinions), the rules also require prominent disclosure that the advice may not be used for penalty protection for non-covered issues. This presents the same delicate issue of having the client concerned about the effort and expertise being put into the overall advice. New Circular 230 requires that the limited scope opinion must prominently disclose that:

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The opinion is limited to the one or more federal tax issues addressed in the opinion; Additional issues may exist that could affect the federal tax treatment of the transaction or matter that is the subject of the opinion and the opinion does not consider or provide a conclusion with respect to any additional issues; and With respect to any significant federal tax issues outside the limited scope of the opinion, the opinion was not written, and cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. Practitioners have suggested that the language that appears above, be used verbatim, prefaced by, “Pursuant to IRS rules, this advice constitutes a limited scope opinion.”

EXCLUSIONS FROM COVERED OPINIONS New Circular 230 excludes some important items from the definition of a covered opinion. Written advice prepared after a return is filed. Written advice prepared for and provided to a taxpayer after the taxpayer has filed a return for the transaction is generally excluded. However, if the practitioner knows or has reason to know that the taxpayer will use the advice for a future return, including an amended return, the advice is a covered opinion. In-house advice. Written advice from in-house counsel to an employer solely to determine the employer’s tax liability is generally excluded. The advice must be given by the practitioner as an employee of the employer. Other excluded advice. So long it does not encompass a “listed transaction” or a “principal purpose” transaction, other excluded adivce includes: Written advice about the qualification of a qualified plan;

Written advice included in documents filed with the SEC; and Written advice given to a client during the course of an engagement if the practitioner is expected to provide subsequent advice that satisfies new Circular 230. Negative advice Many practitioners had concerns if negative advice (advice concluding that a federal tax issue will not be resolved in a client’s favor) should be considered a covered opinion. In May 2005, when the IRS revised the final Circular 230 regs, it addressed some of their concerns. Generally, negative advice is not a covered opinion. However, if the advice reaches a conclusion favorable to the taxpayer at any level with respect to the client’s tax issue, the advice may be a covered opinion. The IRS gives some examples, such as concluding that an issue is not frivolous, has a realistic possibility of success or has a reasonable basis. This treatment reflects concerns that negative advice could nonetheless be construed as encouraging taxpayers to take aggressive positions on their returns. Practitioners identified two areas where negative advice could be a covered opinion. First, in the context of written advice relating to a “listed transaction” or a “principal purpose” transaction. Second, in situations where written advice addresses more than one federal tax issue and concludes that one or more federal tax issues will not be resolved in the taxpayer’s favor. Preliminary advice If advice is given and the expectation is that it is preliminary to a full analysis, then the advice need not be “full blown.” Of course, it is just because of such an assumption that the client cannot rely on the preliminary advice for penalty protection. In these instances, the practitioner may give informal and “incomplete” advice without having to place a “legend out” statement in the communication.

New Circular 230 requires that preliminary advice be “during the course of an engagement,” which generally requires a written understanding; at least it is more than an engagement that the practitioner may assume exists. Intervening events could arise to scuttle the deal, including the client simply not wanting to pay for more advice but rather “take his chances.” Using language to escape initial qualification as covered opinion. A client usually is not aware of the nuances of confidence levels that have been created under the tax law. As a result, explaining to the client in the written advice that the advice is confirmed by substantial authority or a reasonable basis may exempt the advice on a non-tax shelter matter from being a covered opinion, avoiding the need to add “legend out” language to the correspondence. However, the practitioner must make certain that the principal purpose of advice is not tax avoidance and the advice does not state or imply that it reaches the more-likely-than not confidence level. Many practitioners believe that assuming no principal purpose or more-likely-thannot, or that advice is considered preliminary, is too dangerous, especially considering the disciplinary consequences of being wrong. They argue that they have no choice but to include “legend out” language to every piece of written advice.

Even if the advice is not a covered opinion, it still must meet the standards of “other written advice.” Although more flexible, these standards are also enforced through disciplinary measures if not met.

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2005 Practice Update Other written advice While not triggering the burdensome requirements for advice that is a covered opinion, all other written tax advice also must meet certain standards. The practitioner cannot under any circumastances give advice that is based, in whole or in part, on unreasonable factual or legal assumptions, or if the practitioner unreasonably relies on the representations of others, fails to consider all the relevant facts, or considers the audit lottery risks in the evaluation. “Other written advice” need not be as detailed as covered opinions. The expectation, as being announced informally by Treasury and IRS officials, is that most written advice will fall outside of the “covered opinion” category and into the “other written advice” category. Of course, many practitioners are upset that the actual language of Circular 230 itself implies otherwise. Written advice that contains internally inconsistent legal analyses or conclusions is prohibited. Practitioners have complained that this limitation prevents common “alternative theories” opinions in which opinions are given depending upon how several variations on how the facts may be interpreted.

PRACTITIONERS AND PROMOTERS Promoters are the main target in the IRS’s campaign to terminate the tax shelter industry. The 2004 Jobs Act greatly empowers the IRS to go after promoters, material advisors – indeed anyone – involved in tax shelters. New Circular 230 reflects the government’s intense focus on identifying promoters and through them investors. A covered opinion must disclose the relationship between practitioner and promoter. If there is a referral fee or other type of compensation arrangement, it must be revealed in the opinion. Likewise, the existence of a referral agreement must be disclosed. Similar standards apply to marketed opinions. The opinion must reveal that

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it was written to support the promotion or marketing of the product. Rampant tax shelter promotion fueled the IRS’s quest to toughen Circular 230. The agency hasn’t let up in its campaign to shut down abusive tax shelters. IRS officials jave repeated echoed the agency’s mantra that the government will use all the tools at its disposal to identify tax shelter promoters and investors. Circular 230 is one important tool. Practitioners need to tread very carefully in their relationships with tax shelter promoters.

BOND OPINIONS At the same time the IRS issued final general Circular 230 regs, it also issued proposed regs governing bond opinions. The proposed regs immediately sparked a negative reaction from bond practitioners. The final general Circular 230 regs and the proposed Circular 230 regs appeared to overlap and many practitioners were unsure where they stood. Many bond practitioners also feared that the regs would disrupt the bond market. Bond practitioners have been very active in pushing for changes to the bond opinion rules. They succeeded in June 2005 in having the IRS revise some of the proposed regs. The IRS enhanced the definition of a state or local bond opinion. A state or local bond opinion is written advice concerning: The excludability of interest on a state or local bond from gross income under Code Sec. 103; The status of a state or local bond as a qualified zone academy bond under Code Sec. 1397E; One or more federal tax issues reasonably related and ancillary to tax-exempt bonds; or Any combination of the above. More changes are likely. The IRS may permit bond practitioners to render opinions addressing less than all the significant federal tax issues and make other changes.

“LEGEND OUT” Will the new rules put an end to informal advice, which now must be identified through a “legend” that is so embarrassing to the practitioner that no informal advice will be given? Since informal advice is essential in building client relationships and is a large part of any tax practice, it seems unreasonable that this is the proper solution. Instead, coming up with “legend out” language that will be accepted by the client and by the IRS (albeit, begrudgingly) likely is the solution, at least until tax professionals might convince the IRS to change the regs. In giving written tax advice, a practitioner now has three choices: (1) Give a complete opinion that fully complies with the rules; (2) Conclude that the IRS has no reasonable basis for challenging the issue(s) and not offer any disclaimer to the client; or (3) Prominently “legend out” a disclosure in the correspondence that follows the language of new Circular 230 indicating that it is an opinion that cannot be relied on for avoiding IRS penalties if the advice is incorrect. All three options are problematic and the consequences are unknown. For example, giving a complete opinion that fully complies with the rules could be very costly to clients in minor matters. It could discourage clients from seeking clarification of minor matters. Many practitioners believe that option 3 is the only practical course to take in most everyday client correspondence but as of yet there is no consensus on what “legend out” language practitioners should use. If the advice concerns an opinion or transaction with its principal purpose tax avoidance, no legend out is effective. Only when a non-listed transaction has tax reduction as a significant but not principal purpose, may the advice be less than complete is a legend out is added.

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Practitioners who are putting disclaimers on their communications are uncomfortable when they inform a client that the client cannot rely on the advice for tax penalty protection. This is unfair, many practitioners argue, because it implies that the advice is incorrect or inadequate. It is also unfair to clients who may need advice but are uncomfortable with the “legend out” language.

The new rules tend to penalize small businesses and unsophisticated taxpayers. Sophisticated taxpayers and large corporations are more likely to be able to form their own opinion about potential shelter transactions. For others, the only choice is to rely on their practitioner’s advice, but that reliance is not available unless the client pays high fees for a covered opinion.

“LEGEND OUT” LANGUAGE The IRS hasn’t provided any example language. It only draws the parameters within Circular 230 and, unfortunately, leaves the “details” to interpretation. Section 10.35(b)(4) in Circular 230 provides “Written advice…is not treated as a reliance opinion if the practitioner predominately discloses in the written advice that it was not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” Many practitioners plan to place “legend out” language on correspondence as a matter of course. “Legend out” language for what is otherwise a reliance opinion must disclose, must disclose “that it was not intended or written by the practitioner to be used, and

that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” Similarly, Circular 230 states that legend out language for what is otherwise a marketed opinion must communicate that (1) the advice was not intended or written by the practitioner to be used, and that it cannot be used by the taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer; (2) the advice was written to support the promotion of marketing of the transaction or matters addressed by the written advice; and (3) the taxpayer also should seek advice from an independent tax advisor based on the taxpayer’s particular circumstances. Based on this language from Circular 230, at least two “legend out” statements – as an alternative to quoting Circular 230 exactly, which may be a bit awkward— have been proposed by practitioners. “Legend out” statement #1 “This written advice is not intended or written to be used, and it cannot be used by an taxpayer, for the prupose of avoiding penalties that may be imposed on the taxpayer.” (See the Sample Client Letter on page 11 for further details.) “Legend out” statement #2 “Additional issues may exist that could affect the federal tax treatment of the transaction on the matter that is the subject of this advice and this advice does not provide a conclusion with respect to such issues. With respect to such issues outside the limited scope of this advice, the advice was not written and cannot be used for penalty protection.” “Legend out” statement #3 “Please be advised that, based on current IRS rules and standards, the advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty that the IRS should assess related to this matter. That said, please do not hesitate to call me if you have any further questions regarding this matter.”

The greatest challenge in writing and placing the legend is to make certain that clients understand that it is not an excuse for sloppy advice. Practitioners need to assure clients that the quality of the advice is still excellent but its scope is limited because of government regulations. Many firms have already begun the process of “client education.” New Circular 230 requires that the “legend out” statement be prominently disclosed. An item is prominently disclosed if it is readily apparent to a reader of the written advice. Circular 230 uses a facts and circumstances test to determine if an item is prominently disclosed. At a minimum, a “legend out” must be placed in a separate section in a typeface that is the same size or larger than the typeface used in the advice. A “legend out” statement cannot be in a footnote. Emails Emails raise special concerns. Can a “legend out” statement be added to, or appear immediately before, the typical boilerplate confidentiality statement common at the end of professional emails. Would the IRS consider this a prohibited “footnote?” Ending the correspondence with a closing and signature before the “legend out” statement would probably run afoul of Circular 230. Placing the “legend out” statement in the last paragraph of every correspondence probably would be adequate. However, many practitioners hope that such placement will read like boilerplate language and not attract a reader’s full, critical attention as a result. What about text messages? Circular 230 is silent if a “legend out” statement must be part of a text message. One problem is the size of the typeface and the length of the response.

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2005 Practice Update According to Jeffrey Paravano, a former Treasury official now with Baker & Hostetler, a consortium of roughly 50 law firms has been meeting to devise consistent practices for complying with the new regs and issuing disclaimers. Some firms intend to require disclaimers for communications issued by particular practice areas (in addition to tax), such as real estate and corporate law. For other practice areas, some firms are devising computer search programs that will look for particular words, such as “tax,” in outside communications and trigger the use of the disclaimer language.

The New York State Bar Association’s Tax Section recommends keeping the “legend-out” requirement for marketed opinions and listed transactions but “flipping” the requirement for reliance opinions. It recommended that a statement from the practitioner be required only when the intention is to give penalty protection. So far, the IRS has rejected this approach.

Can client assume full advice without “legend out?” If the practitioner violates new Circular 230, the client is not home free. Before a taxpayer may be considered to have reasonably relied in good faith on advice, two threshold requirements must be satisfied: (1) The advice must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances, including taking into account the taxpayer’s purpose for entering into a transaction and for structuring a transaction in a particular manner, and is not adequate if the taxpayer fails to disclose a fact that it knows, or should know, to be relevant to the proper tax treatment of an item; and (2) The advice must not be based on unreasonable factual and legal assump-

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tions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person, including a representation or assumption the taxpayer knows, or has reason to know, is unlikely to be true.

“BEST PRACTICES” Another important part of the new Circular 230 is the “best practices.” The IRS expects practitioners to observe these practices to provide clients with the highest quality service. The IRS calls the best practices “aspirational.” Failure to comply does not automatically subject a practitioner to sanctions. However, practitioners expect that those standards will raised the bar generally since they likely will now be used as a benchmark under state-law malpractice actions. What are best practices? New Circular 230 describes what the IRS means by “best practices.” Practitioners are expected to communicate clearly with clients about the terms of the engagement. The IRS gives an example. Practitioners must determine the client’s expected purpose for and use of the advice and they should have a clear understanding with the client about the form and scope of the advice and assistance. Practitioners should establish the facts and determine which facts are relevant. They should evaluate the reasonableness of any assumptions or representations and relate the applicable law to the relevant facts. Potentially applicable judicial doctrines also must be explored. Conclusions must be supported by law and the facts. Practitioners should advise clients about the importance of the conclusions they reach. This would encompass, the IRS explained, advising a

client that he or she may avoid the accuracy-related penalties if the client acts in reliance on the advice. Practitioners are expected to act fairly and with integrity when practicing before the IRS. Supervisors Practitioners with supervisory authority have additional responsibility. They should take reasonable steps to ensure that their firm’s procedures comply with Circular 230’s best practices guidelines.

”OTHER” CIRCULAR 230 REQUIREMENTS While “covered opinions” and “best practices” clearly hold the current spotlight, the IRS Office of Professional Responsibility (OPR) is reminding practitioners that there is a lot more to Circular 230 and that practitioners will be held to all the rules. A summary of these rules includes the following highpoints: Who may practice? The ability to practice before the IRS is limited to attorneys, CPAs, enrolled agents and enrolled actuaries. CPAs, attorneys and enrolled actuaries must submit a written declaration that they are licensed and authorized to represent a designated party. Certain government employees cannot practice before the IRS including federal employees and officers, members of Congress, officers and employees of the District of Columbia, and state officers and employees that handle tax matters for the state government.

The IRS is considering extending the privilege to practice before it to another group of professionals: public accountants. Currently only, public accountants in three states, Pennsylvania, New Jersey and Rhode Island, can practice before the IRS.

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Maintaining active status. After being granted active enrollment, each individual must have their enrollment renewed. The deadline for enrollment renewal depends on the date of the individuals’ initial enrollment and the last number of the individuals’ Social Security number or Tax Identification Number. To qualify for renewal, a practitioner must satisfy continuing professional education requirements. Currently, 16 hours of credits must be completed each year, however for renewals after April 1, 2007, 72 hours of credits must be completed every three years with a minimum of 16 credits completed each of the three years. Practitioners must keep records of their credit hours for three years after the date that their enrollment was renewed. Failure to meet these requirements or to file a timely application for renewal will result in a practitioner being placed inactive status. An individual on inactive status is ineligible to practice before the IRS. Due diligence A practitioner is required to exercise due diligence when preparing, approving and filing tax returns, documents, affidavits, and other papers to the IRS. In addition, due diligence must be exercised when determining whether oral or written representations to the Treasury or IRS are correct. Reliance on the work product of another creates a presumption of due diligence if the practitioner used reasonable care in engaging, supervising, training and evaluating the person. Knowledge of client’s omission. Circular 230 covers situations involving practitioners with knowledge that a client has committed a violation of the Tax Code or has omitted or failed to provide information in a return or document sub-

mitted to the IRS. In such a case, the practitioner has a duty to advise the client of the presence and consequences of the noncompliance, omission or error. However, Circular 230 does not indicate that the practitioner must inform OPR or the IRS of the taxpayer’s noncompliance, omission or error. Information to be furnished. A practitioner must submit any information or documents requested by an agent of the IRS unless the practitioner believes in good faith and on reasonable grounds that the material is privileged. If the requested material is not in the hands of the practitioner or the practitioner’s client, the practitioner must notify the IRS. The practitioner must also provide the IRS agent with information on who the practitioner believes may have possession of the documents or information. The practitioner is required to make a reasonable inquiry of the client regarding the whereabouts of the material. The practitioner is not required to independently verify the information supplied by the client or ask persons other than the client about the whereabouts of the documents or information. Violations of Circular 230. A practitioner must reveal any information regarding a violation of Circular 230 when requested by the OPR director unless the practitioner believes in good faith and on reasonable grounds that the information is privileged. Interference. Circular 230 also forbids any practitioner from interfering or attempting to interfere with a proper and lawful effort by the IRS or OPR to obtain documents or information unless practitioner believes that the information is privileged. In addition, a practitioner must not unreasonably delay the prompt disposition of any IRS matter. Fees A practitioner may not charge a client an “unconscionable fee” for representation before the IRS. Since Circular

230 does not elaborate on the definition of unconscionable, practitioners are left on their own to determine if a fee is unconscionable. Charging clients contingent fees for providing tax advice is limited by Circular 230. A contingency fee is defined as a fee arrangement in which a practitioner will reimburse a client’s fee if a position taken on a tax return or other filing is challenged or sustained by the IRS. A contingency fee arrangement for preparing an original tax return or for advice in connection with a position relating to an original tax return is prohibited under Circular 230. However, a contingency fee may be charged for advice regarding an amended tax return or a claim for a refund if the practitioner reasonably anticipates that the amended return or refund claim will receive substantive review by the IRS. If a practitioner publishes information on fees, the practitioner is bound by the published amounts for at least 30 days after the last publishing date. Conflict of Interest Circular 230 prohibits a practitioner from representing a client before the IRS if the representation involves a conflict of interest. A conflict of interest is present if: Representation of one client will be directly adverse to another client; or A significant risk exists that representation of the client will be materially limited by the practitioner’s responsibilities to others. Even if a conflict of interest exists, the practitioner may still represent a client if three elements are met: The practitioner reasonably believes that the practitioner can provide competent and diligent representation to each client; The representation is not prohibited by law Each affected client given informed, written consent.

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2005 Practice Update Circular 230 requires practitioners to keep the written consents for at least three years from the conclusion of the representation. The practitioner must relinquish these written consents if requested by an agent of the IRS. Return of client records At the request of a client, a practitioner is generally required to promptly return all client records necessary for the client to comply with his or her tax obligations. A dispute between the practitioner and the client does not relieve the practitioner of this obligation. Circular 230 defines client records rather broadly to include nearly all documents in connected with the representation of the client. However, a practitioner may continue to withhold a document if the client has not satisfied its contractual duty to pay fees associated with the document. Advertising The method and manner in which a practitioner may advertise or solicit services is also restricted by Circular 230. Many of these restrictions mirror regulations promulgated by state bar association for attorneys. For instance, a practitioner may not use any false, fraudulent, misleading, deceptive, or coercive statement or form of public communication. A solicitation must identify itself as a solicitation. Practitioners must keep copies of radio and television advertisements for at least three years after the actual transmission. A practitioner is also barred from contacting a prospective client if the prospective client has communicated that they do not wish to be solicited.

ENFORCING CIRCULAR 230 Many practitioners want to know how Circular 230 sanctions and enforcement will be handled. While the IRS published as part of Circular 230 “aspirational best practices” for which non-compliance holds no penalty, all other Circular 230

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sections are mandatory. The penalties for violating Circular 230 are severe. IRS Office of Professional Responsibility The IRS Office of Professional Responsibility (OPR) handles Circular 230 investigations, compliance efforts, education, and sanctions for failing to comply. In the past, IRS enforcement efforts have been stymied by personnel and funding shortages. Now, implementation of the new standards in Circular 230 is one of the IRS’s top four enforcement goals. OPR’s budget has increased and its staff has doubled. OPR Director Cono Namorato recently highlighted OPR’s renewed emphasis on maintaining the highest quality standards of practice. While in the past the bulk of OPR cases had been matters involving personal tax noncompliance by enrolled agents, the focus now has shifted to address tax abuses. Namorato reported that OPR is selecting cases “to leverage a small office of professional responsibility into an effective arm of tax administration.” He cited tax professionals as playing a key role in the abusive transactions of the past ten years. Too often, practitioners knew what was going on in connection with a client’s unreported income and looked the other way or they were active participants in facilitating abusive behavior. While characterizing these practitioners as only a relatively small number, Namorato observed that all practitioners are impacted.

Some practitioners have complained that in the bureaucratic environment of the federal government, an organization, such as OPR, with a budget and little to do will find something to do. In this case, once OPR runs out of egregious tax-shelter related cases, the fear is that it will begin investigating other, more

routine matters, looking for violations of Circular 230. Allegations of misconduct OPR gets allegations of misconduct in two ways: (1) From IRS employees who will make an OPR referral after establishing a pattern of misconduct on the part of the practitioner; or (2) From the general public, including former clients and other practitioners, by way of “good faith letters” pointing to misconduct. A practitioner may not learn about an accusation against him or her, depending on the seriousness of the claim, and whether any action is taken. If action is taken against the practitioner, of course, a series of events is set into motion. Because the IRS has the authority to censure, suspend or disbar from practice before the IRS any practitioner who willfully, recklessly or through gross negligence violates Circular 230, the standards for fact-finding are strict. Steps in the process When the IRS receives either an oral or written statement from an IRS employee or third party alleging misconduct, after an initial examination, if it seems as though a violation has indeed occurred, a written report is “promptly” made to OPR. Upon receipt of the report, OPR may do nothing, may issue a reprimand, or may commence proceedings to censure, suspend or disbar a practitioner from practice before the IRS. OPR may call a conference with the practitioner, regardless of whether a disciplinary proceeding has been instituted.

Formal disciplinary proceedings If formal proceedings are brought for discipline, OPR must issue a complaint. The complaint must state with specificity, providing “a clear and concise description” of the actions, facts, and law

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that serve as the basis for the proceeding. It must also name the practitioner and be signed by an OPR representative. During the disciplinary proceeding, the rules of evidence do not apply. Failure to appear at a hearing is considered a waiver of the right to a hearing and a decision may be entered against the absent party by default. The hearing’s decision must include a statement of the findings and conclusions, as well as an explanation for reaching those conclusions. If the sanction sought is censure or suspension of less than six months, the alleging party must show the misconduct by a preponderance of the evidence. By contrast, if the sanction sought is IRS disbarment or suspension of six months or longer, the standard is “clear and convincing evidence” of misconduct. An appeal may be made within 30 days from the date of the decision by either party. Oversight responsibility Part of what makes Circular 230 so troublesome is that a practitioner who actually commits the misconduct may not be the only person on the hook in a disciplinary proceeding. Any practitioner who has as his or her primary responsibility the authority to oversee a firm’s practice of advice concerning federal tax issues “must take reasonable steps to ensure that the firm has adequate procedures in effect for all members, associates, and employees for purposes of complying” with the Circular 230 rules. If the practitioner responsible for the firm’s Circular 230 compliance willfully, recklessly, or with gross negligence fails to do so, or if one or more of the individuals for whom that practitioner is responsible engages in a pattern or practice of misconduct, the oversight practitioner may be sanctioned as well. Additionally, the practitioner with the authority to oversee compliance with Circular 230 may be sanctioned for failing to take prompt action against the noncompliance if he or she knew or

should have known that one or more subordinates engaged in a prohibited act. The reality of this mandate is that firms will have to adopt a procedure for ensuring that everyone in the firm, even individuals not

in the firm’s tax department, complies. This may include, for example, correspondence to a client from a partner in the corporate department passing along a tax conclusion drawn in an intra-firm conversation with a tax partner or associate.

SAMPLE CLIENT LETTER The following letter can be used to inform clients about the Circular 230 and the use of a disclaimer in your communications. Dear Client: The IRS has issued new rules that will affect how we, tax professionals, communicate with you, our client. The rules, which took effect June 21, apply whenever a practitioner provides written advice, including e-mails, faxes, and letters, on tax issues. While the rules are motivated by the government’s well-founded concern with abusive tax shelters, they will apply to advice given on many common and accepted transactions. The rules grew out of the government’s decision to attack the mechanisms used by tax shelter promoters to sell abusive tax shelters. The new rules address the practice of promoters to obtain boiler-plate opinions for tax shelters. Taxpayers engaging in abusive transactions use these types of opinions to escape tax penalties of 20 percent or more, on top of what they owe in taxes, by claiming they “reasonably” and “in good faith” relied on the tax opinion for their belief that the transaction was permissible. In the new IRS rules, clients cannot rely on a tax opinion for protection from penalties unless the practitioner provides a comprehensive opinion that considers and discusses: • All relevant facts and applicable law, • The relationship between the facts and the law, • A conclusion as to the legal consequences of each tax issue, and • The likelihood that the taxpayer will prevail if the IRS challenges the transaction. The new rules apply to tax advice for transactions that have a “significant purpose” of tax avoidance. This standard is vague and uncertain, in large part because the IRS did not want to create any loopholes. Consequently, the new rules may sweep in many routine, non-abusive transactions. The penalties to practitioners can be severe for providing written advice that does not meet these requirements, including disbarment from practice before the IRS. Because of the new rules, the cost of securing a comprehensive opinion will be higher. An alternative to writing an expensive opinion is to include a disclaimer on written advice furnished to the client. This disclaimer will state that the client cannot rely on the opinion for protection from tax penalties. Accordingly, effective June 21, this firm will routinely include the following language in written communications: “This written advice is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.” Even with this legend, there are other penalty defenses to penalties. You will not automatically be penalized if the IRS challenges a transaction. Please be assured that we will continue to act diligently to meet your needs. The use of this legend does not change the quality of our service and the advice you have come to expect from us. In appropriate cases, after consultation with you, we will provide a comprehensive opinion that meets the new rules. If you have any questions about this important development, please contact us. Sincerely,

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Count on CCH to provide you with practical and timely resources to help you understand and comply with the new standards in Circular 230.

Order today and put these references to work for you! New Circular 230 Requirements: Compliance Tips and Insights — The new rules resulting from Circular 230 are controversial for many and, in many cases, unclear as to exactly what is the right way to provide tax-planning opinions. CCH is offering a live audio Register Today! seminar June 30th featuring attorney Michael Goller and CPA Harvey Coustan to provide you with the necessary insight to help keep your practice in the safe zone during the early uncertainty that comes with changes like this. To register online using a credit card, go to: krm.com/cch. To register by phone, call customer service at 800-775-7654. For pricing and additional information, go to Tax.CCHGroup.com/230. Live Audio Conference June 30th

Reflects Recent Legislation

Tax Shelter Alert Newsletter — The most controversial provisions in new Circular 230 deal with tax shelter-type opinions. CCH’s Tax Shelter Alert Newsletter will provide ongoing coverage of these changes and what you need to do to stay compliant. One-Year Subscription Price: $497.00. Publishes: Monthly. Offer #: 16738001 Click here to order.

Reflects Recent Legislation

Journal of Tax Practice and Procedure — The penalties for violating Circular 230 are severe. CCH’s Journal of Tax Practice and Procedure will bring you the latest information on how Circular 230 sanctions and enforcement will be handled. Edited by Claudia Hill, EA, ATA, MBA, the Journal offers regular columns and feature articles written by experienced tax practitioners. One-Year Subscription Price: $225.00. Publishes: bi-monthly. Offer #: 11593001 Click here to order.

You might also be interested in: Understanding IRS Communications (3rd Edition) — Provides clear explanations that foster a current awareness and comprehension critical for litigation and other dealings with the IRS. Price: $39.50 per copy. Pub.: Nov. 2004, 144 pages. Book #: 05492301 Click here to order.

Federal Taxation: Practice and Procedure (7th Edition) — by Robert E. Meldman, J.D., LL.M. and Richard J. Sideman, J.D., LL.M.— Provides practical information on the day-to-day workings of IRS practice and illustrates important concepts and principles with standardized letters, forms and notices used by the IRS. Price: $115.00 per copy. Pub.: Aug. 2004, 1,000 pages, hardbound. Book #: 04607301 Click here to order.

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