The Necessity of Tax Opinions

by John Anthony Castro, J.D., LL.M.

Introduction

In a recent 2018 federal court case, a company, Alternative Carbon Resources LLC, was assessed $39 million in penalties despite the fact that the company called the IRS for advice, contacted their local attorney for advice, and even paid for a consultation with a nationally recognized tax attorney. Why would the court uphold $39 million in penalties despite all of the actions taken by the taxpayer in that case? Because the taxpayer did not get a formal tax opinion.[1] Allow us to explain.

The United States Code of Federal Regulations, Title 31, Part 10, regulates the practice of federal tax law before the Internal Revenue Service. Section 10.37 establishes the “requirements for written advice.”[2] In other words, Section 10.37 explains to practitioners how to issue what we in the legal community informally refer to as “Tax Opinions,” which is written legal advice on international and federal tax matters including ancillary state tax matters.

Section 10.37(a) sets the standards, which require an attorney to make reasonable efforts to identify and ascertain facts, reasonably consider all facts they should know, apply law and authorities to the facts, and not take into account the likelihood of examination by the IRS.[3] However, Section 10.37(a) also permits the attorney to make reasonable factual and legal assumptions, reasonably rely on facts, representations, statements, findings, and agreements provided by the client as long as the attorney does not know or should not have reasonably known they were incorrect, incomplete, or inconsistent.[4] In other words, do your job as an attorney, but that doesn’t mean you have to investigate every minor detail and fact. For example, if the client says he is not a U.S. citizen, there is no requirement for an attorney to insist on the production of a birth certificate as well as birth certificates of parents to confirm his citizenship status, especially since that would be a question of law under immigration and nationality laws. An attorney can simply rely on a client’s statement that he or she is not a U.S. citizen; perhaps just verbally ask whether they were born in the U.S. since many are unaware of birthright citizenship in the U.S. You get the point. Be reasonable and diligent; do you job.

It is also important to know the “scope” of the opinion. The “scope” of an opinion letter refers to the level of authority the opinion issuer is providing. In other words, how confident is the practitioner? There are various levels of authority.

A “Will Opinion” means the issuer has absolutely no doubt whatsoever that the legal position would be accepted by both the IRS and any federal judge that reviews the case. A “Should Opinion” generally means that, if contested by the Service, the position advanced has a 70 percent to 85 percent chance of succeeding on the merits. A “More Likely Than Not Opinion” means that, if contested by the Service, the position advanced has a greater than 50 percent chance of succeeding on the merits. A “Substantial Authority Opinion” means that, if contested by the Service, the position advanced has a greater than 35 percent but less than 50 percent chance of succeeding on the merits; in other words, it is not likely to prevail in court. A “Reasonable Basis Opinion” means the issuer is limiting the opinion to the possibility that, if challenged by the Internal Revenue Service, the tax position advanced has a 20 percent to 35 percent chance of succeeding on the merits; in other words, you can take the legal position but it is substantially likely to not be upheld in court.[5]

It is important to note that determining the “chance of success on the merits” is determined by the relative weight of authorities supporting or not supporting the legal position advanced, and this standard is measured objectively by reviewing and applying the pertinent or relevant authorities to the facts at hand.[6]

Why does the IRS seem so concerned with regulating the issuance of tax opinions?

Section 6662 allows the IRS to impose an accuracy-related penalty if the IRS can show that the taxpayer was either negligent or the legal position resulted in a substantial understatement of income tax. Having a formal tax opinion with a mere confidence level of a “reasonable basis” or greater avoids these penalties.

Accuracy-Related Penalty for Negligence

Section 6662(c) defines negligence to include “any failure to make a reasonable attempt to comply” with tax laws.[7] In other words, the only requirement to avoid a finding of negligence is having reasonable basis for taking the legal position. As explained above, reasonable basis is a very easy standard to meet; at least for experienced attorneys with sophisticated legal research tools. Some have quantified the standard to require 20% of legal authorities to support a proffered legal position. Others have theorized that even a legal position with zero legal support but an 11% legal chance of success on the merits has reasonable basis if it is a good faith attempt to change existing law since, if at least one Supreme Court Justice was convinced, that would unquestionably qualify as being reasonable, and, being that there are 9 United States Supreme Court Justices, one-ninth is quantified as 11%.

The reasonable basis standard is not satisfied by a return position that is merely arguable or a colorable claim, and it is a significantly higher standard than “not frivolous” or “not patently improper.”[8] Reasonable basis requires reliance on legal authorities and not on opinions rendered by tax professionals; however, a court may certainly examine the authorities relied upon in a tax opinion to determine if a reasonable basis exists.[9] In other words, it’s the quality and thoroughness of a Tax Opinion that makes it valuable; the audience for the Tax Opinion is the federal judge that would be reviewing the case.[10]

Accuracy-Related Penalty for Substantial Understatement of Tax

Any legal position resulting in a substantial understatement of tax is exempt from the Section 6662 Accuracy-Related Penalty if it was adequately disclosed in the tax return and there is reasonable basis for the legal position.[11] Since we have already exhaustively analyzed reasonable basis above, the key here is “adequate disclosure.”

IRS Form 8275 was specifically created to accomplish adequate disclosure when the legal position a taxpayer is taking is not adequately disclosed elsewhere in the return.

Good-Faith Reasonable Cause Exception

Furthermore, 6664(c)(1) explains that “no penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”

Case law generally sets forth the following three requirements in order for a taxpayer to use “reliance on a tax professional” to avoid liability for a Code section 6662(a) penalty: (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the tax adviser; and (3) the taxpayer actually relied in good faith on the adviser’s advice.[12] Courts have grappled with this issue for decades.[13]

Merely turning matters over to a tax professional without more discussion, however, will not suffice.[14] However, assuming substantive discussion and expert determination, oral advice that no tax liability was incurred[15] or that there was no liability for a return[16] is reasonable cause. There is also no need to get a second opinion.[17] Even an informal opinion from a reputable attorney has been held to be sufficient to avoid the Section 6662 penalty.[18] However, you need to confirm that the tax advisor is disinterested in the matter and not peddling a tax shelter.[19]

Whether reasonable cause exists is a “question of fact decided on a case-by-case basis.”[20] The most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability, judged in light of the taxpayer’s experience, knowledge, and education.[21] The taxpayer bears the burden of demonstrating reasonable cause and that the IRS assessment was incorrect.[22]

Alternative Carbon v. U.S

This brings us to the point of this article. In a recent case from the United States Court of Federal Claims, Alternative Carbon Resources LLC was assessed $39 million in penalties despite the fact that the company called the IRS for advice, contacted their local attorney for advice, and even paid for a consultation with a nationally recognized tax attorney. The federal court concluded that, because the taxpayer did not secure a Tax Opinion for a transaction involving a large sum of money, the taxpayer acted neither reasonably nor in good faith.[23]

This is a warning to all taxpayers. You cannot use free consultations to get informal advice with the hope of relying on that to avoid tax penalties. Securing a formal written Tax Opinion is the only guarantee against tax penalties because that’s the exhaustive process by which we thoroughly analyze all relevant facts and law.

Conclusion

If you think you could benefit from a Tax Opinion, even if it’s for a past transaction that has already been finalized, please contact us to schedule a free consultation by clicking here.


[1] See Alternative Carbon Res., LLC v. U.S., 137 Fed. Cl. 1 (2018).

[2] 31 C.F.R. § 10.37.

[3] 31 C.F.R. § 10.37(a)(2)(i)-(vi).

[4] 31 C.F.R. § 10.37(a)(3).

[5] Reasonable basis is defined in (b)(3) of the regulations as follows: Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in § 1.6662–4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in § 1.6662–4(d)(2). (See § 1.6662–4(d)(3)(ii) for rules with respect to relevance, persuasiveness, subsequent developments, and use of a well-reasoned construction of an applicable statutory provision for purposes of the substantial understatement penalty.) In addition, the reasonable cause and good faith exception in § 1.6664–4 may provide relief from the penalty for negligence or disregard of rules or regulations, even if a return position does not satisfy the reasonable basis standard. Treas. Reg. § 1.6662–3.

[6] See Treas. Reg. § 1.6662-4(d)(3)(iii).

[7] See IRC § 6662(c).

[8] See Pederson v. C.I.R., 105 T.C.M. 1365 (2013). Treas. Reg. § 1.6662-3(b)(3).

[9] See Klamath Strategic Inv. Fund, LLC v. U.S., 472 F. Supp. 2d 885, 901 (E.D. Tex. 2007), aff’d sub nom., 568 F.3d 537 (5th Cir. 2009) (quoting Treas. Reg. § 1.6662-4(d)(3)(iii)).

[10] Thus, even “Reasonable Basis Opinions” are valid and can allow a taxpayer to run the 3-year statute of limitations to lawfully avoid taxation as long as there is adequate disclosure in the return, which will be explained below.

[11] See IRC § 6662(d)(2)(B)(ii)(I)-(II).

[12] See 106 Ltd. v. C.I.R., 684 F.3d 84 (D.C. Cir. 2012) (it is unreasonable to rely on the advice of a tax attorney who was a tax shelter promoter and not independent counsel); Stobie Creek Investments, LLC v. U.S., 82 Fed. Cl. 636, aff’d, 608 F.3d 1366 (Fed. Cir. 2010); Neonatology Associates, P.A. v. C.I.R., 115 T.C. 43 (2000) aff’d, 299 F.3d 221 (3d Cir. 2002) (taxpayers did not establish that they received advice from competent professional who had sufficient expertise to justify reliance); Brown v. C.I.R., 693 F.3d 765 (7th Cir. 2012) (taxpayers did not make reasonable efforts to determine their tax liability and made no effort to research legal basis for their position or to obtain opinion from accountant or tax attorney until IRS challenged their position); Kim v. C.I.R., 679 F.3d 623 (7th Cir. 2012) (taxpayer could not take advantage of “reasonable basis” exception to substantial-understatement penalty, where taxpayer did not show what information he had furnished to his accountant or whether accountant had competently analyzed taxpayer’s situation).

[13] See Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. U.S., 659 F.3d 466 (5th Cir. 2011) (partnership acted with reasonable cause in relying on tax opinions issued by a law firm and an accounting firm; partnership disclosed all pertinent facts to firms and it carried out transactions consistently with their opinions); Romanowski v. C.I.R., T.C. Memo. 2013-55 (2013) (married taxpayers reasonably and in good faith relied on professional advice from tax attorney and return preparer when deducting expenses; preparer advised them expenses were deductible, and preparer was independent and experienced CPA to whom taxpayers provided all requested information); Rawls Trading, L.P. v. C.I.R., T.C. Memo. 2012-340 (2012) (corporate taxpayers relied in good faith on advice of accountant in relation to income tax liability for transactions); Blackwood v. C.I.R., T.C. Memo. 2012-190 (2012) (married taxpayers acted with reasonable cause and in good faith when they excluded from their gross income $100,000 settlement payment that wife received where taxpayers relied on advice of counsel that settlement was excludable from gross income); Ajah v. C.I.R., T.C. Summ. Op. 2010-90 (2010) (non-precedential) (passive rental real estate Code provisions represented complex area and, although one taxpayer was attorney running her own firm, she was not tax attorney and thereby sought guidance and advice and relied upon their accountant’s analysis of the relevant documents and information); Longoria v. C.I.R., T.C. Memo. 2009-162 (2009) (taxpayer acted reasonably and in good faith, relied on advice of CPA in reporting settlement payment as nontaxable income); Perkins v. C.I.R., T.C. Memo. 2008-41 (2008) (court concluded that petitioner demonstrated that she actually relied in good faith on advice of her attorneys and therefore demonstrated reasonable cause and good faith for the underpayment); Mezrah v. C.I.R., T.C. Memo. 2008-123 (2008) (reasonable, good faith reliance on accountant who misclassified passive activity losses as ordinary losses where taxpayers lacked tax background); Klamath Strategic Inv. Fund, LLC v. U.S., 472 F. Supp. 2d 885 (E.D. Tex. 2007) aff’d, 568 F.3d 537 (5th Cir. 2009) (not liable for penalty where there was substantial authority for partnerships to rely on opinions rendered by tax professionals; reasonable cause exception was established by partners’ good faith reliance on the advice of qualified tax attorneys and accountants); Litman v. U.S., 78 Fed. Cl. 90 (Ct. Fed. Cl. 2007) (reasonable cause and good faith reliance on tax advice prevented imposition of negligence penalty on taxpayer); Thrane v. C.I.R., T.C. Memo. 2006-269 (2006) (taxpayer reasonably relied in good faith on tax return preparer’s professional expertise); Smith v. C.I.R., T.C. Memo. 2007-154 (2007) (relied in good faith upon the tax advice given by accountant when self-preparing tax return).

[14] See Broker v. U.S., CIV. A. 00-1930 (E.D. Pa. 2000) (taxpayer showed reasonable cause where he relied on his CPA’s advice that the taxpayer would owe no federal taxes for the year in question, and that he did not need to make any estimated tax payments); also see Estate of Liftin v. U.S., 111 Fed. Cl. 13 (2013) (counsel advised estate’s executor that estate tax return could be filed late without incurring penalty; therefore advice was reasonable cause; however, counsel’s advice that estate could delay filing until it could submit accurate return was not reasonable cause for estate’s delay in filing, and estate’s nine-month delay in filing return without reasonable cause subjected the estate to maximum late-filing penalty). But see Estate of Young v. U.S., 110 A.F.T.R.2d 2012-7065 (D. Mass. 2012) (CPA’s advice that it would be “better” to file late could not excuse its failure to meet a known filing deadline); Russell v. C.I.R., T.C. Memo. 2011-81 (2011) (Court found that taxpayer’s testimony that her advisor advised her to file late tax return after waiting for losses from her husband’s business to be calculated, so as to avoid filing “fraudulent” or “perjurious” return, was not credible, and thus held that taxpayer did not establish reasonable cause based on reliance on such advice).

[15] See Hollingsworth v. C.I.R., 86 T.C. 91 (1986); Furman v. C.I.R., T.C. Memo. 1998-157 (1998) (taxpayers had reasonable cause for failing to file where they relied on advice of attorney that returns were not necessary).

[16] See Estate of Paxton v. C.I.R., 86 T.C. 785 (1986); U.S. v. Red Stripe, Inc., 792 F. Supp. 1338 (E.D.N.Y. 1992); Neptune Mut. Ass’n, Ltd., of Bermuda v. U.S., 13 Cl. Ct. 309 (1987) aff’d in part, vacated in part, 862 F.2d 1546 (Fed. Cir. 1988); Burruss Land & Lumber Co., Inc. v. U.S., 349 F.Supp. 188 (W.D. Va. 1972); McMahan v. C.I.R., 114 F.3d 366 (2d Cir. 1997).

[17] See U.S. v. Boyle, 469 U.S. 241 (1985); Thomas v. C.I.R., T.C. Memo. 2001-225 (2001).

[18] See C.I.R. v. American Ass’n of Engineers Employment, 204 F.2d 19 (7th Cir. 1953).

[19] See Van Dyke v. C.I.R., T.C. Memo. 1983-190 (1983); also see New Phoenix Sunrise Corp. v. C.I.R., 132 T.C. 161 (2009) aff’d, 408 Fed. Appx. 908 (6th Cir. 2010) (obtaining a written tax opinion from a well-respected law firm that developed and was marketing a transactions did not amount to reasonable cause and good faith; attorneys were promoters rather than independent counsel).

[20] Stobie Creek, 608 F.3d at 1381.

[21] Treas. Reg. § 1.6664–4(b)(1).

[22] U.S. v. Boyle, 469 U.S. 241, 245 (1985); Conway v. U.S., 326 F.3d 1268, 1278 (Fed. Cir. 2003).

[23] See Alternative Carbon Res., LLC v. U.S., 137 Fed. Cl. 1 (2018).

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