What should a tax director do to obtain tax advice that will provide penalty protection? Recently, the Tax Court, in Canal, laid out a list of things that will cause a taxpayer to lose its penalty protection. Did the Tax Court go too far? Debatable. Nonetheless, the Canal decision raises anew the practical question of what a tax director can do to strengthen the company’s likelihood of successfully showing reasonable cause and good faith in relying on the advice of its outside service providers. In this edition of Tax Advisor Weekly, we look at the statutes, the regulations and some of the more recent case law to provide a roadmap for tax directors seeking the advice of outside advisors.
IRC Section 6664 was added to the Code in 1989. Section 6664(c) provides a defense to the imposition of the accuracy-related penalties of Section 6662 and the fraud penalty of Section 6663. To sustain the defense, a taxpayer has the burden of proof to show that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. Later, in 2004, Congress added Section 6664(d) to provide more specific rules addressing the reasonable cause defense for reportable transaction understatements.
In reviewing corporate cases decided before the listed transaction era of the early 2000s, we found that the reasonable cause and good faith exception inquiry became an examination of a three-part test. For taxpayers to show reasonable cause and good faith, they had to show that:
(1) They provided the return preparer with complete and accurate information;
(2) An incorrect return was a result of the preparer’s mistakes; and
(3) The taxpayers believed in good faith that they were relying on the advice of a competent return preparer.
In several Tax Court memorandum decisions prior to 2001, the Tax Court focused in on whether the taxpayer provided complete and accurate information to its advisor. For example, in United Circuits, Inc. v Commissioner, the court found that the taxpayer did not provide the relevant leasing documents to its return preparer to allow the return preparer to determine the proper tax treatment of such leasing transactions. In each instance, the Tax Court determined that the taxpayers could not have relied in good faith on their advisors because they did not provide the advisors with complete and accurate information.
Further, to determine whether the taxpayers actually believed in good faith that they were relying on the advice of a competent advisor, the courts looked at the sophistication, education and experience of the taxpayers. In Neonatology Associates, P.A. v. Commissioner, the court denied the taxpayers’ good faith reliance argument after finding that the taxpayers were highly educated professionals (doctors) who “should have recognized that it was not likely that by complex manipulation they could obtain large deductions for their corporations and tax free income for themselves.” In Compaq Computer Corp. v. Commissioner, the court found that the taxpayers’ sophistication in investments should have caused them to be skeptical of the transaction and thus denied the taxpayers’ claims that they acted in good faith.
The third prong of the three-part test, described above, has become very important in Son of BOSS and similar listed transaction cases decided in the late 2000s and now. In this group of cases, the courts are applying the traditional three-prong test laid out in United Circuits et al. but also evaluating whether the advice upon which the taxpayer relied came “from a competent and independent advisor unburdened with a conflict of interest and not from promoters of the investment."
Perhaps the most objective test for determining whether the taxpayer can show actual reliance in good faith was set forth recently by the Tax Court in 106 Ltd. v. Commissioner. In that case, the Tax Court provided another three-part test for determining a taxpayer’s actual reliance in good faith. That test looks to three factors to consider:
(1) The taxpayer’s business sophistication and experience;
(2) The quality of the opinion letter; and
(3) Whether the advisors upon whom the reliance is placed are promoters.
The court found it hard to believe the taxpayer didn’t know the transaction was improper, given the taxpayer’s extensive business experience as a founder of American Home Shield, a CEO of several Merrill Lynch subsidiaries and a partner at the world’s largest senior executive placement firm.
The Tax Court in 106 Ltd. v. Commissioner also found that the opinion letter was riddled with mistakes. While acknowledging that the Supreme Court has previously held that a taxpayer need not get a second opinion when relying on the advice of an advisor for penalty protection purposes, the Tax Court noted that the problems with the opinion in the case were too hard to miss, especially for a sophisticated taxpayer. The opinion letter did not accurately describe the transaction in the case, but rather described a generic transaction. Also, the opinion letter relied heavily on representations of the taxpayer. And, as if the heavy use of representations wasn't bad enough, the court found that the representations were not true.
Finally, the Tax Court looked at whether the advisors were promoters. The court adopted the definition of promoter defined in Tigers Eye Trading, LLC v. Commissioner, that is, “an adviser who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.” The court also pointed to another of its decisions, where it defined when an advisor is not a promoter of a transaction. In Countryside Ltd. v. Commissioner the Tax Court found that the following characteristics would indicate that an advisor is not a promoter of a transaction:
• The advisor has a long-term and continual relationship with the client;
• The advisor does not give unsolicited advice regarding the tax shelter;
• The advisor advises only within his or her field of expertise (and not because of regular involvement in the transaction being scrutinized);
• The advisor follows a regular course of conduct in rendering advice; and
• The advisor has no stake in the transaction besides what is billed at his or her regular hourly rate.
Significant to the court in 106 Ltd. v. Commissioner was that the advisors arranged the entire transaction. The advisors set up the structure, issued the opinion letter and coordinated the transaction from start to finish — and did so for numerous clients. Also, the advisors charged a flat fee that would not have been paid if the taxpayer did not decide to go through with the transaction. The court contrasted the advisors' activities as being engaged not to evaluate the deal or to tweak a real business deal to increase its tax advantages, but rather to make the deal happen. For these reasons, the court found the advisors to be promoters, which “take the good faith out of good faith reliance.”
All of the above cases, both shelter and non-shelter, were decided by the Tax Court. The Fifth Circuit and the U.S. District Court for the eastern District of Texas have found that at least one group of taxpayers that engaged in Son of BOSS and BLIPS transactions could rely on the reasonable cause and good faith exception to the Section 6662 penalty. In both Klamath Strategic Investment Fund v. U.S. and NPR Investments, LLC v. U.S., the same law firm partners entered into separate BLIPS and Son of BOSS transactions, respectively. In both cases, the trial courts found that the taxpayers, although attorneys, were not sophisticated in tax matters. They did, however, ask whether the attorney advisors had a conflict of interest. Further, they reviewed the opinion prepared by the attorney advisors with their CPA advisor. The trial courts found that the taxpayers received a quality opinion from the law firm and that it reached objectively reasonable conclusions about the tax implications based on the law as it existed at the time of the transactions.
It is easy to see that the courts addressing the reasonable cause and good faith defense in the recent listed transaction cases are following the requirements set out in Section 6664(d) relating to reportable transaction understatements. It seems, however, that the Tax Court in Canal Corp. v. Commissioner has borrowed from the Son of BOSS case law and Section 6664(d) in evaluating the reasonable cause and good faith claim in the context of a non-reportable transaction case. Perhaps that is the proper approach, considering the myriad of weaknesses the Tax Court found in Canal Corp.’s reliance. The opinion was shoddy, the fee was excessive and contingent on the transaction being implemented, and the advisor was the party that brought the transaction to the taxpayer, wrote the opinion and managed the transaction from start to finish. And the advisor, which also happened to be the taxpayer’s Big 4 audit firm, was found to have a conflict of interest.
What can tax directors take from these cases in determining how to strengthen their reasonable cause and good faith defense to the Section 6662 and 6663 penalties? Clearly, opinions rendered by promoters (“disqualified tax advisors” in Section 6664(d)) of reportable transactions will not provide penalty protection. But Canal seems to extend the disqualified tax advisor inquiry to non-reportable transaction cases. And, perhaps more now than ever, after Canal, a tax director should consider all of the company’s tax positions for penalty exposure as part of the tax provision process.
At a minimum, tax directors should make sure they provide their advisors with accurate and complete information relating to the advice being sought. While tax directors are not required to get second opinions, they should review carefully the facts, representations, analysis and conclusions drawn in any rendered opinion. This step may already be forced on tax directors by their audit firms — whom we hear inform tax directors that they will have to audit, and come to their own independent conclusion, with respect to any advice received by the company from another advisor. Nonetheless, Canal may be reason enough for tax directors to seek advice from an advisor other than their audit firm in order to strengthen the taxpayer’s reliance defense.
Alvarez & Marsal Taxand Says:
Tax directors can still rely on the advice of outside advisors for penalty protection, but several precautions should be followed:
• All relevant facts need to be made available to advisors.
• The advisors’ opinions should be reviewed in depth by the tax director.
• The tax director should steer clear of any advisor for whom a conflict of interest may be present.
• A tax director should re-evaluate any of the positions for which outside advice has been rendered as part of the tax provision process.
Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239), Section 7721(a)
Klamath Strategic Investment Fund v. U.S., 568 F.3d 537, 548 (5th Cir. 2009)
American Jobs Creation Act of 2004 (P.L. 108-357), Section 812(c)(1)
United Circuits, Inc. v. Commissioner, 70 T.C.M. (CCH) 1619 (1995); American Valmar International Ltd.v. Commissioner, 76 T.C.M. (CCH) 911 (1998); G.B. Data Systems Inc. v. Commissioner, TC Memo 2000-29; Reed-Merrill, Inc. v. Commissioner, TC Memo 2000-215; Calypso Music Inc. v. Commissioner, TC Memo 2000-293|
United Circuits, Inc. v. Commissioner, 70 T.C.M. (CCH) 1619 (1995)
Neonatology Associates, P.A. v. Commissioner, 299 F.2d 221, 234 (3rd Cir. 2002)
Compaq Computer Corp. v. Commissioner, 113 T.C. 214 (1999), rev’d on other grounds, 277 F.3d 778 (5th Cir. 2001)
Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006)
106 Ltd. v. Commissioner, 136 T.C. No. 3 (2011)
U.S. v. Boyle, 469 U.S. 241, 251 (1985)
Tigers Eye Trading, LLC v. Commissioner, TC Memo 2009-121
Countryside Ltd. v. Commissioner, 132 T.C. 347, 352-55 (2009)
Klamath Strategic Investment Fund v. U.S., 568 F.3d 537 (5th Cir. 2009)
NPR Investments, LLC v. U.S., 732 F. Supp. 2d 676 (ED, TX 2010)
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