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2004
Index (back)
Report 14
THURSDAY, JANUARY 8, 2004 (CONTINUED)
Reporter: John Warnick Esq.
11:30 a.m. - 12:15 p.m.
Tax Shelters - The Ethical Dilemma
Andrew H. Weinstein
He did not follow the outline but rather provided an overview
of the new tax shelter regulations and the related enforcement
provisions.
The outline materials were only up-to-date through November.
There are significant developments which took place at the
end of December. By January they will have updated materials
which will be made available to all attendees who request
the updated outline by e-mail [to Holland & Knight].
What is the ethical dilemma involving tax shelters? It has
been suggested that there is no ethical dilemma because tax
shelters are unethical per se or there is no ethics in the
marketing of tax shelters.
When he first started looking at tax shelters in the 70's
it was easy to spot a tax shelter. Anyone could look at the
shelters and tell they were bogus. By the 1990's the IRS's
focus was on collection and there were many strategies which
technically didn't appear to be tax shelters. These new transactions
were sophisticated and at least offered the appearance of
being grounded within the code.
Now we all have to worry and what do we do about it?
He doesn't have a magic formula. But it starts with one simple
premise: Please guide yourself appropriately.
The Office of Tax Shelter Analysis ("OTSA")is the
focal point for the IRS' tax shelter compliance initiative.
OTSA is headed by Nicholas J. DeNovio who will join me this
afternoon in the workshop. He is responsible for planning
and coordinating tax shelter initiatives. OTSA generally serves
as a clearing house for information reported to or through
the IRS through taxpayer and promoter disclosures.
In 2001 the IRS announced an anti-tax shelter initiative.
This was focused on disclosure, guidance and perhaps most
importantly increased tax shelter training for agents. This
strategy was supplemented in 2003 with its continuing pursuit
of promoters, targeted audits and litigation against taxpayers
and its offering of settlement initiatives.
Mr. Weinstein noted that a meaningful discussion of whether
the substance of a tax strategy will be respected by the IRS
is beyond the scope of his presentation. He was going to discuss
estate planning considerations, the tax shelter regulations
and the consequences to taxpayers if the tax consequences
of their strategy are not respected. He will also discuss
list maintenance, penalties, and ethics. He will not cover
registration of tax shelters.
What we need to understand is how the substantive law affects
our clients:
1. Will the transaction trigger the tax shelter regulations;
2. Whether the taxpayer's tax position will be respected;
3. The consequences to the taxpayer if his position is not
respected; and
4. Claims of privilege.
Second, we must understand how the substantive law affects
us as advisors
1. Whether our advice on the tax advice of the transaction
is correct;
2. Whether the transaction will trigger obligations for us
as advisors under the tax shelter regulations;
3. Whether we will be subject to penalties under the regulations
or under revised Circular 230; and
4. Claims of privilege.
Third, we must understand our ethical obligations. Tax shelter
rules make our ethical duties more complicated. Especially
if we are called upon to render an opinion.
Mr. Weinstein's hope is that after he has concluded his remarks
that we will understand how the tax shelter regulations affect
us and our clients and we will understand what we must do
and should do to meet these new requirements.
Estate planning considerations
So far the focus of the IRS has been on the identification
and dismantling of tax shelters. Designers and promoters of
tax shelters are looking for uncharted territory. To date
the IRS focus has been on income tax shelters. But logic suggests
that we should see a growing number of transfer tax shelters
promoted to our clients. Promoters will contact us as the
closest advisors to high net worth individuals. They will
present us with products, ideas and concepts and ask us to
introduce them to our clients.
Eventually the IRS focus will reach estate and gift tax matters.
The IRS is estimating that estate and gift tax matters will
be the third highest area of growth for accounting firms.
The IRS focus on transfer tax shelters is in its infancy.
But there are certain abusive trust strategies which the IRS
has identified. The characteristics that the IRS is looking
for include: reduction or elimination of tax; deductions for
personal expenses paid by the trust; depreciation deductions
of an owner's personal residence; stepped-up basis for property
transferred to a trust; reduction or elimination of self-employment
taxes; reduction or elimination of gift and/or estate taxes.
While specific guidance has not been issued by the IRS, Mr.
Weinstein feels we should anticipate the IRS to pay increasing
attention to abusive trust and abusive insurance transactions
which significantly reduce any type of tax.
Estate planners must be aware of what will trigger the tax
shelter regulations.
The current IRS regulations are not triggered by most transfer
tax strategies unless they are substantially similar to listed
transactions or fit into one of the other five categories
of reportable transactions. In the afternoon session we will
be discussing with Nick what "substantial similarity"
means.
What is a tax shelter? "It is a deal done by very smart
people which absent tax considerations would be considered
very stupid." The good tax shelters do have economic
benefits. So those of us who thought that we only had to test
a tax shelter for economic substance, need to realize that
we have to learn how to ride our bikes again.
The final tax shelter regulations were issued in February
2003. Even the application of these regulations depends on
whether a transaction is deemed a reportable transaction.
The substantive merits of the taxpayer's position have nothing
to do with whether the tax shelter regulations apply.
Think of tax shelters not as a definable term but as a concept.
The concept is a transaction that complies with the black
letter of the code but violates the spirit of the code.
For instance , § 6662 (the accuracy related penalties)
defines "tax shelter" as basically any plan which
has tax avoidance as a significant purpose. This could cover
virtually anything the estate planner does.
The tax shelter disclosure regulations do not have a definition
of tax shelter. Rather their application depends on whether
the transaction is a "reportable transaction".
The List Maintenance regulations apply to "abusive tax
shelters", a term which is defined as "confidential
corporate transactions" and "reportable transactions."
Neither of these terms are similar to the definition in §
6662.
Mr. Weinstein strongly suggested you look at the Winter 2002
issue of the Tax Law Review and particularly the article entitled
"Ten Truths About Tax Shelters" by Professor David
Weisback. The following are paraphrased highlights of comments
from Professor Weisback as quoted by Mr. Weinstein in his
talk.
"There is no constitutional right to engage in tax planning"
"The right to minimize taxes is not a basis principle
of moral philosophy".
"Tax planning does not rank with freedom of thought,
speech, association or religion."
"There is no social benefit to tax planning...tax planning
is like polluting because polluters pollute too much."
"Tax advisors do, however, serve a few socially valuable
functions in limited tax planning situations, in adversarial
practice and in compliance."
"Tax planning deserves little or no protection. Disclosure
is not enough. It just increases complexity, eliminates the
tax shelter 'du jour' and makes the law even more unstable."
Treasury issued the final tax shelter regulations in February,
2003. The regulations basically require three things: disclosure
by taxpayers, list maintenance by tax advisors and promoters,
and registration by promoters and sellers. The regulations
are intentionally overbroad.
A tax professional's failure to advise a client on the necessity
of disclosure can have serious consequences. The tax advisor
must be mindful of the fees received in order to comply with
the list maintenance requirements. The tax advisor also needs
to be aware of the limits on privilege. The regulations are
clearly a trap for the unwary.
Disclosure statements (Form 8886) must be filed by taxpayers
who participate in "reportable transactions".
There is a four prong analysis to determine if disclosure
is necessary. (SEE 14-6) The critical date for this analysis
is whether the transaction was entered into on or after February
28, 2003. Reporter's Note: in the materials at footnote 26
citing Treas. Reg. § 1.6011-4(b)(2) Mr. Weinstein offers
this comment: "If a transaction involving estate or gift
tax entered into on or after January 1, 2003 is identified
as a listed transaction in published guidance, the transaction
must be disclosed in the matter described in such published
guidance."
If the answer to all four questions in this analysis is in
the affirmative then the taxpayer must disclose.
Reportable transactions don't have any connection to whether
the transaction has a defensible tax position.
There are six categories of reportable transactions: listed
transactions; confidential transactions; transactions with
contractual protection; loss transactions; transactions with
a significant book-tax difference; and transactions involving
a brief asset holding period. (SEE 14-7)
The IRS is going to give "green light notices"
for transactions which the IRS determines are legitimate.
The IRS is also going to try to give advance notice to taxpayers
of transactions which it considers abusive. "Yellow flag"
notices will be issued when the IRS determines it is likely
to issue guidance in a particular area. "Red light"
notices will be issued for transactions which the IRS considers
abusive tax shelters, and will most likely include these strategies
within the "Listed Transactions" category.
A "Listed transaction" is a transaction which is
the same or substantially similar to one of the types
of transactions that the IRS has determined to be a tax avoidance
transaction and identified by published guidance as a listed
transaction. The most recent comprehensive publication of
the transactions the IRS has identified as "listed transactions"
is Notice 2003-76 which identified 24 transactions. The latest
guidance is Notice 2004-8 dealing with abusive Roth IRA transactions.
The IRS also posts a list on its web
site.
The listed transactions cover a wide variety of fact patterns.
Here is a list of some of these transactions that should be
of particular interest to estate planners: 1) deductions for
contributions to retirement plans; 2) allocation of income
to tax different parties; 3) distributions from charitable
remainder trusts; 4) artificial inflation of outside partnership
basis; 5) Guam trusts; 6) selling corporate assets through
an intermediary; 7) 351 contribution of high basis assets;
8) reinsurance arrangements; and 9) trusts for contested liabilities.
The materials' list is current only through November, 2003.
See 14-7 to 14-11.
The second category of reportable transactions is "confidential
transactions." This has been the subject of considerable
controversy.
Under the original rule there were two situations where the
definition of confidentiality was met: 1) if the taxpayer's
disclosure of the tax treatment was limited in any way or
2) if the taxpayers knows or has reason to know that his use
or disclosure of the information relating to the tax consequences
is limited in any other manner for the benefit of any person
who is making a statement about the potential tax consequences.
Under the original definition standard personal injury settlement
agreements were caught if they contained language regarding
tax effects or treatment of the payments.
Originally it was contemplated there would be a carve out
of specific transactions.
Under the new rules which were issued in December 2003 (and
which are not covered in the materials handed out at Heckerling)
a "confidential transaction" is defined as a transaction
offered to a taxpayer under conditions of confidentiality
where the taxpayer has paid a minimum fee to an advisor. Conditions
of confidentiality exist only when the advisor who receives
the minimum fee imposes the limitation on disclosure to protect
the advisor's tax strategies. The fact that the confidentiality
is not legally binding on the taxpayer is not relevant. The
new definition significantly narrows the breadth of the definition
and should narrow the concern over the scope of this rule.
.
Mr. Weinstein skipped the discussion of the last four categories
of reportable transactions as they are adequately covered
in the outline in order to focus on disclosure which he feels
is very important.
What are the consequences of a taxpayer entering into a reportable
transaction? The taxpayer must file a disclosure statement
on Form 8886 to his tax return. The taxpayer must retain copies
of all documents relating to the transaction until the expiration
of the statute of limitations. If a transaction the taxpayer
has entered into becomes a listed transaction after the taxpayer
entered into the transaction, then the taxpayer must file
a disclosure statement to his next tax return if the statute
of limitations for the listed transaction has not yet expired.
If you are unsure, file a protective disclosure statement.
Failing to disclose significantly increases the likelihood
of penalties. Failure to disclose is a strong demonstration
of a lack of good faith on the part of the taxpayer.
Disclosure may prompt some type of activity by the IRS such
as audit. At this point we don't know exactly what type of
IRS activity will occur upon disclosure as the regulations
are new. Clients should expect the worst.
How should we advise our clients. Look to the proposed revisions
to Circular 230. These are very important. As a tax advisor
you should complete a substantive analysis of the tax consequences
of the transaction. You should feel comfortable advising them
on the substantive merits of the transaction.
The guidance issued by the IRS may serve as authority to
invalidate the tax treatment.
The failure to disclose a reportable transaction significantly
increases a taxpayer's penalty exposure. § 6662 imposes
the accuracy related penalties. Substantial authority for
the tax position is usually a defense to the accuracy related
penalties. The taxpayer must have a reasonable believe that
the tax treatment is "more likely than not".
Even in the case of a tax shelter, the understatement penalty
is generally avoid when the taxpayer can demonstrate that
there was reasonable cause for the underpayment and that he
acted in good faith. Reasonable cause exists when a taxpayer
reasonably and in good faith relies on an opinion basis on
a professional tax advisor's analysis of the relevant law
and facts if the advisor unambiguously concludes that there
is a greater than 50% likelihood (the more likely than not
standard) that the treatment of the item will be sustained
by the IRS.
Under the rules proposed on December 29, 2003, a taxpayer's
failure to disclose is a strong indication that the taxpayer
failed to act in good faith. Thus the failure to disclose
would generally make the taxpayer ineligible for the reasonable
cause exception to the imposition of penalties.
Taxpayers should construe the regulations broadly in favor
of disclosure.
In its release of the new rules the IRS has announced it
will not accept, as evidence of good faith or reasonable cause,
reliance on a tax shelter opinion from a tax adviser with
a financial interest in the tax shelter or a pre-existing
referral agreement with the tax shelter promoter.
Taxpayers engaging in reportable transactions may find themselves
facing the fraud penalty and this would be especially so in
the context of listed transactions. Mr. Weinstein mentions
this by way of future caution because he has seen references
to penalties up to 75% and that is the fraud penalty.
List Maintenance rules apply to advisors and promoters -
have limited application because of the level of fees that
must be received. The rules are discussed in detail in the
outline. The fee threshold for advice provided to a non-corporate
taxpayer is $50,000 but it is reduced to $10,000 in the case
of a listed transaction. All fees for services or advice,
whether or not tax advise, in the implementation of the transaction
are taken into account. Failure to comply with the List Maintenance
rules gives rise to penalties of up to $100,000 per year.
It is recommended that advisors who are subject to List Maintenance
requirements fairly and openly advise their clients of this
requirement prior to the client entering into the transaction.
That warning must include details on what information will
be on the list and that it must be given to the IRS upon request,
and that if given to the IRS the client should expect an inquiry
or audit from the IRS.
Privilege and Work Product Claims. We need to be honest with
our clients and bring their expectations of privacy down to
the new reality we face as a result of the expansion of the
IRS summons power. For now we should assume the identity of
a client participating in a tax shelter is not privileged.
We need to proceed with caution until the privilege and the
work product claims are resolved. We need to be honest with
our clients and bring their expectations down to reality.
This will reduce countless client conflicts down the line
and once clients know what to expect they can act within those
parameters. This will no doubt make our malpractice carriers
happy as well.
Mr. Weinstein closed with a discussion of the ethical considerations.
Circular 230 contains guidelines that an advisor must follow
in practice before the IRS. It is obvious that the IRS is
going in a certain direction and that is to beef up the best
practices it expects from advisors representing taxpayers
before it. It mandates disclosure of an advisor's referral
agreement or financial interest in the transaction. Disclosure
should also be made to the client that the client may not
rely on the opinion of any non-independent advisor.
Revised Circular 230 adopts the broad definition of tax shelter
contained in § 6662.
We now need to review Circular 230 whenever we are advising
a client with respect to a tax shelter or whenever we are
preparing a tax opinion. Violations of Circular 230 in connection
with tax shelters are punishable by suspension or disbarment
if the violation is reckless, willful or the result of gross
incompetence.
Disciplinary action begins with the referral of professional
misconduct to the Office of Professional Responsibility. The
IRS has significantly beefed up their Office of Professional
Responsibility. It conducts an informal review. Then it notifies
the practitioner and provides the practitioner with an opportunity
to respond to the allegations. If the Office of Professional
Responsibility institutes a formal proceeding for suspension
or disbarment that proceeding takes place before an administrative
law judge, whose opinion can be appealed to the Secretary
of The Treasury and ultimately to Federal District Court.
Mr. Weinstein's advise is to "stay away".
Mr. Weinstein has personally watched through the Standards
of Tax Practice Committee of the American Bar Association
the evolution of the activity involving the IRS' Office of
Professional Responsibility. He feels that we should look
forward to substantial enforcement efforts. Until now IRS
enforcement has been sporadic. That is now going to change.
He then quoted Commissioner Everson's attack on "fast
and loose attorneys" as quoted in David K. Johnston's
article in the December 29, 2003 issue of the New York Times
How do the Model Rules apply to us. We must provide timely
and competent advice. We must learn and understand what transactions
will trigger the tax shelter regulations. It is not an easy
task. The sheer volume and technical difficulty involved in
conducting a tax shelter analysis is something we now must
do. Lawyers are not to assist a client in conduct the attorney
knows is criminal or fraudulent. The commentary to Model Rule
1.2(d) explains that this rule applies whether or not the
defrauded party (i.e., the IRS) is a party to the transaction,
and specifically prohibits a lawyer's participation in a transaction
which results in the criminal or fraudulent avoidance of tax
liabilities.
Mr. Weinstein cautions that we must ask ourselves: 1) does
this rule create an affirmative duty to third parties such
as the IRS? 2) is a lawyer's ability to offer advice that
falls short of being criminal or fraudulent restricted? Is
the fact that the activity is not criminal or fraudulent adequate
support for a favorable tax opinion.
Mr. Weinstein also raises the issue of what are the estate
planning attorney's responsibilities in the context of the
valuation of assets in connection with estate planning transactions.
Can the attorney assist the appraiser? Can the attorney indicate
to the appraiser that the client needs a low appraisal? Should
the attorney recommend an appraiser that he knows will be
more accommodating to the client's wishes?
Model Rule 1.4 explains the requirements for proper communications
with a client. What type of information should a client know
about a tax transaction to make an informed decision? Is the
fact that the client may be required to file a disclosure
statement with his tax return something the client should
be informed of. Mr. Weinstein challenges us to think of what
we consider to be "best practices" with regards
to the level of disclosure to our clients.
As Mr. Weinstein concluded his remarks Thursday morning,
he asked, "is it buyer beware or is it advisor beware?"
******************************
2:00 - 3:30 p.m. - Special Sessions III
Session III-C - Tax Shelters - The Ethical Dilemma
Andrew H. Weinstein
Nicholas J. DeNovio
[Ed. Note: These materials are still in
the process of being prepared. If they become available in
time, they will be sent as part of the Final Report, Report
No. 15]
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