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Following up on our earlier post, Deconstructing Canal Corp. v. Commissioner – Part I, we now examine the second question raised by Judge Kroupa’s opinion. Specifically, where a taxpayer relies on the opinion of an advisor to establish a “reasonable cause and good faith” defense to the imposition of penalties, have the modifications to the penalty preparer rules of Code section 6694 obviated the need for a judicial rule disallowing taxpayer reliance on the opinion of an advisor who has a conflict of interest?
Code section 6664 generally eliminates the imposition of penalties for any portion of an understatement for which the taxpayer has reasonable cause and acts in good faith. To encourage taxpayers to seek independent tax advice in furtherance of their federal tax compliance obligations, the regulations under section 6664 allow a taxpayer's reliance on professional advice to constitute reasonable cause and good faith if "such reliance was reasonable and the taxpayer acted in good faith." Treas. Reg. § 1.6664-4(b)(1), (c).
Courts, however, have limited taxpayers’ ability to rely on the opinion of an advisor where the advisor had a conflict of interest (e.g., a fee dependent on the execution of the transaction) that, in the courts’ view, prevents the advisor from rendering impartial advice. Courts criticize taxpayers’ reliance on advice from conflicted advisors because, in the courts’ view, such advisors have more of an incentive to bless transactions, irrespective of their merits, than to render impartial advice about the correct interpretations of federal tax law.
In the last few years, however Congress has also been concerned about the risks of tax advisors providing overly aggressive interpretations of federal tax law to their clients. Prior to 2007, the so called "tax return preparer" penalty under section 6694(a) imposed a de minimis $250 penalty for overly aggressive advice. The penalty applied only to undisclosed or frivolous positions that the advisor "knew or reasonably should have known" "had no realistic possibility of being sustained on its merits."
Reflecting its concern, Congress strengthened section 6694 in 2007 to discourage what it considered to be the provision of unduly aggressive tax advice. See Pub. L. 110-28, § 8246(b) (2007). The 2007 version of section 6694 penalized any undisclosed position if the advisor did not have a "reasonable belief that the position would more likely than not be sustained on its merits." Disclosed positions were subject to penalty if not supported by a reasonable basis. The amendment also substantially increased the amount of the penalty, putting as much as 50% of the advisor's fee at risk.
The tax bar erupted. See, e.g., Coder and Sheppard, Preparer Penalty Headaches on Full Display at ABA Midyear Meeting, 2008 TNT 15-2 (Jan. 23, 2008). In response, Congress amended section 6694 once again in 2008. See Pub. L. 110-343, § 506(a) (2008). Under the current section 6694 regime, other than in the case of tax shelters, disclosed transactions must be supported by a "reasonable basis" and undisclosed transactions need be supported by "substantial authority." The amount of the penalty remains 50% of the advisor's fee.
Under the provisions of section 6694, a "tax return preparer" can be subject to a penalty of up to 50 percent of the fee earned for advice that is provided in connection with a tax return or claim. Code section 6694(a). If the advisor does not have a “reasonable basis” for the underlying position or, if the position is not disclosed to the IRS, does not have “substantial authority” for the underlying position, the penalty applies. Id. For these purposes, the term "tax return preparer" is given a fairly broad definition and generally includes someone who provides legal advice on which a return position is based. See Michael I. Saltzman, IRS Practice and Procedure ¶ 4.06[a] (2010).
To be sure, the tax year at issue in Canal Corp. predated the amendments to section 6694 by nearly a decade. As a result, the carrot being offered to tax advisors (in Canal Corp., an $800,000 fee) far outweighed the stick being carried by the commissioner (at the time, a $250 penalty). Nevertheless, at least going forward, an important question remains: do the return preparer penalties of section 6694, which are now potentially substantial in magnitude, sufficiently realign the incentives for tax advisors so that the judicial “conflict-of-interest” doctrine need no longer apply?
Both section 6694 and the “conflict-of-interest” doctrine stem from similar concerns – namely, that tax advisors will dispense opinions to clients that adopt overly aggressive interpretations of the law. We believe there are two important reasons why the “conflict-of-interest” doctrine should be laid to rest in light of the strengthened preparer penalties of section 6694.
First, section 6694 addresses the concern by punishing tax advisors, whereas the “conflict-of-interest” doctrine addresses the concern by punishing taxpayers. The underlying rationale of the “reasonable cause” defense to penalties suggests that punishing advisors for issuing unduly aggressive advice is a better mechanism than punishing taxpayers. Consider the following dilemma: a taxpayer seeks advice from an advisor to interpret complex rules (e.g., the consolidated return regulations). If the advisor issues an opinion aggressively interpreting those rules, how is the taxpayer to determine whether its reliance on that advise is itself consistent with a whole other set of complex rules (i.e., the accuracy-related penalty regulations)? See United States v. Boyle, 469 U.S. 241, 251 (1985) ("To require the taxpayer to challenge the attorney, to seek a "second opinion," or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place."). In other words, it makes more sense to place the onus on the reliability of the advice on the person who is already supposed to be most familiar with federal tax law –the advisor.
Second, as suggested above, the goal behind both section 6694 and the “conflict-of-interest” doctrine is to discourage unduly aggressive interpretations of federal tax law. But section 6694 should, in theory, discourage such interpretations irrespective of whether the advisor has a conflict of interest in issuing an opinion. Thus, even if the advisor is receiving a fixed, contingent fee for issuing an opinion (a la Canal Corp.), if the merits of the opinion’s analysis would satisfy the requirements of section 6694, courts should be indifferent to the advisor’s conflict because the desired result – i.e., discouraging unduly aggressive advice – will already have been achieved.
This second rationale is further supported by Congress's 2008 solution to the problem it created in 2007. One of practitioners' primary criticisms of the 2007 amendment was that it created a conflict of interest in advisors against their clients. See, e.g., Brenner, New Standard for Tax Return Positions Is Inappropriate, 2007 TNT 157-31 (Aug. 13, 2007). Under the 2007 amendment, if an advisor thought his position was not more likely than not to be sustained on its merits, he was incentivized to disclose the position to avoid the section 6694 penalty; but his taxpayer-client was incentivized not to disclose because the penalty imposed against him under section 6662 could only apply if the position was found not to be supported by substantial authority.
Congress implicitly recognized the wedge it drove between taxpayers and their advisors by synchronizing the section 6662 and section 6694 penalty standards in 2008. Now, Congress subjects taxpayers and their advisors to the same penal standards with respect to disclosed and undisclosed transactions. Congress has found the appropriate balance between under-penalizing advisors (as it did prior to 2007), and over-penalizing advisors (as it did after the 2007 amendment). In doing so, it has aligned advisors' interests with their clients.
In sum, it seems to us that the strengthened penalty regime of section 6694 may undercut the rationale for Judge Kroupa’s opinion for later tax years. In short, the judicial “conflict-of-interest” doctrine has been precluded by a more fundamental rule – the rule of economic incentives. Congress may wish to adjust those incentives from time to time; and, in light of its apparent willingness to do so, the time has arrived for courts to defer to that legislative prerogative.