Estate Planning and Circular 230

“Circular 230” is the body of federal government regulations which regulate individuals that “practice before” the Internal Revenue Service on tax matters.  By now, many professionals have either adopted firm procedures for dealing with “Circular 230” or have begun to notice Circular 230 “disclaimers” plastered over letters, memos and even emails!  While the prolific use of “Circular 230” disclaimers was not intended by the IRS, they have become a necessary result of the way the IRS implemented these new rules.

Circular 230 is not new.  What is new in the “Circular 230 regime” is the mechanism for enforcement.  As a result of the ENRON and Worldcom scandals, as well as a number of additional tax-related scandals such as “BOSS” and “Son of BOSS”, senior officials of the IRS have indicated that they were concerned by practices of the tax practicing community.  They believe the aggressive steps of taxpayers and their advisors using the “audit lottery” have resulted in loss of public confidence in the self assessing tax structure.

Before “Circular 230”, Congress and the IRS attempted to restrict questionable tax positions by authorizing the IRS to impose penalties on those taxpayers who took positions which were later deemed to be contrary to existing law.  One mechanism for penalty abatement is the taxpayer claim of reliance on competent tax advisor, tax attorney, licensed public accountant or enrolled agent.  A penalty may be abated for “reasonable cause” where they advice is based on all pertinent facts and circumstances, and the law as it relates to those facts and circumstances.  The new Circular 230 regulations attempt to limit instances in which a taxpayer can claim that reliance on a tax expert’s advice amounts to “reasonable cause.”

The unique, new aspect of Circular 230 is the manner in which the government obtains its goal.  Under Circular 230, if a tax practitioner issues a written tax opinion that is based upon unreasonable factual or legal assumptions; unreasonably relied on representations, statements, findings or agreements of the taxpayer or any other person; fails to consider all relevant facts or takes into account the possibility that a return will not be audited; or that an issue will not be raised on audit or that an issue will be settled – the tax practitioner faces sanctions.  The result of this new change in policy is that the tax practitioner now has a vested interest in making certain the information they are relying upon in issuing a written tax opinion is true, correct and fully and completely analyzed.

The breadth of these new rules is not entirely certain.  First, it is not entirely clear what it means to “practice before” the IRS, but has generally been construed to include anyone (attorney, accountant, enrolled agent) that provides any type of tax advice, whether written opinion, recommendation or in tax return preparation.  Clearly, tax attorneys and CPAs were aware that the advice being rendered was “tax advice.”  However, oftentimes, divorce settlements are tax-driven.  Many matrimonial practitioners may be affected by the rule, notwithstanding their ignorance to the provisions.  Moreover, engineers have been competently providing cost analysis for purposes of depreciation.  Would these reports be subject?  Does a life insurance agent who provides recommendations to a client based upon estate tax fall within its purview?

Senior IRS officials have advised practitioners that they should try to adopt a common sense approach when dealing with these regulations, notwithstanding the broad scope of the written words.  Nevertheless, by making these revisions, the IRS will likely inhibit the flow of information from tax practitioners to the public.

In the event of non-compliance with these new rules, a practitioner may be “censured, suspended or disbarred from practice before the IRS” whether such non-compliance is willful or reckless violation of the regulations or due to gross incompetence.  Most tax practitioners are taking these provisions seriously and are notifying their clients in each item of correspondence that, unless otherwise stated, they cannot rely upon the advice for tax penalty protection.

In estate planning practice, many of the transactions recommended are tax-driven.  For example, when a client establishes a Will which sets forth a “Marital Trust/Family Trust”, the provisions are based upon a recommendation concerning the tax treatment.  Thus, to allow a letter to a client to comply with the parameters of Circular 230, the attorney could not write a one or two page letter summarizing the salient points.  Instead, the attorney would need to write a full and detailed analysis with information about the client’s assets, the current state of the law and the application of the law to the facts at hand.

Some people have questioned why it would matter if the advice provided is essentially correct.  Such assumptions regarding the correctness to the position stated can be confused by the manner in which circumstances later change.  Suppose a client establishes an Irrevocable Life Insurance Trust with withdrawal rights to the beneficiaries to qualify for the estate tax “annual exclusion” amount.  This so-called “Crummey Trust” would appear on its face to be well-settled and non-controversial law.  However, suppose the client later funds the Trust with illiquid investments such as stock in a closely-held business.  The “annual exclusion” could be lost on the premise of Hackl v. Commissioner, where gifts of illiquid assets were not treated as “present interest.”  Thus, the practitioner could have violated Circular 230 by not commenting on this aspect at the outset.

The operative provisions of Circular 230 are complicated by reliance on rules which are very sensitive to many defined terms.  However, the tax practitioner must become familiar with the details in order to understand how and when the provisions can apply.

In summary, the recently-revised provisions of Circular 230 have dramatically altered the manner in which practitioners provide tax advice to their clients.  In order for a practitioner to protect himself/herself, a client must be notified in writing that they cannot rely on written advice for protection from tax penalties.  By contrast, to provide a client with written advice upon which they can rely, a full and complete “covered opinion” must be prepared to fully analyze all potential angles.