THE TAX LAWYER AS GATEKEEPER...the tax lawyer’s primary role is, and should remain, that of an advisor (or in the case of an adversarial proceeding, an advocate), the tax lawyer

THE TAX LAWYER AS GATEKEEPER

Rachelle Holmes Perkins, George Mason University School of Law

University of Louisville Law Review, Vol. 49, No. 2, pp. 185-230, 2010

George Mason University Law and Economics Research Paper Series

14-39

This paper is available on the Social Science Research Network at http://ssrn.com/abstract=2488663

185


Rachelle Y. Holmes

TABLE OF CONTENTS

I. INTRODUCTION ........................................................................... 187

II. THE TAX LAWYER AS GATEKEEPER ........................................... 190

A. What Is a Gatekeeper?....................................................................190

B. The Case for Tax Lawyers as Gatekeepers ........................................192

1. Why Does the Current System Fail? .................................192

a. Information Asymmetries Between Taxpayers and the IRS ....193

b. Low Audit, Detection and Penalty Rates .............................193

c. Lawyer and Client Reputations Are Not a Sufficient Constraint ...

......................................................................................195

2. Why the Tax Lawyer?........................................................197

3. What About the Tax Lawyer’s Duties to Her Client? .....199

III. THE CURRENT TAX “FENCE” ..................................................... 201

A. Taxpayer Penalties for Underpayments of Tax ..................................202

B. Reliance on Tax Advisors and the Reasonable-Belief Defense ..............204

C. Circular 230 .................................................................................206

D. Standards and Penalties for Preparers of Returns ...............................207

E. List-Maintenance Requirements for Tax Advisors ..............................208

IV. BUILDING THE TAX GATE........................................................... 209

A. When Should the Gate Come Down? A Standard for Tax Legality .....210

1. Mixed Messages from the Government and the Bar .......210

2. “More-Likely-Than-Not” as the Standard for Tax Legality.

................................................................................... 212

a. Purported Difficulties in Reaching the 50% Threshold .........212

b. The Tax Return as an Adversarial Document......................215

186 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 49:185

c. Conformance with Accounting Standards for Reporting Tax

Positions.................................................................................217

B. Where Should the Gate Come Down? ...............................................220

1. The Opinion .......................................................................221

2. The Return .........................................................................223

V. REINFORCING THE GATE ............................................................ 225

A. Limiting the Ability To Shop for Compliant Advisors .........................226

B. Reestablishing the Privilege..............................................................227

V. CONCLUSION ............................................................................... 229

2010] THE TAX LAWYER AS GATEKEEPER 187


Rachelle Y. Holmes∗

I. INTRODUCTION

Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic

duty to increase one’s taxes.1 -Judge Learned Hand

Judge Hand’s often-quoted statement serves as a mantra to the most clever and sophisticated taxpayers and tax advisors who develop increasingly clever transactions designed to take advantage of imperfections in the U.S. tax system. Yet, the line between legitimate tax planning, duly recognized by Judge Hand, and overly aggressive or abusive reporting by taxpayers continues to get pushed. Not surprisingly, the U.S. Treasury, more often than not, ends up the loser in this game of cat and mouse.

While it is the rare person who actually enjoys turning over hard-earned dollars to the U.S. Treasury,2 the U.S. tax system nevertheless plays a critical role in the government, and its success is necessary to ensure that sufficient funding exists for our national security, infrastructure improvements, and government programs. The rise of tax shelters and aggressively structured tax products over the last twenty years has resulted in billions of dollars in lost tax revenue. It is estimated that the U.S. tax gap, which is the amount of revenue the United States estimates it should receive less the amount of revenue it voluntarily and timely collects, tripled over the past two decades and approaches nearly $350 billion annually.3

∗ Assistant Professor of Law, George Mason University School of Law. This Article has benefited greatly from comments by the participants of the Junior Tax Scholars Conference, who provided extraordinarily thoughtful suggestions. I also thank the attendees of the Robert A. Levy Fellows Workshop in Law & Liberty and Caroline Mala Corbin for their helpful feedback. 1 Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935). 2 See David M. Schizer, Enlisting the Tax Bar, 59 TAX L. REV. 331, 341 (2006) (“The tax collector is unlikely to be a hero in a nation founded in a rebellion against British taxes. The rhetoric of limited government and individual initiative is pervasive in U.S. public life.”); cf. Good Morning America (ABC television broadcast Sept. 17, 2009) (featuring interview with Vice President Joe Biden in which he states his view that wealthier citizens have a patriotic duty to pay taxes at higher rates). 3 See James M. Bickley, CRS Updates Report on Proposals To Narrow Tax Gap, 2009 TAX NOTES TODAY 145–


As concerns about tax abuses have escalated, Congress and the Internal Revenue Service (IRS) have employed any number of measures to curtail these troubling trends. Their response tactics have targeted taxpayers and tax advisors alike, and include increasing the penalties applicable to tax shelters,4 strengthening tax-return-preparer liability,5 forcing increased reporting and disclosure,6 and greatly expanding the ethical rules governing tax practice under Treasury Department Circular No. 230 (Circular 230).7

Although the ultimate perpetrator of any tax shelter is the taxpayer, the tax lawyer has been viewed both as an accomplice in the rise of tax shelters and as a tool in the enforcement against them.8 Perhaps because of this dualistic view of the tax lawyer (as a crucial part of both the problem and the solution), enforcement efforts to date have often saddled the tax lawyer with conflicting duties with respect to their clients and the IRS. To be sure, the reality is that tax lawyers, like lawyers in many other disciplines, are often called upon to serve in various capacities during the representation of their clients. Yet, under the current tax regime, it is not unusual for the tax lawyer to play the roles of advisor, advocate, endorser, insurer, engineer, and even adversary.

26 (July 31, 2009) (citing the estimated $345 billion underpayment by taxpayers in 2001 as the latest IRS appraisal of the tax gap). This amount consists of underreporting of tax liability ($285 billion), nonfiling of tax returns ($27 billion), and underpayment of taxes ($33 billion), and is offset by an additional $55 billion obtained through the government’s collection efforts. See id. This underpayment amount represented a little over 17% of the nearly $2,000 billion of total U.S. revenue receipts in 2001. See CBO Examines Budget, Economic Outlook, 2010 TAX NOTES TODAY 17–29, tbl.F-3 (Jan. 1, 2010). 4 See I.R.C. § 6662A (West 2010) (creating a new taxpayer 20% understatement penalty for reportable transactions, increasing to 30% if not disclosed); id. § 6700 (raising the tax-shelter organizer penalty for a false statement from $1,000 to 50% of gross income derived from the activity); id. § 6707 (increasing the penalty for failure to register a tax-shelter transaction from $500 to $50,000 for reportable transactions other than listed transactions and increasing the penalty up to 75% of gross income derived from the activity for listed transactions); id. § 6707A (creating a new taxpayer penalty for failure to disclose a reportable transaction); I.R.C. § 708 (2006) (replacing a $50 penalty for failure to maintain investor lists with a $10,000 per day penalty for failure to turn over these lists upon request from the IRS). 5 See I.R.C. § 6694(a)(1)(A)–(B) (West 2010). 6 See id. § 6111; I.R.C. § 6112 (2006); id. § 6707; id. § 6707A; see also I.R.S. Announcement 2010-9, 2010-7 I.R.B. 408 (Jan. 26, 2010) (announcing plans to develop a new schedule that will require large corporate taxpayers to disclose uncertain tax positions with their tax returns). 7 31 C.F.R. §§ 10.0–10.93 (2010); see, e.g., Regulations Governing Practice Before the Internal Revenue Service, 69 Fed. Reg. 75,839, 75,844 (proposed Dec. 20, 2004) (to be codified at 31 C.F.R. pt. 10); Regulations Governing Practice Before the Internal Revenue Service, 67 Fed. Reg. 48,760, 48,771, 48,774 (proposed July 26, 2002) (to be codified at 31 C.F.R. pt. 10); Notice of Proposed Rulemaking and Notice of Public Hearing, 68 Fed. Reg. 75,186, 75,189–90 (Dec. 30, 2003); Notice of Proposed Rulemaking and Notice of Public Hearing, 66 Fed. Reg. 3,276, 3,294–96 (Jan. 12, 2001); Advanced Notice of Proposed Rulemaking, 65 Fed. Reg. 30,375, 30,375 (May 11, 2000). 8 While tax accountants also provide significant tax preparer functions, this Article will focus on the special role of the tax lawyer. Many of the issues facing tax lawyers, however, face tax accountants as well.


It can be a tricky business wearing all of these hats, particularly when tax lawyers are facing mounting pressures from powerful clients aggressively pushing to minimize their tax liabilities.9 The tension caused by trying to fill all of these roles adequately while pleasing demanding clients is only compounded by the disparate professional guidelines set forth by the tax laws, bar associations, and rules of professional responsibility.

As a result, many difficult questions often arise in the context of a tax lawyer’s representation with which the tax bar and tax regulators must tussle: Should a tax lawyer be able to help minimize her client’s tax liability by creating tax structures that exploit admitted technical deficiencies in the law? How much, if any, information should a tax lawyer be forced to keep on file or turn over to the IRS regarding her client’s involvement in a potentially abusive tax transaction? How much due diligence should a tax lawyer have to perform on her own client before rendering a legal opinion on a client’s tax issues? Should the client have to disclose the tax lawyer’s opinion in order to shield himself against potential penalties?

While the answer to any of these questions can undoubtedly be debated from both sides, they reflect a subset of the perceptible issues regarding conflicting legal duties that many tax lawyers face in their day-to-day practices. In a sense, all of these questions can be readily boiled down to one pivotal inquiry: How much duty and loyalty does the tax lawyer owe to her client versus that which is owed to the IRS and tax system as a whole?

In this Article, I argue that the proper balance can best be achieved by formally installing the tax advisor in a gatekeeper capacity.10 That is, while the tax lawyer’s primary role is, and should remain, that of an advisor (or in the case of an adversarial proceeding, an advocate), the tax lawyer is also properly positioned to provide certain gatekeeping functions, including compliance monitoring and misconduct prevention. Such functions would

9 The pressure on multinational corporations to reduce their tax liabilities has only increased as U.S. corporate statutory rates have become increasingly high relative to peer jurisdictions. Today, the U.S. has the second highest statutory rate among all OECD nations. See Organisation for Economic Co-operation and Development, OECD Tax Database, tbl.II.1, available at http://www.oecd.org/ctp/taxdatabase (scroll down to Section C and follow hyperlink “Basic (nontargeted) corporate income tax rates”) (last visited Sept. 28, 2010); see also TD Bank Call for Lowering of Corporate Tax Rate, 2009 TAX NOTES TODAY 242–75 (Dec. 21, 2009) (noting that aggressive tax planning has mitigated this burden, with the result that U.S.-based multinational corporations are able to achieve comparatively low effective tax rates). 10 Accountants and corporate lawyers have already been installed as gatekeepers for the securities market. See Certification of Management Investment Company Shareholder Reports and Designation of Certified Shareholder Reports as Exchange Act Periodic Reporting Forms; Disclosure Required by Sections 406 and 407 of the Sarbanes–Oxley Act of 2002, Exchange Act Release No. 47,262, Investment Company Act Release No. 25,914, 79 SEC Docket 1448 (Jan. 27, 2003).


be wholly compatible with the long-standing professional responsibility duties of a lawyer. However, under the current applicable tax rules and guidelines, although the tax lawyer is certainly vested with a number of quasi-gatekeeper responsibilities, her duties often either over-effect or under-effect an ideal gatekeeper model. As a result, certain modifications to the present tax regime must be made to realize fully the benefits of the tax lawyer’s gatekeeping capabilities.

Part II of this Article outlines the ideal function of a gatekeeper and establishes when such a position is most ideally instituted. It then argues that the tax lawyer is well positioned to serve in this capacity because of the numerous failures of the tax system and the tax lawyer’s necessary involvement in the taxpayer’s transaction structuring and return processes. Part III provides an overview of the current tax “fence,” which includes Circular 230, the taxpayer-penalty regime, list maintenance and reporting, and the newly introduced tax-return-preparer rules. Together, these regulations often clumsily place, without much deterrence, the tax advisor in quasi-gatekeeping capacities. Parts IV and V outline how the tax lawyer’s gatekeeping role should be implemented and reinforced, including eliminating some of the ineffective and overly adversarial elements of the current system, raising the standards for tax legality and penalty protection between tax lawyers and taxpayers, and augmenting the tax lawyer’s due diligence responsibilities. Part VI concludes.

II. THE TAX LAWYER AS GATEKEEPER

A. What Is a Gatekeeper?

Before analyzing what the tax lawyer’s proper role in gatekeeping should be, it is necessary to understand what a gatekeeper is, what functions a gatekeeper performs, and under what conditions a gatekeeper can best be used. In the seminal article on gatekeeping, Reinier Kraakman defines gatekeepers as “parties who are able to disrupt misconduct by withholding their cooperation from wrongdoers.”11 Thus, when duties are properly

11 Reinier H. Kraakman, Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy, 2 J.L. ECON. & ORG. 53, 53 (1986). Not surprisingly, there are many variations of this basic definition. See, e.g., Assaf Hamdani, Gatekeeper Liability, 77 S. CAL. L. REV. 53, 58 (2003) (defining gatekeepers as “parties who sell a product or provide a service that is necessary for clients wishing to enter a particular market or engage in certain activities”); John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms 12 (Columbia Law Sch. Ctr. for Law and Econ. Studies Working Paper No. 237, 2003), available at http://ssrn.com/abstract=447940 (proposing a more narrow definition of gatekeeper as “a reputational intermediary who provides verification or certification services to investors”).


imposed on gatekeepers, although they are not the primary perpetrators of the misconduct, they are nonetheless able to help prevent it.12

A traditional gatekeeper can prevent misconduct by withholding services or certifications that are necessary for the wrongdoing to succeed—that is the “gate” through which the wrongdoer must pass.13 As part of this dynamic, the gatekeeper can provide helpful compliance monitoring and guidance functions as she works to assist the potential offender through the gate. In other words, gatekeepers are able to disrupt the occurrence of prohibited conduct by “chaperoning” the principal through the process. A gatekeeper, however, should not be confused with a whistleblower. While a gatekeeper may screen, monitor, or withhold assistance, she has no positive duties to “blow the whistle” to enforcement officials about the wrongdoer.14 These affirmative reporting duties against potential wrongdoers go beyond the scope of traditional gatekeeper responsibilities.

Generally, the installation of a gatekeeper is required only if the current set of legal rules and penalties are insufficient to prevent wrongdoing adequately in the applicable market. Direct enforcement is often the cheapest and most effective way to deter wrongdoing and is the quintessential strategy for enforcing legal norms.15 This is particularly true when reputational constraints or other market forces are in place to buttress direct-enforcement efforts sufficiently. Nevertheless, when there are general market failures, and the ability to raise sanctions and penalties to a level high enough to deter misbehavior adequately is not feasible,16 gatekeeping can be an effective complementary strategy. In these cases, effective direct detection and enforcement is too costly or even impossible, and a gatekeeper’s preemptive efforts can provide a valuable function by either stopping or deterring misconduct such that direct enforcement is unnecessary. To be clear, even in ideal gatekeeping situations, it is not expected that all potential misconduct will be eliminated. Rather, the gatekeeper merely augments direct-enforcement efforts by “confin[ing] [the] violators to a smaller subset.”17 A gatekeeper, therefore, should not be viewed as the enforcement solution, but rather as one of any number of tools

12 See Kraakman, supra note 11, at 53. 13 Id. at 54. 14 See id. at 54 n.3. 15 See id. at 56. 16 See infra Part II.B.1.b (suggesting that it may not be practical or feasible for the government to impose large enough penalties for a rational wrongdoer, taking into account the probability of detection, to refrain from the prohibited behavior). 17 Ke Steven Wan, Gatekeeper Liability Versus Regulation of Wrongdoers, 34 OHIO N.U. L. REV. 483, 511 (2008).


that are employed by the direct enforcers in an overall effort to thwart misconduct.

Even if a gatekeeper can be successfully installed to aid in the prevention of misconduct, one should only be used when the benefits of the gatekeeper’s deterrence efforts come at a relatively acceptable cost.18 The social harm prevented through the gatekeeping activities must exceed the costs incurred to establish the gate. These costs not only include the costs incurred by the gatekeeper to man the gate, but also any costs incurred by the primary enforcement agency to keep the gatekeepers induced to perform their gatekeeping responsibilities,19 as well as any incidental harm that would result to the gatekeeper–principal relationship.20 The calculus also should reflect the likelihood that the gatekeeper’s efforts will succeed in preventing the targeted misconduct,21 as well as the likelihood that the efforts will lead to overscreening such that legitimate market transactions will be disrupted.

B. The Case for Tax Lawyers as Gatekeepers

Taking into account the appropriate uses, limitations, and benefits of gatekeepers, the question becomes whether or not tax lawyers should be installed as gatekeepers of the U.S. tax system. In other words, is it proper to regulate taxpayers by regulating tax lawyers? I conclude that the inability of the government to monitor and enforce taxpayer wrongdoing effectively as a singular line of defense, coupled with the intrinsic entrenchment that tax lawyers have within taxpayers’ structuring and filing processes, ideally situate the tax lawyer to provide substantial gatekeeping functions.

1. Why Does the Current System Fail?

To justify formally installing the tax lawyer as a gatekeeper, it is important to analyze the current failures of the U.S. tax-enforcement

18 See Kraakman, supra note 11, at 75 (noting three types of costs that can be incurred by gatekeeper liability: administrative (the costs of “policing gatekeepers”), private (the costs of the “burdens imposed on the transactions between the gatekeepers and the regulatory targets”—i.e., the prospective wrongdoers), and tertiary (the costs of the burdens imposed “on third parties affected by these transactions”)). 19 In certain situations, gatekeepers may have private interests in foiling the wrongdoing such that no additional inducement is necessary for them to perform their gatekeeping services. 20 For instance, to the extent that the tax lawyer has conflicting duties to the IRS, it could undermine, to some extent, the attorney–client relationship. 21 For instance, as discussed in more detail below, wrongdoing will not be thwarted if the actors can easily shop the market for a corrupt gatekeeper. See discussion infra Part V.A.


system. Because direct enforcement is the natural first line of defense, imposing gatekeeping responsibilities on third parties, such as tax lawyers, is necessary only to the extent that there are general system failures that inhibit wrongdoing from being detected or prevented through traditional direct-enforcement methods. Such failures certainly occur within the U.S. tax system. Indeed, low audit and detection rates, combined with inadequate penalties, insufficient reputational constraints, and enormous information asymmetries, leave the IRS at a vast disadvantage in attempts to restrain taxpayers from taking overly aggressive or even abusive positions on their tax returns.

a. Information Asymmetries Between Taxpayers and the IRS

As noted by Justice Jackson, the “United States has a system of taxation by confession.”22 Each year, taxpayers determine the amount of taxes they believe they owe to the U.S. government, file a federal tax return reporting those self-assessed amounts, and then submit any required payments to the U.S. Treasury. Certainly, there are intermediaries and other agents that have their own withholding and/or disclosure duties to the IRS regarding reportable payments that have been made to taxpayers, which serve as a backstop to the self-reporting system.23 Still, taxpayers largely control the flow of information to the IRS. If the taxpayer has critical information that the IRS needs to know, they are typically the only party in the position to provide it. This is particularly problematic because tax results can turn on even the smallest of facts, and accurate complete information is often necessary to calculate a taxpayer’s “true” tax liability.

b. Low Audit, Detection and Penalty Rates

Even if a taxpayer fully discloses all of the relevant facts relating to a questionable tax position on the return, the probability that such a position will be detected by IRS agents is fairly low. From a purely logistical standpoint, the IRS cannot feasibly review the overwhelming majority of the more than 225 million returns it receives annually.24 As a result, audit rates, and ergo opportunities for misconduct detection, are invariably low,

22 United States v. Kahriger, 345 U.S. 22, 36 (1953) (Jackson, J., concurring). 23 See, e.g., I.R.C. § 1441 (2006) (requiring tax to be withheld at source on interest, dividends and other fixed or determinable annual or periodical U.S. source income paid to foreign persons); id. § 3403 (stating that employers are liable for the payment of income tax required to be deducted and withheld from wages paid to an employee); I.R.S. Form 1099 (2010); I.R.S. Form W-2 (2010). 24 See IRS, IRS DATA BOOK, 2009 4 tbl.2 (2010).


leaving taxpayers often happy to play the so called “audit lottery.”25 This is true even with respect to non-de minimis taxpayers. In fact, audit rates average less than 2%.26 The rate of detection, particularly with respect to large business taxpayers, is even lower.

There is a vast resource imbalance between sophisticated taxpayers and the IRS, in terms of both experience and monetary resources. Thus, even if the IRS does audit a taxpayer’s return, the auditors may not have the time or requisite experience to intuit what particular transactions the taxpayer has in fact engaged in, or what areas of the return require more in-depth probing. For example, the typical tax return of a multinational corporate taxpayer can be thousands of pages long.27 Field agents, understandably, may have significant difficulty detecting wrongdoing by the taxpayer. Not only is the sheer volume of information daunting, but questionable tax positions can be hidden among or lumped in with other noncontroversial items.28 Taxpayers even intentionally befuddle the auditors by adding unnecessary steps or elements to their transactions in order to disguise where the “bodies are buried” on the return.29 Moreover, even if the auditor discovers the offending transaction, they are more-likely-than-not going to be unsuccessful in their collection efforts, largely because the government often finds itself understaffed and outwitted.30

When taxpayers are able to rely not only on low detection rates, but also on low government-enforcement success as well, the ex ante calculus of whether or not to enter into an aggressive transaction can heavily favor pushing the envelope as far as possible. This is particularly true when the penalties that would be imposed, even if the questionable transaction is

25 See Alex Raskolnikov, Crime and Punishment in Taxation: Deceit, Deterrence, and the Self-Adjusting Penalty, 106 COLUM. L. REV. 569, 582 (2006). 26 In 2007, the government audited only 1.03% of individual tax returns and only 0.66% of business tax returns. IRS, Fiscal Year 2007 IRS Enforcement and Service Statistics, IRS.GOV, http://www.irs.gov/pub/newsroom/ irs_enforcement_and_service_tables_fy_2007.pdf. 27 See IRS Releases Tax Season Statistics on Business Return Filings, 2007 TAX NOTES TODAY 71-13 (Apr. 11, 2007). 28 See Raskolnikov, supra note 25, at 572. 29 See Schizer, supra note 2, at 335. 30 See id. at 335–36 (“Although the government has enjoyed some successes of late, the reality is that it must settle most of its cases and, when it litigates, it sometimes offers concessions that it should not offer and at times loses cases that it should win. These lost cases have a troubling ripple effect, serving as precedent that aggressive taxpayers in turn use to justify other aggressive transactions. This prospect of adverse precedent is all the more reason for the government to avoid risky litigation, a reality that is not lost on aggressive taxpayers. They know that, even if their transaction is identified on audit, they have a good chance to settle on favorable terms (for example, no penalties) or, if necessary, to litigate with some prospect of success. So why not roll the dice?” (footnotes omitted)).


detected, are markedly low relative to the detection risk. Indeed, given an audit rate of 2%, penalties would need to be increased to an estimated 4,900% in order for the expected value of the taxpayer’s tax benefit to be low enough to deter them from entering into the transaction.31 However, penalties at this level would not be politically feasible or just, as tax penalties should be at least approximately proportionate to the offense which is being penalized.32

c. Lawyer and Client Reputations Are Not a Sufficient Constraint

Even if a system’s detection, enforcement, and penalty rates are otherwise insufficient to deter most wrongdoing, a gatekeeper still may not be necessary to the extent that other external factors exist, such as reputational constraints, which can backstop the direct-enforcement regime. Unfortunately, with respect to the tax system, reputational concerns on the parts of both client and lawyer are insufficient to overcome the patent deficiencies in the tax-enforcement system.

Large corporations and wealthy individuals may certainly care about their public images. However, cheating or defrauding the IRS has not been viewed with the same public repulsion as cheating or defrauding shareholders. For example, while public outrage regarding Enron’s and WorldCom’s fraudulent financial statements could be heard around the world, public outrage regarding the prosecution of tax evasion schemes entered into by Coltec Industries and BB&T Corporation was much less pronounced.33 Even some recently confirmed cabinet members, while facing some public scrutiny over tax matters, were nevertheless able to take office.34 This seemingly incongruous lack of outcry is possibly due to the 31 Dennis Ventry, Cooperative Tax Regulation, 41 CONN. L. REV. 431, 439–40 (2008). 32 Indeed, numerous criticisms have already been raised regarding the IRS’s disproportionate level of penalties, including the stacking of penalties that can now occur when taxpayers are engaged in listed or tax-haven transactions. See Stuart M. Lewis, ABA Tax Section Recommends Overhaul of Tax Penalty Regime, 2009 TAX

NOTES TODAY 75-25 (Apr. 22, 2009). Moreover, in June 2009, Congress asked the IRS to suspend its enforcement of the harsh I.R.C. § 6707A $200,000 strict liability penalty for nondisclosure, believing that it was too punitive and excessive with respect to the small-business owners against whom it was being assessed. See Letter from Douglas Shulman, IRS Comm’r, to John Lewis, Chairman of Subcomm. on Oversight, Comm. on Ways and Means (July 6, 2009), reprinted in Shulman says IRS Will Suspend Collection of High Shelter Penalties, 2009 TAX

NOTES TODAY 128-15 (July 8, 2009). The IRS complied and acknowledged that in many cases the penalty was disproportionate to the tax savings. Id. 33 See generally BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008); Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). 34 Although Tom Daschle, the nominee for Health and Human Services Secretary, and Nancy Killefer, who had been nominated for the newly created post of Chief Performance Officer, ultimately withdrew their nominations, Treasury Secretary Timothy Geithner was still confirmed despite disclosing that he failed to pay


general consensus among Americans that the U.S. tax system is entirely too complex and onerous, and people may empathize with taxpayers’ efforts to reduce their tax liabilities, even when such efforts subvert the law.35 As a result, a taxpayer is much less likely to be concerned about its perceived compliance with the tax laws than they may be with other laws.

From the lawyer’s perspective, reputational concerns are also not a natural constraint in their provision of tax advice to aggressive taxpayers. Poorly drafted statutes contribute to the pressure on tax lawyers; clients want to push the limits of textualist interpretations in order to capitalize on the loopholes that are created. While lawyers may value their reputation among their colleagues in the bar, they ultimately are more concerned about getting repeat business from existing clients or new business from potential clients. In addition to merely providing tax advice to clients engaged in standard business transactions (for example, helping a client structure a merger to qualify for tax-free treatment), many lawyers are also in the more lucrative business of providing opinions that provide penalty-protection to their clients.36

As discussed in more detail below, when taxpayers take positions on their tax returns that are later contested by the IRS on audit, even if they ultimately are responsible for the tax underpayment, penalties will not be assessed to the extent they have received an opinion from counsel that their tax-return position meets the appropriate opinion level (for example, the position has substantial authority or is more-likely-than-not sustainable on the merits).37 If the tax lawyer wants the client to be a repeat customer, then mounting resistance toward the client’s position in any one particular transaction may not be viewed as an economically sensible course of action. The tax lawyer wants to be sure that the client comes to them again for their next opinion.38 The firm structure further encourages tax lawyers to

self-employment Medicare and Social Security taxes while employed as a policy director at the International Monetary Fund from 2001 to 2003. See Obama: ‘I Screwed Up’ in Daschle Withdrawal, MSNBC (Feb. 3, 2009), http://www.msnbc.msn.com/id/28994296. 35 Note, however, that there is a vast difference in public perception regarding industries or tax brackets receiving tax cuts relative to other industries or tax brackets. The institution of a tax break or holiday is much more highly scrutinized by the public and politicians than is actual compliance on the back-end. See, e.g., Obama: Rivals Support of Gas Tax Holiday a ‘Gimmick,’ Political Radar, ABCNEWS.COM http://blogs.abcnews.com/ politicalradar/2008/05/obama-rivals-su.html (May 1, 2008 12:29 EST). 36 Clients have offered tax lawyers upwards of $1 million in total fees for such opinions. See, e.g., Lynnley Browning, Top Tax Lawyer No Longer at a Big Firm, N.Y. TIMES, June 30, 2004, at C1 (discussing large firm charging $900,000 for one opinion letter). 37 See, e.g., I.R.C. § 6662(d)(2)(B)–(C) (West 2010); id. § 6664(d)(3). 38 The expansion of in-house counsel departments in corporations has led to the use of outside counsel primarily for transaction-specific assistance. JOHN C. COFFEE, JR., GATEKEEPERS: THE PROFESSIONS AND

CORPORATE GOVERNANCE 194 (2006). This makes it more likely that the attorney will have to compete with


sign off on transactions because it is often the case that the firm’s corporate department will assist in executing the transactions, resulting in even more legal fees for the firm. If anything, tax lawyers’ reputations among would-be high-end clients may only benefit if they are known as “cooperators” in the penalty-protection-opinion process. Thus, sufficient reputational incentives do not exist to encourage lawyers to proactively prevent misconduct by their clients.39

2. Why the Tax Lawyer?

Even if a gatekeeper should be implemented, why should it be the tax lawyer? Gatekeeping responsibilities are most properly imposed on those who can and will prevent misconduct reliably at a reasonable cost.40 To that end, I believe the tax lawyer is well-positioned to provide efficacious and cost-effective gatekeeping. In particular, because prevention and detection are increasingly difficult for the government to achieve consistently once the return is filed, installing the tax lawyer in a position to ensure the soundness of the taxpayer’s return positions ex ante would decrease the number of issues that the IRS would need to enforce through the audit process. Tax lawyers would perform gatekeeper work within the system to prevent misreporting before it occurs by providing attestation and verification services to the IRS through the opinion and return filing processes.

Despite these purported benefits, will tax lawyers’ gatekeeping come at a price that is too high to justify their involvement? If a lawyer can successfully be used to prevent overly aggressive taxpayers from taking positions on returns that do not have a sufficient legal basis, the social benefits would include greater revenue in the U.S. fisc and increased confidence and sense of fairness in the overall tax system. It would also decrease the deadweight loss generated by the extensive amount of time and resources spent by taxpayers on the front end, and IRS officials on the back

other firms for continued business. Id. 39 See Fred C. Zacharias, Effects of Reputation on the Legal Profession, 65 WASH. & LEE L. REV. 173, 181–82 (2008) (noting that sophisticated clients may in fact seek tax lawyers “who will press their case to the limits”). In-house lawyers have even less incentive to be effective monitors, although they are in a superior position to do so, because their primary objective is to minimize to the greatest extent possible their employers’ tax liabilities and often feel great pressure to do so. See COFFEE, supra note 38, at 95. 40 See Hamdani, supra note 11, at 99 (arguing that “third parties should face liability only if they can (1) detect wrongdoing at a reasonable cost, and (2) prevent clients they know to be wrongdoers from committing misconduct”); Kraakman, supra note 11, at 61.


end, in respective efforts to structure and unwind highly engineered, abusive tax strategies.41

On the other side of the trade-off equation, it is important to consider the costs. As more fully discussed below, I believe that gatekeeping functions can be implemented in a way that would impose no or only marginal incremental costs above those already incurred by taxpayers.42 Nearly all of the monetary costs related to the proposal are already being borne by taxpayers in the ordinary course of their current tax-related compliance and business efforts. Moreover, the costs of legal services will decline for those taxpayers who currently expend extensive resources developing overly aggressive transactions to the extent that they are successfully deterred from doing so by the gatekeeper.43 Even if there were to be an unanticipated increase in compliance costs, in absolute terms, the costs incurred for the lawyer’s gatekeeping should be far outweighed by the reduction in underreported tax liabilities.44

Finally, I believe that the tax lawyer can be given a gatekeeping role that does not unduly hamper the execution of nonabusive, socially desirable business transactions. While it is necessary that any gatekeeping system be effective at deterring the targeted bad behaviors, it is equally important that the gatekeeping system itself not cause frictions that inhibit or prevent nonoffending transactions from occurring.45 As discussed further below, this Article proposes a system in which compliant taxpayers and their advisors should not be deterred from entering into nonabusive transactions for fear of unwittingly triggering penalties or sanctions.46

41 See, e.g., Chris Edwards, Cato Policy Analysis Addresses Corporate Tax ‘Distortions,’ 2003 TAX NOTES TODAY 158-23 (Aug. 15, 2003) (estimating that “[a] typical large corporation spends tens of millions of dollars per year on tax planning and paperwork”). 42 See infra Parts IV, V. 43 In other words, to the extent that the gatekeeping system proposed herein is successful and tax lawyers are effective in preventing would-be offender clients from entering into abusive transactions, would-be offenders will be much less likely to consider these transactions and, consequently, from hiring legal counsel to assist with execution. 44 Underreported tax liabilities are estimated to comprise $285 billion of the estimated $345 billion annual tax gap. Bickley, supra note 3. 45 Hamdani, supra note 11, 73–74 (arguing that overly stringent gatekeeper regimes can deter law-abiding clients from entering into legitimate markets). 46 See infra Part IV.


3. What About the Tax Lawyer’s Duties to Her Client?

In implementing a gatekeeping system involving lawyers, it is necessary to maximize the amount of gatekeeping services that the lawyer can perform without unduly infringing on her loyalty to the client. There could be an unjustifiable cost to inserting the tax lawyer between the taxpayer and the government in a way that would undermine the very nature of the attorney–client relationship.47 As such, even if the tax lawyer can effectively provide monitoring and misconduct-prevention functions at a reasonable cost, it is critical that these gatekeeping duties do not improperly impede on the lawyer’s quintessential ability to serve as advisor and advocate to her client. I believe, however, that a carefully tuned gatekeeping system, which is explored in detail below, can properly balance these potentially conflicting roles.48

A lawyer’s paramount duty is to serve as an advisor to her client. Not only is this a hallmark of legal practice and the backbone of the rules of professional responsibility, but also a duty widely emphasized by both the bar and the tax laws.49 Circular 230, the regulations governing the standards of lawyers practicing before the IRS, implores tax advisors to “provide clients with the highest quality representation . . . by adhering to best practices in providing [tax] advice.”50 As advisor, the tax lawyer should “provide[] a client with an informed understanding of [the client’s] legal rights and obligations and explain[] the practical implications” of his actions.51 Given the overwhelming complexity of the tax regime, it is imperative that tax lawyers be fully able to help their clients comply with the myriad of requirements under the Code and Treasury regulations.52

47 The attorney–client privilege is “the most sacred of all legally recognized privileges, and its preservation is essential to the just and orderly operation of [the] legal system.” United States v. Bauer, 132 F.3d 504, 510 (9th Cir. 1997). 48 See infra Part IV. 49 See 31 C.F.R. § 10.33(a) (2010); MODEL RULES OF PROF’L CONDUCT pmbl. (2008). 50 31 C.F.R. § 10.33(a). 51 MODEL RULES OF PROF’L CONDUCT pmbl. 52 As Willard Taylor notes, the current U.S. tax system is “a cumbersome creation of stupefying complexity” with “rules that lack coherence and often work at cross purposes.” Willard Taylor, Partner, Sullivan & Cromwell, LLP, Presentation at the Meeting of the President’s Advisory Panel on Federal Tax Reform (Mar. 31, 2005), available at http://govinfo.library.unt.edu/taxreformpanel/meetings/meeting-03312005.html; see also Reuven S. Avi-Yonah & Kimberly A. Clausing, Reforming Corporate Taxation in a Global Economy 5 (June 2007), available at http://www.brookings.edu/~/media/Files/rc/papers/2007/06corporatetaxes_clausing/ 200706clausing_aviyonah.pdf (“The U.S. system is also notoriously complex: observers are nearly unanimous in lamenting the heavy compliance burdens and the impracticality of coherent enforcement.”).


Because a lawyer must be fully informed of her client’s actions in order to provide accurate legal advice, the ability of the client to be fully candid with his advisor is of paramount importance. Legal advice that does not take into account the totality of the relevant facts and circumstances regarding a client’s particular situation may prove worthless or even detrimental. This is particularly true in tax law, where even the smallest change in facts can cause entirely divergent tax consequences, such as causing an expenditure to be deductible versus nondeductible, or income to be taxable rather than nontaxable.53 Full and complete openness between client and lawyer is thus essential.

Historically, clients have generally felt comfortable sharing even the most incriminating details of their activities under the cloak of confidence provided by the attorney–client privilege. “The attorney–client privilege is one of the oldest recognized privileges for confidential communications” known to the common law.54 Yet, this privilege, and thus the client’s level of candor with his advisor, is invariably eroded to the extent that rules are put in place that impose affirmative reporting or whistleblowing duties against the client. Such rules are dangerous, not only because they disturb the long-standing bedrock upon which legal practice has been built, but also because they actually undermine the fundamental purpose behind the privilege: to facilitate the lawyer’s ability to promote compliance by clients.55 Even the most well-meaning client, for fear that he may inadvertently trigger a legal landmine, may permanently adopt a “hide the ball” rapport with his advisor in order to avoid any potential lurking reporting duties. In such a situation, a lawyer obviously cannot assist her client in avoiding these landmines to the extent that the client is reticent to share the full scope of his plans and activities.

A gatekeeper can best prevent a client’s potential misconduct by shepherding them through the compliance gate. There is nothing wrong with a lawyer telling her client that a proposed course of conduct may improperly push the boundaries of the law. To the contrary, lawyers are under a duty to advise clients as to both the correct legal course of action and what consequences the client may face for any questionable positions

53 For example, the determination of whether the receipt of funds is an includable advance payment or a nonincludable security is highly fact specific and turns on the nature of the rights and obligations that are assumed when the deposit or payment is made. See Comm’r v. Indianapolis Power & Light Co., 493 U.S. 203, 210 (1990); Treas. Reg. § 1.451-5(a)(1) (as amended in 2001). 54 Swidler & Berlin v. United States, 524 U.S. 399, 403 (1998). 55 See Upjohn Co. v. United States, 449 U.S. 383, 392 (1981) (justifying attorney–client privilege by reference to the need to facilitate lawyers’ ability to promote law compliance by clients).


the client decides to take.56 While a lawyer must have allegiance to her client, she does not have to agree with her client’s aims, and must candidly advise her client of all relevant considerations.57 Thus, a lawyer should not be a mere parrot to her client’s commands, signing off on whatever the client wants to do. Even further, a lawyer should not passively or affirmatively assist the client in any misconduct.58 Accordingly, gatekeeping functions that are geared toward ensuring compliance with the relevant legal rules, including withholding cooperation with respect to misconduct, are consistent with the lawyer’s duties to her client, particularly in the precontroversy phase of representation.

If, however, the lawyer’s representation enters into a controversy stage, she must not merely advise her client, but rather she must be unhindered to serve as a committed advocate for her client to the fullest extent allowable by law. The professional responsibility rules provide that a client is entitled to have a lawyer that is an advocate for the client’s cause.59 In the controversy context, it is clear that the lawyer’s role as advocate prevails. As advocate, a lawyer must zealously assert her client’s position within the confines of the rules of the adversary system.60 Accordingly, I believe that once the representation reaches an adversarial posture, any gatekeeping duties should be restricted. It should be noted, however, that tax lawyers primarily act as transaction engineers and rarely appear in court or have direct contact with litigation.61 Rather, the bulk of their work involves planning, structuring, and compliance work.62

III. THE CURRENT TAX “FENCE”

Before outlining the proposed modifications to the tax-enforcement system, this Article will review the current tax-enforcement regime. In

56 MODEL RULES OF PROF’L CONDUCT R. 1.2, 2.1 (2008). 57 MODEL RULES OF PROF’L CONDUCT R. 1.2(b) (providing that a lawyer’s representation of a client does not constitute an endorsement of the client’s activities); MODEL RULES OF PROF’L CONDUCT R. 2.1 cmt. 1 (“A client is entitled to straightforward advice expressing the lawyer’s honest assessment. Legal advice often involves unpleasant facts and alternatives that a client may be disinclined to confront. . . . [A] lawyer should not be deterred from giving candid advice by the prospect that the advice will be unpalatable to the client.”). 58 MODEL RULES OF PROF’L CONDUCT R. 1.2(d) (“A lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent . . . .”). 59 See MODEL RULES OF PROF’L CONDUCT R. 1.3 cmt. 1 (“A lawyer must also act with commitment and dedication to the interests of the client and with zeal in advocacy upon the client’s behalf.”). 60 MODEL RULES OF PROF’L CONDUCT R. 3.1 cmt. 1 (providing that the lawyer, as advocate, “has a duty to use legal procedure for the fullest benefit of the client’s cause”). 61 COFFEE, supra note 38, at 192. 62 Id.


particular, it is important both to understand the level and manner in which tax advisors are presently inserted into the process and to understand the obligations and penalties that may befall taxpayers and those who advise them if tax liabilities are misreported. In general, taxpayers are primarily liable for underpayments of tax,63 but they are often able to rely on tax advisors in reporting and assessing their tax liabilities so long as their advisors adhere to the applicable standards of practice.64 Tax advisors have also been charged with certain policing duties by being forced to maintain and disclose lists regarding their clients’ involvement in potentially abusive tax transactions.65

A. Taxpayer Penalties for Underpayments of Tax

Taxpayers engaged in nonreportable or non-tax-shelter transactions are generally subject to a 20% accuracy-related penalty on underpayments of tax that are due to negligence or disregard of the rules,66 or to understatements that are “substantial.”67 The penalty increases to 40% if the underpayment is the result of a gross valuation misstatement.68 These penalties, however, generally can be avoided with respect to an undisclosed position if the taxpayer has “substantial authority” or, with respect to a disclosed position, if he has a “reasonable basis.”69

63 See I.R.C. § 6662 (West 2010) (describing situations in which penalties will be assessed on taxpayer understatements). 64 Treas. Reg. § 1.6664-4(b)(1), (c) (as amended in 2003) (stating that a taxpayer may often rely on professional advice to protect the taxpayer from the accuracy-related penalty for negligence or disregard of rules, so long as this reliance is reasonable). See generally discussion infra Part III.B. 65 See I.R.C. §§ 6111–6112 (2006); see also discussion infra Part III.D. 66 I.R.C. § 6662(b)(1). “‘[D]isregard’ includes any careless, reckless, or intentional disregard.” Id. § 6662(c). “‘[N]egligence’ includes any failure to make a reasonable attempt to comply with the provisions of [the Code]” or “to exercise ordinary and reasonable care in the preparation of a tax return.” Id.; Treas. Reg. § 1.6662-3(b)(1) (as amended in 2003). “Negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.” Id. § 1.6662-3(b)(1)(ii). 67 See I.R.C. § 6662(b)(2)–(5). For noncorporate taxpayers, an understatement of income tax is “substantial” for purposes of the accuracy-related penalty if the understatement exceeds the greater of (i) “10 percent of the tax required to be shown on the return for [that year],” or (ii) “$5,000.” Id. § 6662(d)(1)(A). For corporate taxpayers, an understatement is substantial if the amount of the understatement exceeds the lesser of (i) “10 percent of the tax required to be shown on the return for [that tax] year (or, if greater, $10,000),” or (ii) $10 million. Id. § 6662(d)(1)(B). In addition, for underpayments attributable to transactions entered into after March 30, 2010, a 20% penalty applies to an underpayment attributable to “[a]ny disallowance of claimed tax benefits by reason of a transaction lacking economic substance . . . or failing to meet the requirements of any similar rule of law.” Id. § 6662(b)(6). 68 I.R.C. § 6662(h)(1). 69 See I.R.C. § 6662(d)(2)(B). In addition, penalties can be avoided if the taxpayer can show that he acted


Thus, if a taxpayer properly discloses his position, he will not be subject to the accuracy-related penalty so long as he has a “reasonable basis” for his reporting position.70 A taxpayer properly discloses his position if he files a completed Form 8275 or 8275-R with his return.71 These forms require only a bare minimum of factual information with respect to the transaction to be disclosed.72 The position itself need only rise to the level of having a “reasonable basis,” which needs to be “significantly higher than not frivolous or not patently improper,” but does not need to rise to the level of being supported by “substantial authority.” This standard has been interpreted by both the government and the practicing tax bar to equate to a position that has just a 20% chance of prevailing on the merits.73 Accordingly, as long as a taxpayer files a de minimis amount of factual information with his return, he can make his tax payments based on positions that have only a one-in-five chance of being the “correct” position.

If a taxpayer does not disclose his position related to the understatement, then penalties will be assessed if the position cannot be supported by “substantial authority.”74 Substantial authority is established if “the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.”75 This position has been interpreted as requiring a taxpayer to have about a 40% chance of prevailing on the merits.76 Thus, even if a taxpayer’s position is not disclosed on his return, he need not believe that his position will more-likely-than-not prevail if litigated.

A taxpayer will have to reach a higher standard of certainty with respect to his disclosed positions to avoid penalties with respect to his tax understatements if the underlying transactions are “reportable transactions” or “tax shelters.” In these cases, the 20% penalty is not imposed if the position is properly disclosed, is backed by substantial authority, and the

with reasonable cause and in good faith with respect to his underpayment. I.R.C. § 6664(c)(1) (West 2010). The taxpayer has the burden of proof regarding reasonable cause and good faith and this exception is generally geared toward taxpayers having honest misunderstandings of law or who make isolated computational or transcription errors. Treas. Reg. § 1.6664-4(b)(1). 70 See I.R.C. § 6662(d)(2)(B)(ii)(II). 71 See Treas. Reg. § 1.6662-4(f) (as amended in 2003); Rev. Proc. 2010-15, 2010-7 I.R.B. 404. 72 For a summary of new proposed additional disclosure rules relating to uncertain tax positions, see infra notes 174–77 and accompanying text. 73 STAFF OF THE J. COMM. ON TAXATION, 106TH CONG., STUDY OF PRESENT-LAW PENALTY AND

INTEREST PROVISIONS AS REQUIRED BY SECTION 3801 OF THE INTERNAL REVENUE SERV. RESTRUCTURING AND REFORM ACT OF 1998 (INCLUDING PROVISIONS RELATING TO CORPORATE TAX

SHELTERS) 152 tbl.7 (Comm. Print 1999) [hereinafter PENALTY STUDY]. 74 I.R.C. § 6662(d)(2)(B)(i). 75 Treas. Reg. § 1.6662-4(d)(3)(i). 76 See PENALTY STUDY, supra note 73, at 152 tbl.7.


taxpayer reasonably believes that his tax treatment is “more likely than not the proper treatment” (i.e., greater than 50%).77 A “tax shelter” is a partnership, entity, plan, or arrangement “if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.”78 A reportable transaction, which is a transaction of a type that the government “determines as having a potential for tax avoidance or evasion,” also needs to be disclosed to avoid the accuracy-related penalty.79 The disclosure for these targeted transactions is properly made on Form 8886.80 If the disclosure is not provided, the penalty will be raised to 30%,81 and the reasonable-belief defense, discussed below, will not be available.82

B. Reliance on Tax Advisors and the Reasonable-Belief Defense

Both the accuracy-related and substantial-understatement penalties can be avoided if the taxpayer can show that he acted with reasonable cause and in good faith with respect to his underpayment.83 In order for a taxpayer to avoid penalties with respect to a reportable transaction by using a reasonable-cause-and-good-faith defense, however, the taxpayer must also properly disclose the transaction.84 In all cases, the taxpayer has the burden of proof regarding reasonable cause and good faith, and the most important factor is the extent of the taxpayer’s efforts to ascertain his true tax liability.85

In this regard, a taxpayer may rely on professional advice, including an opinion of counsel, to establish that he acted with “reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and

77 I.R.C. § 6664(d)(3)(A)–(C) (West 2010). 78 I.R.C. § 6662(d)(2)(C)(ii). Penalty abatement is only available for noncorporate taxpayers. See Treas. Reg. § 1.6662-4(g)(1). 79 I.R.C. § 6707A(c)(1). This includes “listed transactions” which are reportable transactions that are the same as, or substantially similar to, transactions specifically identified by the government as having tax avoidance purposes. Id. § 6707A(c)(2). 80 Treas. Reg. § 1.6011-4(d) (as amended in 2010) (“The information provided on [Form 8886] must describe the expected tax treatment and all potential tax benefits expected to result from the transaction, describe any tax result protection . . . with respect to the transaction, and identify and describe the transaction in sufficient detail for the IRS to be able to understand the tax structure of the reportable transaction and the identity of all parties involved in the transaction.”). 81 I.R.C. § 6662A(c) (West 2010). 82 See infra Part III.B. 83 I.R.C. § 6664(c)(1). 84 See I.R.C. § 6664(d)(3)(A). 85 See Treas. Reg. § 1.6664-4(b)(1) (as amended in 2003).


the taxpayer acted in good faith.”86 A taxpayer’s reliance on a tax opinion would not be reasonable, for example, to the extent the opinion did not properly take into account all of the taxpayer’s relevant facts and circumstances.87 Indeed, in order to rely on an opinion or advice for penalty-protection purposes, the taxpayer must disclose to the tax advisor all “fact[s] that it knows, or reasonably should know, to be relevant to the proper tax treatment of an item.”88

The ability of taxpayers to use opinions from qualified tax advisors to establish a defense against return penalties creates a critical dynamic in the relationship between tax advisor and taxpayer. Indeed, once a taxpayer client receives a qualifying opinion from tax counsel, he can feel fairly comfortable that the most egregious sanction he will face is merely the return of his purported tax benefits. As a result, the risk–benefit analysis for a taxpayer contemplating an aggressively structured transaction becomes extremely favorable from a tax perspective, so long as he is able to secure an opinion from qualified tax counsel. For example, if a taxpayer has intended tax benefits of $100 million and receives a qualifying opinion that can form a reasonable belief for the taxpayer’s reporting position, then there is no tax-related risk for the taxpayer to enter into the transaction.89 On the upside, the taxpayer’s transaction will be respected, and it will receive $100 million in tax benefits. In the worst-case scenario, the taxpayer’s treatment will be disallowed, and he will have to return the tax benefit to the IRS (with appropriate interest),90 but no additional fees or penalties will be assessed. Thus, even if the risk of detection was fairly high (which in reality it is not) with respect to a questionable transaction, the economic payoff would always suggest that the taxpayer engage in the transaction if he has an opinion supporting the reporting position from a tax advisor.

86 Id. The tax advisor’s opinion may not be relied upon to establish the reasonable belief of a taxpayer, however, if the tax advisor is a disqualified tax advisor. I.R.C. § 6664(d)(4)(B)(i)–(ii) (providing that an advisor is disqualified if it (i) is a “material advisor” or “is compensated . . . by a material advisor,” (ii) has a contingency fee based on the “intended tax benefits” of the transaction at issue, or (iii) “has a disqualifying financial interest” in the transaction). 87 See Treas. Reg. § 1.6664-4(c)(1)(i). 88 Id. The opinion must also not rely on any unreasonable assumptions or the invalidity of a regulation. Id. § 1.6664-4(c)(1)(ii)–(iii); see also I.R.C. § 6664(d)(4)(B)(iii). 89 It is understood that other considerations may dissuade a company from entering into a transaction, even if the risk of penalties is low, such as reputational or accounting reporting concerns. 90 See I.R.C. §§ 6601(a), 6621(a)(2) (2006).


C. Circular 230

Because taxpayers often seek to rely on advice and opinions of tax advisors for purposes of analyzing the treatment of items that will appear on their returns, the IRS has promulgated rules under Circular 230,91 which governs the standards of practice for these practitioners.92 These standards can be enforced through disciplinary actions, including disbarment, suspension or censure, and monetary sanctions.93

First, Circular 230 generally requires a tax practitioner who “knows that the client has not complied with” the tax laws or has “made an error in or omission from any return” or other official document to “advise the client promptly of the fact” of, and consequences related to, “such noncompliance, error, or omission.”94 Second, a tax advisor must not give written advice that:

[(i) is based] upon unreasonable factual or legal assumptions[; (ii)] unreasonably relies on representations, statements, findings or agreements of the taxpayer or any other person[; (iii)] does not consider all relevant facts that the practitioner knows or should know[;] or [(iv)] in evaluating a Federal tax issue, takes into account the possibility that a tax return will not be audited, that an issue will not be raised on audit, or that an issue will be resolved through settlement.95

The tax practitioner has an even higher standard if she is rendering a “covered opinion” to a taxpayer. “Covered opinions” include those that render advice about transactions having a principal purpose of tax avoidance or about transactions having a significant purpose of tax avoidance if the opinion is intended to be used for penalty protection.96 In 91 The rules contained in Circular 230 are codified at 31 C.F.R. §§ 10.0–10.93 (2010). 92 31 C.F.R. § 10.0. These rules are applicable to “attorneys, certified public accountants, enrolled agents, and other persons representing taxpayers [and practicing before] the [IRS].” Id. Practice before IRS includes, but is “not limited to, preparing and filing documents, corresponding and communicating with the [IRS], rendering written advice with respect to any entity, transaction, plan or arrangement, or other plan or arrangement having a potential for tax avoidance or evasion, and representing a client at conferences, hearings and meetings.” 31 C.F.R. § 10.2(a)(4). On the other hand, simply “preparing a tax return, furnishing information at the request of the IRS, or appearing as a witness for the taxpayer is not practice before IRS.” IRS, PUB. NO. 947, PRACTICE BEFORE THE IRS AND POWER OF ATTORNEY (2009). 93 31 C.F.R. § 10.50(a), (c). 94 31 C.F.R. § 10.21. 95 31 C.F.R. § 10.37(a). 96 See 31 C.F.R. § 10.35(b)(2). For purposes of the covered opinion rules generally, “the principal purpose of a partnership or other entity, investment plan or arrangement, or other plan or arrangement is the avoidance or evasion of any tax imposed by the Internal Revenue Code if that purpose exceeds any other purpose.” Id. § 10.35(b)(10).


these cases, the tax advisor has certain due diligence requirements and may not merely assume that a transaction has a business purpose or is potentially profitable apart from the tax benefits.97 The tax advisor also must evaluate and state a “conclusion as to the likelihood that the taxpayer will prevail on the merits” for each significant tax issue,98 as well as provide an “overall conclusion as to the likelihood that the [tax] treatment of the transaction or matter that is the subject of the opinion is the proper treatment.”99 If the advisor is unable to conclude that the taxpayer is more-likely-than-not to prevail on the merits, the opinion must indicate that failure,100 and it must disclose that the opinion cannot be used by the taxpayer for penalty-protection purposes.101

D. Standards and Penalties for Preparers of Returns

Newly revised compliance standards and penalties are also applicable to preparers of tax returns.102 For purposes of these rules, a “return preparer” generally includes a person who prepares a substantial portion of a tax return.103 This definition has been interpreted to encompass not only the signing return preparer but also a nonsigning advisor who gives advice on a completed transaction comprising a substantial portion of a return.104 Accordingly, many tax lawyers providing prefiling advice on significant tax issues to their clients also will be governed by the tax-return-preparer rules.

Under the rules, a tax return preparer will be subject to penalties if she prepares any return or refund claim for which any part of a tax liability understatement is due to an “unreasonable position,” and the preparer

97 31 C.F.R. § 10.35(c)(1)(iii) (“The practitioner must not base the opinion on any unreasonable factual representations, statements or findings of the taxpayer or any other person[, such as a] factual representation that the practitioner knows or should know is incorrect or incomplete. . . . The opinion must identify in a separate section all factual representations, statements or findings of the taxpayer relied on by the practitioner.”). 98 31 C.F.R. § 10.35(c)(3). 99 31 C.F.R. § 10.35(c)(4)(i). 100 Id. 101 31 C.F.R. § 10.35(e)(4). 102 See I.R.C. § 6694(a)(1)(A)–(B) (West 2010). 103 I.R.C. § 7701(a)(36)(A); see also Treas. Reg. § 301.7701-15(b)(3)(i) (as amended in 2009) (“Whether a schedule, entry, or other portion of a return . . . is a substantial portion is determined based upon whether the person knows or reasonably should know that the tax attributable to the . . . portion [or entry] is a substantial portion of the tax required to be shown . . . . [The f]actors to consider in determining whether [it] is a substantial portion include but are not limited to (A) the size and complexity of the item relative to the taxpayer’s gross income; and (B) the size of the understatement attributable to the item compared to the taxpayer’s reported tax liability.”). 104 See Treas. Reg. § 301.7701-15(b)(2).


knew or should have known of the position.105 The standards for “unreasonableness” generally track the standards applicable to the actual taxpayer. Accordingly, undisclosed nonabusive positions must have substantial authority, disclosed nonabusive positions must have a reasonable basis, and reportable and tax-shelter transactions must be more-likely-than-not sustainable on their merits.106 The penalty assessed to the return preparer for each return or claim that is unreasonable is “equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or claim.”107 No preparer penalty will be assessed, however, if considering all the facts and circumstances, there is reasonable cause for the understatement and the preparer acted in good faith.108 “For purposes of demonstrating reasonable cause and good faith, a tax return preparer may rely without verification upon advice and information furnished by the taxpayer and information[, opinions,] and advice furnished by another advisor, another tax return preparer or other party.”109

E. List-Maintenance Requirements for Tax Advisors

Notwithstanding any disclosure or nondisclosure made by the actual taxpayer, each material advisor for a “reportable transaction” is required to file an information return with the IRS “identifying and describing the transaction” and the “potential tax benefits expected to result from the transaction.”110 In addition, a material advisor must keep a list identifying each person for whom the advisor acted as a material advisor for the

105 I.R.C. § 6694(a)(1)–(2). 106 I.R.C. § 6694(a)(2). 107 I.R.C. § 6694(a)(1). Return preparers can be subject to further penalties for reckless, willful, or criminal misconduct. See id. § 6694(b); I.R.C. § 6701 (2006). 108 I.R.C. § 6694(a)(3) (West 2010); Treas. Reg. § 1.6694-2(e) (as amended in 2009). 109 Treas. Reg. § 1.6694-2(e)(5) (“The tax return preparer may rely in good faith on the advice of, or schedules or other documents prepared by, the taxpayer, another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer’s firm), who the tax return preparer had reason to believe was competent to render the advice or other information.”). 110 I.R.C. §§ 6111(a), 6707A(c)(1). There are five conditions which make a transactional reportable: (i) listed transactions that are “the same as or substantially similar to [a] transaction[] that the [IRS] has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance as a listed transaction”; (ii) “a transaction that is offered . . . under conditions of confidentiality”; (iii) a transaction for which the taxpayer has contractual protection against the possibility that “all or part of the intended tax consequences from the transaction [will not] be sustained”; (iv) a “transaction resulting in the taxpayer claiming a loss under” I.R.C. § 165 exceeding certain levels; (v) or “a transaction that is the same as or substantially similar to one of the types of transactions that IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest.” Treas. Reg. § 1.6011-4(b)(7) (as amended in 2010).


transaction, whether or not that transaction must be reported to the IRS.111 As previously discussed above, a “reportable transaction” is any transaction for which information must be included with a return or statement because the transaction is of a type that the IRS has determined as having “a potential for tax avoidance or evasion.”112 A “material advisor” is a person who provides certain assistance or advice with regard to the transaction and receives more than a threshold amount of income.113 The list generally must be maintained for at least seven years, and it must be made available to the IRS for inspection upon request.114 A person required to maintain the list who fails to make it available to the IRS for inspection within 20 business days after it is requested may be liable for a penalty of $10,000 per day.115

IV. BUILDING THE TAX GATE

To be sure, tax lawyers have already been empowered with some gatekeeping authority. The above discussed Circular 230 and new tax-return-preparer penalties already place, albeit clumsily, the tax advisor in monitoring and endorsement roles. As currently constructed, however, the tax advisor’s gatekeeping function is inefficient. In many respects it muddles the roles of the tax lawyer, causes undue client conflicts, and merely serves as an obstacle to the sound and efficient provision of legal advice while failing to deter significant amounts of wrongdoing. The gatekeeping structure proposed herein seeks to maximize the tax lawyer’s gatekeeping capabilities by eliminating some of the ineffective and overly adversarial elements of the system, raising the standards for tax legality and penalty protection between tax lawyers and taxpayers, and augmenting the tax lawyer’s due diligence responsibilities.

111 I.R.C. § 6112(a) (2006). Information required to be included on the list, includes (i) “[t]he name of each reportable transaction”; (ii) “[t]he name, address and [taxpayer identification number] of each person required to be included on the list”; (iii) “[t]he date on which each person required to be included on the list entered into each reportable transaction”; (iv) “[t]he amount invested in each reportable transaction by each person required to be included on the list”; (v) “[a] summary or schedule of the tax treatment that each person is intended or expected to derive from participation in each reportable transaction”; and (vi) “[t]he name of each other material advisor to the transaction.” Treas. Reg. § 301.6112-1(b)(3)(i) (as amended in 2007) . 112 I.R.C. § 6707A(c)(1). 113 See I.R.C. § 6111(b)(1)(A). “[T]he threshold amount is $50,000 [for] a reportable transaction substantially all of the tax benefits from which are provided to natural persons, and $250,000 in any other case.” Id. § 6111(b)(1)(B). 114 See I.R.C. § 6112(b)(1). 115 See I.R.C. § 6708(a)(1) (2006).


A. When Should the Gate Come Down? A Standard for Tax Legality

“[B]efore one can figure out how to promote compliance, one must first determine what conduct will count as compliance.”116 I believe that a fundamental flaw in the U.S. tax system is the mixed message that low penalty levels send in relation to what is purported by the government to be the standard for tax legality. This message is only further muddled by the low standards set forth by the national tax bar. In order to properly install a gatekeeping system, it is imperative that the penalty and bar standards be raised to reflect a singular standard of tax legality. I conclude that this standard is best expressed by requiring reported tax positions to be “more-likely-than-not” sustainable on their merits. Not only will this standard help strengthen compliance through both direct and gatekeeping enforcement methods, but also it will further efforts to eliminate differences in tax and financial-statement reporting.

1. Mixed Messages from the Government and the Bar

Chart A demonstrates the varying levels of confidence that can be required with respect to a taxpayer’s return positions.

Chart A

According to the IRS and the Treasury Department, the true tax

liability of a taxpayer is “the amount of tax that would be determined for

116 Michael Doran, Tax Penalties and Tax Compliance, 46 HARV. J. ON LEGIS. 111, 113 (2009).


the tax year in question if all relevant aspects of the tax law were correctly applied to all of the relevant facts of that taxpayer’s situation.”117 Noncompliance purportedly occurs when the taxpayer does not pay his “true tax liability” voluntarily and timely.118 The government seems to assert that a taxpayer’s tax liability, and ergo the amount that is reported and filed on his tax return, should be based on his best guess at the correct application of the known tax laws to his individual tax situation. Presumably, to be “correct” a position must have at least a greater than 50% chance of being sustained on its merits.

If this is the standard of tax legality, as perceived by the government, then it is difficult to reconcile this “correctness” standard with the standards applicable to taxpayers to avoid penalties on their tax returns. As previously discussed, taxpayers need only show a reasonable basis for a disclosed return position.119 Thus, a taxpayer need only believe that he has a 20% chance of being sustained on the merits in order to avoid penalties.120 Even if the position is not disclosed, the level of confidence need only be 40%, which is still not the position the taxpayer believes to be the correct position.121 Accordingly, under the current penalty regime, a taxpayer is under no duty to report items on his tax return, with or without any additional disclosures, in a manner he believes reflects the proper amount of tax he should pay under the applicable tax rules and regulations.

The ABA Ethics Committee also has set forth relatively low standards regarding the tax lawyer’s advisory duties with respect to her taxpayer client’s reporting positions. In Formal Opinion 85-352, the ABA Ethics Committee states that lawyers “may advise reporting a position on a tax return so long as the lawyer believes in good faith that . . . there is some realistic possibility of success if the matter is litigated.”122 The ABA Ethics Committee justifies this standard on the basis that the “ethical standards governing the conduct of a lawyer in advising a client on positions that can be taken in a tax return are no different from those governing a lawyer’s conduct in advising or taking positions for a client in other civil matters.” 123 117 IRS, U.S. DEP’T OF THE TREASURY, REDUCING THE FEDERAL TAX GAP: A REPORT ON IMPROVING

VOLUNTARY COMPLIANCE 6 (2007) (emphasis added), available at http://www.irs.gov/pub/irs-news/ tax_gap_report_final_080207_linked.pdf. 118 Id. 119 See I.R.C. § 6662(d)(2)(B)(ii)(II) (West 2010); see also supra note 69 and accompanying text. 120 See PENALTY STUDY, supra note 73, at 152 tbl.7. 121 See id.; see also supra text accompanying notes 74–76. 122 ABA Standing Comm. on Ethics and Prof’l Responsibility, Formal Op. 85-352 (1985) [hereinafter Formal Op. 85-352] (emphasis added). 123 Id.


As discussed more fully below, this comparison incorrectly assumes an adversarial nature of a tax return and draws parallels that do not hold up when compared to typical controversy proceedings.124 Rather, in the absence of disclosure, advising the client to report the tax liability that to the best of his knowledge is the correct liability is fully consistent with a lawyer’s ethical duties to her client.125

2. “More-Likely-Than-Not” as the Standard for Tax Legality

Why should a taxpayer report a position on his tax return if he does not believe that it is the “right” position? Under the current tax regime, the answer is: “Because he does not have to!” There are certainly those who do not believe that there is any problem with the current standards for reporting;126 however, I believe that if a position is undisclosed, the taxpayer should base his return position on the amount he believes is more-likely-than-not the correct amount of tax owed. Yet, the standard for undisclosed positions currently only requires a taxpayer to believe he has a two-in-five chance of succeeding on the merits.127 I believe that the bar and tax regulators have clung to standards below the 50% level based on two misguided premises: (i) it is impossible to correctly determine one’s tax liability in all situations; and (ii) the tax return is an adversarial document.

a. Purported Difficulties in Reaching the 50% Threshold

Congress rationalized levying penalties at a standard below the level of correctness to avoid having the understatement penalty triggered for those who endeavor in good faith to fairly self-assess their taxes in situations

124 See discussion infra Part IV.A.2.b. 125 Indeed, the Model Rules generally encourage the lawyer to advise the client on, and make disclosures to third parties on the basis of, accurate statements of fact and law. See, e.g., MODEL RULES OF PROF’L CONDUCT

R. 2.1, 4.1 (2008). 126 See AM. INST. OF CERTIFIED PUB. ACCOUNTANTS, STATEMENT SUBMITTED TO SENATE FINANCE

COMMITTEE, FILING YOUR TAXES: AN OUNCE OF PREVENTION IS WORTH A POUND OF CURE 3 (2007) [hereinafter AM. INST. OF CPAS STATEMENT] (arguing that the higher reporting standard would impose “an unworkable burden for the entire tax system” by prompting excessive disclosure); American Bar Association Section of Taxation Comments on Changes to Standards for Imposition of Certain Penalties, 7 TAXCORE (BNA) No. 222 (Nov. 19, 2007) (discussing increased preference for the substantial authority standard over the more-likely-than-not standard); Letter from Patrick C. Gallagher, Chair, N.Y. State Bar Ass’n Tax Section, to Charles B. Rangel, Chairman, House Comm. on Ways and Means, James McCrery, Ranking Member, House Comm. on Ways and Means, Max S. Baucus, Chairman, Senate Fin. Comm., & Charles E. Grassley, Ranking Member, Senate Fin. Comm. (Jan. 28, 2008), reprinted in 8 TAXCORE (BNA) No. 18 (Jan. 29, 2008) (urging adoption of substantial authority standard rather than more-likely-than-not standard). 127 See PENALTY STUDY, supra note 73, at 152 tbl.7.


where a definitive conclusion may be impossible.128 This concern undoubtedly arises from the fear that given the overwhelming complexity of the U.S. tax laws a more stringent standard will somehow subject innocent filers to unwarranted penalties.129 This concern, though, is misguided.

As an initial matter, “more-likely-than-not” means just that—it is a taxpayer’s best guess as to the probable correct determination of his tax liability. This standard still recognizes that there can be doubt, even considerable doubt (up to 49.9%), regarding the taxpayer’s position. Reasonable cause and good faith exceptions are already in place in the Code as defenses to the understatement penalty.130 This standard undoubtedly could be met if the IRS believed that a taxpayer fell on the opposite side of a close case, and penalties should be waived in these instances. Penalties should only be assessed when a taxpayer is purposely or negligently averting the proper application of the law, not when a taxpayer is doing “the best” he or she can.

This Article is in no way arguing that the tax law is a binary system in which every tax question can be definitely answered with a “yes” or “no” response. Detailed analysis, careful readings, intensive factual assessments, and well-reasoned examinations may all be necessary in order for a taxpayer or his advisor to make a more-likely-than-not determination, and even then the answer may not be entirely clear. Nevertheless, concerns about uncertainty in close cases should not be the justification for lowering the standards for tax legality across the board. Close cases will occur no matter where the legality line is set.

What if a taxpayer is on the fence as to whether or not he should disclose in order to ensure eligibility for penalty protection? Even under the current regime, it can be difficult to determine whether or not a taxpayer has met the substantial-authority threshold for nondisclosure of a tax item. Tax law is complicated, and close cases will arise at any point along the legality spectrum. It is hard to believe that it is any more difficult to assess confidence at 50%, versus the present levels of 40% and 20%. In situations where the stakes are very high, a tax lawyer is trained to engage in rigorous legal analysis and to make difficult legal determinations. Indeed, that is

128 See H.R. REP. NO. 97-760, at 575 (1982). 129 See AM. INST. OF CPAS STATEMENT, supra note 126, at 3–4. 130 See supra Part III.B.


what they are paid to do. If a taxpayer is in a position to hire legal counsel, he will be able to rely on that opinion for purposes of penalty protection.131

Other concerns that have been raised with respect to the more-likely-than-not standard include cases in which novel issues arise for which there is no guidance available and cases in which there are more than two possible tax treatments that could be applicable to a tax item.132 In regards to the former, I believe that the compromise laid out in the regulations applicable to the tax shelter’s more-likely-than-not standard is sound. That is, a position can be treated as more-likely-than-not “sustain[able] on its merits despite the absence of other types of authority if the position is supported by a well-reasoned construction of the applicable statutory provision.”133 In other words, if there is no direct authority on point, it is permissible to take a position based on the taxpayer’s best reasoned guess. In addition, if a taxpayer is particularly concerned about a tax position, a prefiling agreement or ruling can be sought.134

The other concern raised pertains to situations in which the number of potential treatments of a taxpayer’s items is greater than two. Some critics argue that in these cases it could be impossible for the taxpayer to reach a greater than 50% comfort level on any one position.135 I believe that this concern is also overstated. Any payment is an example of a tax item that has more than two potential tax treatments. The payment could be deductible, nondeductible and capitalizable, or nondeductible and

131 See Treas. Reg. § 1.6664-4(b)(1) (as amended in 2003). 132 See, e.g., Harold A. Stamey, Accountants’ Group Comments on Impact of Proposed Preparer Penalty Regs on Small Business Taxpayers, 2008 TAX NOTES TODAY 166-19 (Aug. 26, 2008) (“We believe it will be extremely difficult, if not impossible, to determine the probable correctness of the treatment of some routine items with the degree of certainty required for the higher ‘more-likely-than-not’ standard because there is often little guidance for the tax treatment of an item at the time the item must be reported on a return; and the proper treatment of any item frequently depends on an analysis of unique or unusual facts and circumstances that were not contemplated in published guidance.”); Letter from Neil D. Traubenberg, Tax Executive Inst., to Charles B. Rangel, Chairman, House Comm. on Ways and Means, Dave Camp, Ranking Member, House Comm. on Ways and Means, Max S. Baucus, Chairman, Senate Fin. Comm., & Charles E. Grassley, Ranking Member, Senate Fin. Comm. (Dec. 4, 2009), reprinted in 2009 TAX NOTES TODAY 232–89 (Dec. 7, 2009) (“In many cases, it may be impossible to determine whether a given tax return position has ‘more likely than not’ support until the IRS provides guidance on a new provision.”). 133 Treas. Reg. § 1.6694-2(b)(1) (as amended in 2009). 134 See Rev. Proc. 2009-1, 2009-1 I.R.B. 1 (detailing procedures for requesting an IRS private letter ruling, by which a taxpayer can solicit the IRS’s views on the applicability of the law and the regulations to a transaction he “proposes” to enter); Rev. Proc. 2009-14, 2009-3 I.R.B. 324 (“[A] taxpayer under the jurisdiction of the [IRS’s] Large and Mid-Size Business Division [may] request that the [IRS] examine specific issues relating to [the taxpayer’s] tax return[] before [the] return[ is] filed. . . . A pre-filing examination [can] provide[] the taxpayer with certainty regarding the examined issue [before their return is filed.]”). 135 See sources cited supra note 132.


noncapitalizable. Just because there are three potential tax treatments of a payment, however, in no way means that a taxpayer will be unable to reach a greater than 50% comfort level as to its proper treatment. If a taxpayer makes interest payments on a mortgage on his primary residence, the payments are deductible.136 If a taxpayer makes payments to his teenage son for mowing the lawn, the payments are nondeductible and noncapitalizable.137 Both of these positions easily surpass the 50% confidence threshold even though the universe of possible treatments is greater than two. Again, the more-likely-than-not standard does not require that the position has to be the right position, it only has to be the position that the taxpayer reasonably believes, taking into account all of the relevant circumstances, is more-likely-than-not the right position.

b. The Tax Return as an Adversarial Document

A second assumption underlying the lower tax-reporting standards, particularly as articulated by the ABA Ethics Committee, is the view that the tax return is an adversarial document.138 In justifying the applicable return standard as any position having a reasonable possibility of success (which is interpreted as a 33% likelihood), the Committee notes that:

In many cases a lawyer must realistically anticipate that the filing of the tax return may be the first step in a process that may result in an adversary relationship between the client and the IRS. This normally occurs in situations when a lawyer advises an aggressive position on a tax return, not when the position taken is a safe or conservative one that is unlikely to be challenged by the IRS.139

They then go on to recite Rule 3.1 of the Model Rules, which provides: “A lawyer shall not bring or defend a proceeding, or assert or controvert an issue therein, unless there is a basis for doing so that is not frivolous, which includes a good faith argument for an extension, modification or reversal of existing law.”140

136 I.R.C. § 163(a), (h)(1)–(3)(A) (West 2010). 137 See I.R.C. § 262(a) (2006) (“Except as otherwise expressly provided . . . , no deduction shall be allowed for personal, living, or family expenses.”); Treas. Reg. § 1.262-1(b)(3) (as amended in 1972) (stating that expenses to maintain one’s household are generally not deductible because they are considered personal or living expenses). 138 See Formal Op. 85-352, supra note 122. 139 Id. 140 Id. (quoting MODEL RULES OF PROF’L CONDUCT R. 3.1 (2008)).


However, in extending this standard to lawyers assisting clients in the context of preparing a tax return, the ABA Ethics Committee is analogizing a tax return to a document submitted in the context of an adversarial proceeding. This analogy is not warranted in the context of undisclosed return positions. Just because a tax return may serve as the basis for a future dispute with the IRS, this in no way justifies its classification as a document in controversy. As articulated by Lee Sheppard: “A tax return is not adversarial. A return is an attested document. It is signed by the taxpayer and the preparer under penalties of perjury. It is not an opening offer.”141 Indeed, the attestation lines on IRS Forms 1040 (for individuals) and 1120 (for corporations) both provide: “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.”142 There is an enormous difference between “realistic possibility” and “correct.” Indeed, the IRS is asking the taxpayer to swear that if the taxpayer has an undisclosed position, it should reflect the amount that, to the best of his knowledge, is the “true” and “correct” amount of tax owed. As such, for undisclosed positions, no adversarial characterization of a return is warranted or proper.

If, however, an item on a return is placed into controversy through audit, then the tax lawyer should by all means make any nonfrivolous argument to place her client in a position to prevail. That is consistent with a tax lawyer’s ethical duties to the legal system and her client.143 Furthermore, I believe that as long as a taxpayer fully discloses the basis for his reporting position, including any appropriate contrary authorities, he should be able to take return positions having as little as a one-in-five chance of success on their merits (i.e., a reasonable basis). In these situations, although the taxpayer is not submitting a return position based on the amount of “true” tax he likely owes, he is submitting a claim that is in essence placing his reported item in controversy. That is, the taxpayer is fully disclosing that he is taking a position that may not be supported by the weight of authorities and that he believes is perhaps not more than likely to succeed on its merits.144

141 Lee A. Sheppard, What are Penalties For?, 85 TAX NOTES 709, 709 (1999). 142 IRS Form 1040 (2009) (emphasis added); IRS Form 1120 (2009) (emphasis added). 143 See MODEL RULES OF PROF’L CONDUCT R. 3.1 cmt. 2 (“What is required of lawyers . . . is that they inform themselves about the facts of their clients’ cases and the applicable law and determine that they can make good faith arguments in support of their clients’ positions. Such action is not frivolous even though the lawyer believes that the client’s position ultimately will not prevail.”). 144 It is acknowledged that some taxpayers, even if they believe they have the weight of the law on their side,


Here, the ABA Ethics Committee’s views are more reasonably applied and the comparisons with adversarial proceedings are more proper. Indeed, while Comment 2 to Model Rule 3.3 acknowledges that the lawyer “has an obligation to present the client’s case with persuasive force” when advocating on behalf of her client,145 the lawyer still owes a duty of candor to the legal establishment and must disclose any controlling legal authorities that the lawyer knows “to be directly adverse to the position of the client.”146 Accordingly, while lower reporting standards are acceptable if full disclosures of a taxpayer’s positions are made, in an ordinary nondisclosure context the treatment of the tax return as an adversarial document is not justifiable.

c. Conformance with Accounting Standards for Reporting Tax Positions

The Financial Accounting Standards Board (FASB) struggled with similar reporting issues in trying to determine when an “uncertain” tax benefit should be able to be booked for financial accounting purposes. In 2007, it made dramatic changes to its then-current standards by issuing FASB Interpretation No. 48 (FIN 48).147 Under FIN 48, a company cannot book a tax benefit unless the tax position will more-likely-than-not be sustained on its merits.148 Thus, in preparing financial statements, a company must analyze each tax position and determine whether or not it meets the more-likely-than-not standard. This analysis must be supported by documentation, and opinions from tax lawyers are often used for this purpose.149

If a position is unable to meet the more-likely-than-not standard, the company is not able to book the benefit until the uncertainty is resolved, and it must disclose the position by showing a liability for the unrecognized tax benefit.150 A benefit failing the standard can only be booked on the financial statements if there is a change of law that pushes the likelihood of success over the 50% threshold, the position is favorably resolved with the

will nevertheless disclose in an abundance of caution in order to avoid any potential penalties. 145 MODEL RULES OF PROF’L CONDUCT R. 3.3 cmt. 2 (2008). 146 Id. R. 3.3(a)(2). 147 FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, FIN. ACCT. SERIES, June 2006. 148 See id. ¶ 6 (“The more-likely-than-not recognition threshold is a positive assertion that an enterprise believes it is entitled to the economic benefits associated with a tax position. The determination of whether or not a tax position has met the more-likely-than-not recognition threshold shall consider the facts, circumstances, and information available at the reporting date.”). 149 See id. ¶ B34 (“The [FASB] believes that a tax opinion can be external evidence supporting a management assertion and that management should decide whether to obtain a tax opinion after evaluating the weight of all available evidence and the uncertainties of the applicability of the relevant statutory or case law.”). 150 See id. ¶ 17.


IRS, or the statute of limitations applicable to the position lapses such that no further adjustments can be made.151

Again, if the proper conclusion is that tax benefits should not be booked on a company’s financial statements unless the tax benefit is likely to be sustained, why should the same standard not apply to the taxpayer’s actual submission to the IRS? In other words, should a company have a more stringent reporting duty with respect to its tax liabilities when communicating with the public than it does when communicating with the government? I do not believe that there is a persuasive basis for this distinction. The purpose behind providing investors with audited financial statements is to ensure that they have an accurate assessment of the income, cash flows, liabilities, and assets of a company. Surely no less accuracy and candor should be required when that company is making disclosures to an agency, such as the IRS, to which its liabilities are in fact owed.

Interestingly, the book–tax gap is again taking center stage, and the IRS is keen to know when a company’s financial accounting (book) income differs significantly from its taxable income.152 In that regard, the IRS has recently instituted a book–tax reconciliation initiative that requires large corporations to file Schedule M-3, which is used to reconcile their financial accounting net income with their taxable income.153 This schedule is used primarily as an investigative tool for ferreting out tax shelters. “The purpose of this project has been to make differences between financial accounting net income and taxable income more transparent. Schedule M-3 provides information that will identify taxpayers that may have engaged in aggressive transactions and therefore should be audited.”154 Large book–tax differences frequently indicate the existence of an abusive transaction. The new Schedule M-3 will enable the IRS to identify quickly those differences that warrant additional scrutiny.155

151 See id. ¶ 10. 152 See, e.g., I.R.S. Announcement 2010-9, supra note 6, at 3 (“The information developed in the course of complying with FIN 48 or other accounting standards is highly relevant to understanding the taxpayer’s tax positions and assessing how those positions affect the taxpayer’s tax liability. That information also would aid the Service in focusing its examination resources on returns that contain specific uncertain tax positions that are of particular interest or of sufficient magnitude to warrant Service inquiry, as well as allowing examination teams to identify all of the issues underlying the tax returns more quickly and efficiently.” (citation omitted)). 153 See Joann M. Weiner, Closing the Other Tax Gap: The Book–Tax Income Gap, 2007 TAX NOTES TODAY 104–46 (May 30, 2007). 154 IRS Announces Release of Schedule M-3 for Corporations, 2004 TAX NOTES TODAY 131-16 (July 8, 2004) (internal quotation marks omitted). 155 See id.


Ironically, because the FIN 48 standard is higher than the tax reporting standard, growing concern has been raised that IRS agents will use a taxpayer’s FIN 48 disclosures, and potentially even analysis, as a roadmap to potential issues in the tax return.156 The IRS even issued a field guide stating that “Revenue Agents should not be reluctant to pursue matters mentioned in FIN 48 disclosures.”157 This directive is essentially an acknowledgement by the IRS that the accounting disclosures made with respect to tax positions may be more helpful than those provided directly to the government. Indeed, companies may acknowledge their uncertainty as to the proper treatment of a tax item more fully in their financial statements than they do on their actual tax return. For example, the financial statement may be the only way the IRS can learn of a position taken by a taxpayer that has substantial authority (and thus is not disclosed), but fails to meet the more-likely-than-not standard. Conflicts are certainly caused for corporations faced with varying standards for their tax and accounting reporting, particularly when the information can be used affirmatively by the government as a basis to come after them for additional taxes.

Conforming the tax reporting standard to more-likely-than-not could help yield more consistent reporting of book and tax income by taxpayers. In a recent step toward this move, the IRS announced a proposal that would require corporations with more than $10 million in assets to report the maximum exposure they have for each “uncertain tax position” (which primarily include those positions for which a tax reserve must be established under FIN 48) on a new schedule to be filed with their annual tax returns.158 The IRS would

require (i) a concise description of each uncertain tax position for which the taxpayer or a related entity has recorded a reserve in its financial statements and (ii) the maximum amount of potential federal tax liability attributable to each uncertain position (determined without regard to the taxpayer’s risk analysis regarding its likelihood of prevailing on the merits).159

Not surprisingly, taxpayer outcry to this proposal has been widespread.160

156 See, e.g., IRS Position on Definition of Tax Accrual Workpapers Generates Skepticism, 2007 TAX NOTES TODAY 137-3 (July 17, 2007). 157 IRS, LMSB-04-0507-045, FIN 48 Implications—LMSB Field Examiners’ Guide, IRS.GOV, http://www.irs.gov/businesses/corporations/article/0,,id=171859,00.html (last updated Mar. 31, 2010). 158 See I.R.S. Announcement 2010-9, supra note 6, at 7. 159 Id. at 4. 160 Among the complaints levied by taxpayers and the tax community is that the requirements currently


Rather than continue to send mixed messages to taxpayers by having varying standards for returns and accounting-related disclosures, the IRS should simply raise its reporting standards to more-likely-than-not. If the IRS is concerned about trying to deduce when taxpayers are not reporting (and thereby not paying) tax on amounts for which they do not have a greater than 50% confidence level, then instead of requiring even more disclosures (which have the sole purpose of helping the IRS ferret out that exact information), why not simply require the taxpayer to report tax liabilities on undisclosed positions only if they meet the more-likely-than-not threshold? If that threshold is not met, then as discussed below, the taxpayer would have to disclose the reported position as part of the return anyway. Schedule M-3 and the newly proposed FIN 48-type schedule appear to be an indirect and inefficient way to get to this same result.

B. Where Should the Gate Come Down?

Even if the tax-legality standard is raised to the more-likely-than-not level, it would still be necessary to determine how the tax lawyer should fit into an overall gatekeeping regime. In general, I believe that the tax lawyer should be able to advise her client freely with respect to all prereturn matters.161 To the extent that she is directly involved in prereturn advice, structuring, opinion drafting, or return preparation, her gatekeeping functions should activate such that she should not encourage or enable her client to take any position on the client’s tax return that does not meet the more-likely-than-not standard, unless such position is properly disclosed. A general standard under Circular 230 should be added to include this directive, and it should be applicable to the rendering of both oral and written advice. However, once an item is placed into controversy, either through return disclosures for positions that are reported at less than the more-likely-than-not level or through a post-return filing audit or examination by the IRS, the lawyer’s ultimate duty should be to serve as an advocate for her client. Chart B illustrates my proposed view of where the tax lawyer’s advisory, gatekeeping, and advocacy roles should dominate.

suggested by the IRS are now greater than those required by companies subject to FIN 48. See Letter from Peter G. Doblee, Jr., Partner, Haskell & White LLP, to IRS (Feb. 9, 2010), reprinted in Firm Advises Against Proposal to Require Reporting of Large Corporations’ Uncertain Tax Positions, 2010 TAX NOTES TODAY 37-20 (Feb. 25, 2010). In particular, under FIN 48, taxpayers are allowed to determine their “tax exposure” based on the professional judgment of the advisors involved, including the likelihood of prevailing on the issues. See id. On the other hand, the IRS’s proposal would require the taxpayer to report only the maximum exposure they could face, even if the overall likelihood of paying the maximum amount is relatively small. See id. 161 Indeed, even after the return is filed the lawyer will still serve in an advisory capacity, but her position as advocate should dominate.


Chart B

In order to have an effective gatekeeping system, it is necessary that

access to the ultimate goal (passage through the gate) can be denied, controlled, or significantly hampered by the gatekeeper. With respect to the tax advisor, these “gates” are the opinion and the tax return. Ideally, the tax advisor should not want to deny the taxpayer client admission through the gate; rather, the tax lawyer should aim to advise or influence the taxpayer to alter his positions sufficiently such that admission through the gate can be granted. Under this Article’s proposed system, this will occur if the taxpayer either meets the more-likely-than-not standard or discloses.

1. The Opinion

The tax opinion is a natural mechanism by which the gatekeeping function of tax lawyers can be exercised. In order for the opinion to be an effective gate, taxpayers need to be encouraged to rely on the advice of their tax advisors. In addition, tax lawyers rendering advice that will be reflected on the taxpayers’ returns must be required to analyze the positions fully,


including conducting due diligence, to ensure that advice is not based on any misleading or false assumptions.162

To encourage a taxpayer’s reliance on the tax advisor, a taxpayer should be able to reasonably rely on an opinion of counsel and avoid understatement penalties in two ways: (i) if the taxpayer is disclosing the position on the return, the opinion should reach a conclusion that the position has a reasonable basis; or (ii) if the taxpayer does not disclose the position on the return, the opinion should reach a conclusion that the position will more-likely-than-not succeed on its merits. By allowing tax opinions to serve as penalty protection for taxpayer understatements, taxpayers who are taking aggressive opinions, or even opinions that are close to the more-likely-than-not line, will have an incentive to obtain legal advice if the dollar value of their tax item is relatively high and the potential penalty imposed is significant.163 Thus, if an issue is sufficiently large to be of interest to the IRS, it is likely that it will also be significant enough for the taxpayer to seek an opinion from a tax advisor. This is important because in order for the gatekeeping system to be most effective, taxpayers should be encouraged to consult frequently with their gatekeeping tax advisors with respect to non-ordinary-course transactions.164

Once the taxpayer engages the tax lawyer to issue a penalty-protection opinion, the tax lawyer would then serve her gatekeeping function by holding the opinion “hostage” until she is satisfied that the taxpayer’s position meets the minimum compliance standards. That is, the tax lawyer would work with her client either to structure the client’s transaction in a way that could meet the more-likely-than-not threshold or to apprise the client fully of the lower comfort level of the position and advise disclosure.165 At that point, if the tax lawyer advises that disclosure is required, the taxpayer may choose instead to restructure his transaction to meet the nondisclosure confidence level of the more-likely-than-not standard.

162 See discussion supra Part III.C. This is consistent with the current requirements for a “qualified opinion” found in Circular 230 Section 10.37(a). See 31 C.F.R. § 10.37(a) (2010). 163 In this regard, the current 20% penalty for understatements is significant and this Article is not proposing to modify current penalty levels. See supra Part III.A. 164 As important as it is for taxpayers to consult tax advisors with respect to novel or aggressive transactions, it is just as important that the gatekeeping system not be so stringent that taxpayers incur unnecessary costs consulting tax advisors, even when there is fairly clear statutory support for the taxpayers’ positions or little to no opportunity for tax abuse or avoidance. 165 As long as the tax advisor advises the taxpayer to disclose, unless she is also the signing return preparer, she should be insulated from penalties or sanctions under Circular 230, even if the taxpayer does not in fact disclose that his position does not meet the more-likely-than-not threshold.


In order to execute her gatekeeping duties effectively, meaningful due diligence requirements should be placed on the tax lawyer as part of the opinion-writing process. To this end, all opinions that will be relied on by the taxpayer for penalty-protection purposes should be subject to rigorous diligence duties and thoroughness standards, similar to those for “covered opinions” under Circular 230.166 Accordingly, the current requirement that distinguishes transactions having a significant purpose for tax avoidance should be eliminated.167 If the opinion is being used for penalty protection, it should be subject to the more thorough covered-opinion requirements. For example, the tax lawyer should be required to fully examine the purported business purpose of the transaction and ensure that the transaction has an economic effect besides the generation of tax benefits (e.g., ensure economic losses are greater than the tax losses), regardless of the ultimate opinion level that is reached. The tax lawyer should not be able to assume away any significant factual information that is necessary to reach the proper legal conclusion. Although the flow of information is ultimately controlled by the client, in many respects the tax lawyer is in the best position to obtain and properly analyze the information, assuming that the client is willing to be forthcoming.168 As discussed below, taxpayers will be much more open with their tax advisors when they feel confident that their communications will be protected by the attorney–client privilege and that their advisor will not be forced to divulge information regarding their involvement in aggressively structured transactions.169

2. The Return

When solicited, the opinion should serve as the initial gatekeeping point in the taxpayer’s process. Either the lawyer will work with her client to structure a transaction, the expected treatment of which should more-likely-than-not succeed on its merits, or the lawyer will advise the client that he must disclose the transaction because sufficient uncertainty exists as to its correct treatment. Thus, even after a client has consulted an advisor during the actual execution of a transaction, the actual compilation and filing of the return is a subsequent point at which the tax advisor can exercise gatekeeping functions. The newly enacted tax-return-preparer rules already

166 See 31 C.F.R. § 10.35 (2010); supra notes 96–101 and accompanying text. 167 See 31 C.F.R. § 10.35. 168 Indeed, taxpayers would not be able to rely on a tax advisor’s opinion for penalty-protection purposes to the extent that the taxpayer has not shared all relevant facts with his advisor. See, e.g., Treas. Reg. § 1.6664-4(c)(1)(i) (as amended in 2003). 169 See discussion infra Part V.B.


impose duties on tax lawyers and other preparers,170 even if they are not the actual signer of the return.171 Still, it is important that significant responsibilities be put in place with respect to the signing preparer who is responsible for compiling the return information.

First, while the signing preparer should be able to rely fully on the opinions of other advisors and professionals when preparing the return, she should have an affirmative duty to inspect these documents in order to confirm that they are internally consistent and do not contain any factual or legal assumptions or representations that the preparer knows or should know to be untrue. Currently, the preparer may generally rely, without verification, on advice and information furnished by the taxpayer and other advisors.172 In order to adequately ensure that the gatekeeping function is operating properly, however, these additional diligence duties should be borne by the preparer. The signing preparer may very well be in a position to have a more complete understanding of the taxpayer’s overall financial and tax situations than any particular advisor or professional who has rendered advice regarding only a portion of a taxpayer’s return items.

Second, the signing return preparer should have a duty to ensure that no position is taken that does not have at least a reasonable basis. No compelling reason exists to allow the taxpayer to report, even with disclosure, tax positions that have less than a 20% chance of succeeding on their merits. If substantial doubt exists with respect to a taxpayer’s position, he should seek a prefiling agreement, ruling, or other guidance from the IRS prior to reporting the transaction.173

Further, if a taxpayer’s position is less than likely to succeed, then the signing preparer should ensure that full disclosures are made so that the taxpayer will avoid penalties.174 To this end, the tax advisor, in her capacity as preparer, should work with the client to properly disclose these positions. I believe that the required disclosures should be more detailed than those

170 See I.R.C. § 6694(a)(1)(A)–(B) (West 2010); discussion supra Part III.D. 171 See Treas. Reg. § 301.7701(b) (as amended in 2009). 172 See Treas. Reg. § 1.6694-2(e)(5) (as amended in 2009). 173 See Rev. Proc. 2009-1, 2009-1 I.R.B. 1 (detailing procedures for requesting an IRS private letter ruling, by which a taxpayer can solicit the IRS’s views on the applicability of the law and the regulations to a transaction he “proposes” to enter); Rev. Proc. 2009-14, 2009-3 I.R.B. 324 (“[A] taxpayer under the jurisdiction of the [IRS’s] Large and Mid-Size Business Division [may] request that the [IRS] examine specific issues relating to [the taxpayer’s] tax return[] before [the] return[ is] filed. . . . A pre-filing examination [can] provide[] the taxpayer with certainty regarding the examined issue [before their return is filed.]”). 174 If the taxpayer chooses to forgo disclosure, the preparer must fully advise the taxpayer of the potentially applicable penalties.


currently required on Form 8275.175 While I do not believe that an attachment of the full tax opinion is necessary, as this would unnecessarily intrude into the sanctity of the attorney–client relationship, the taxpayer should have to provide a more complete summary of the specific tax items at issue, the basis upon which the tax determination was made, the authorities which weigh against the taxpayer’s purported position, and the name of the tax lawyer and associated firm that prepared any opinion upon which the taxpayer is relying.176 In order to safeguard against return disclosures serving as admissions with respect to any potential court proceeding, it is also important that the disclosures be inadmissible in any subsequent controversy.

Accordingly, at the return stage, a tax advisor’s gatekeeping functions should include compiling any written advice upon which the taxpayer is relying, reviewing that advice to make sure that it is consistent with other factual information about the taxpayer that is being reported on the return or that the preparer is otherwise aware of, and ensuring that all reported positions either meet the more-likely-than-not standard or are properly disclosed. To that end, other tax advisors up the chain in the return process (such as those advisors who are issuing opinions but are not in fact compiling the return), should have affirmative duties to provide the preparer (or if not known, another designated company contact) with a copy of any advice upon which the taxpayer is intending to rely. The penalties and fines currently assessed with respect to tax preparers, including those who are not the signing preparers, should be sufficient to induce advisors to perform their gatekeeping duties.177

V. REINFORCING THE GATE

Even if the tax advisor is well positioned to shepherd the taxpayer through the process and is sufficiently incentivized by reputational and penalty concerns to do so, the taxpayer must also cooperate in the process. That is, in order to maximize the effectiveness of the gatekeeping system, the taxpayer must generally be willing either: (i) to choose not to enter into aggressive or questionable transactions, limiting the need to consult advisors for penalty-protection purposes; or (ii) to consult with a tax advisor with respect to most or all aggressive, questionable, or “close case” transactions. In this regard, it is critically important that taxpayers are not freely able to 175 See Treas. Reg. § 1.6662-4(f) (as amended in 2003); Rev. Proc. 2010-15, 2010-7 I.R.B. 404. 176 See discussion infra Part V.A. 177 See I.R.C. § 6694(a)(1) (West 2010); discussion supra Part III.D.


shop around for compliant advisors for penalty-protection opinions, effectively encouraging a race to the bottom. It is also imperative that the taxpayers, in consulting with their advisors, be as open and candid as possible so that the advice rendered will be accurate.

A. Limiting the Ability To Shop for Compliant Advisors

When a taxpayer does choose to consult with an advisor with respect to a transaction, and if the transaction is found to fail the more-likely-than-not standard, the taxpayer must be willing to follow the advisor’s advice to either modify the transaction or disclose. Problems could arise, however, when the taxpayer client receives, or senses he will receive, an opinion not to the client’s liking (i.e., he must disclose); at that point the client may threaten to, or in fact will, take his business elsewhere. If the client’s threat works and he is able to bully the original advisor into modifying her opinion, the gatekeeping system will fail and become corrupted. Likewise, even if the original counsel refuses to bend to the client’s will and the taxpayer thus seeks a second advisor, the taxpayer will have the advantage of knowing the sticking points it had with its previous advisor and will be better able to finesse or repackage its presentation of facts in order to receive a more favorable opinion from the second advisor. Thus, wrongdoing will not be effectively thwarted if the taxpayer can easily shop the market for a corrupt gatekeeper.

In order to combat this potential, some type of safeguard should be put in place to reduce the incentive for a race to the bottom. In this regard, this Article suggests that the taxpayer, when filing a return, should have to list the names of any tax advisors that have rendered written opinions that are the basis of any reporting positions the taxpayer has taken on the return. Beside each advisor’s name should be the line item or transaction to which their advice relates. This disclosure should be required whether or not the opinion level is above or below the more-likely-than-not disclosure threshold.

Disclosing advisors’ participation should accomplish two things. First, it should deter tax advisors from easily yielding to their clients’ demands. Their names will be on the line (both literally and figuratively), and they will be more easily identified by the IRS as participating in the relevant taxpayer’s process and transaction. Not only would this make their participation more transparent for purposes of enforcing the Circular 230


and return-preparer penalty regimes,178 but also, just as importantly, it will trigger very real reputational consequences for the advisor. An advisor will not want to develop a reputation with the government as being an overly aggressive tax planner. Such a reputation would likely make them more of a target for the government in terms of sanctioning and decrease the reputability of her legal advice with the IRS.

This leads to the second benefit of advisor-name disclosure. To the extent that tax advisors develop known reputations, either good or bad, with IRS field teams and auditors, a taxpayer’s selection of an advisor will take this into account. That is, if the taxpayer knows that a particular advisor has a reputation with the IRS for giving good and fair legal opinions, the taxpayer is more likely to engage that advisor because it should impact the government’s assessment of that taxpayer’s return.179 For instance, in a close case, if the IRS agents see that X Firm, which has built a favorable reputation, opined on the tax issue in question, they are more likely to respect the taxpayer’s reporting position. On the other hand, if the taxpayer has used Y Firm, which has developed a reputation with the IRS for issuing overly aggressive or not well-reasoned opinions, then it is more likely that they will challenge the taxpayer’s reporting of that item. In this way, the taxpayer should be less willing to “trade down” or shop around for the most corrupt advisor. Rather, the taxpayer should seek the advisor who can get as close to the most favorable tax treatment as possible while still maintaining a positive reputation with the IRS.

B. Reestablishing the Privilege

Even if taxpayers seek the counsel of a reputable tax advisor, the advice that an advisor gives can only be as good as the information received from the taxpayer. The problem is that the “privilege in the tax area has continued to take a beating.”180 The IRS has been successfully able to hack away at the privilege in current controversies regarding purported tax shelters.181 In addition, several academics have even suggested that all

178 See discussion supra Part III.C–D (discussing Circular 230 and return penalty regimes, respectively). 179 See Schizer, supra note 2, at 361 (“Lawyers will want conservative reputations, and clients will want to hire such lawyers, if the government treats opinions of conservative lawyers more favorably than opinions of aggressive ones.”). 180 Jeffrey H. Paravano & Paul M. Schmidt, Tax Shelters: Evaluating Recent Developments, in 16 TAX PLANNING

FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCS, JOINT VENTURES & OTHER STRATEGIC ALLIANCES 9, 100 (PLI Tax Law & Practice, Course Handbook Series No. J-818, 2008). 181 For example, the identity of a taxpayer listed by a “material advisor” has not been protected by the attorney–client or tax-practitioner privileges. See, e.g., United States v. BDO Seidman, 337 F.3d 802, 813 (7th Cir.


prereturn privilege and work-product protections be eliminated with respect to tax advisors and their clients.182 In order for the tax lawyer to properly serve in a gatekeeping capacity, it is critical that taxpayers feel comfortable to share freely all of the relevant facts surrounding their transaction and do not play “hide the ball” with their tax advisor. In that regard, the attorney–client privilege should be restored to its traditional state in order to preserve the sanctity of the lawyer–client relationship.

Having lawyers keep lists regarding their clients’ participation in potentially aggressive tax transactions and forcing the disclosure of such information only encourages clients to be less than forthcoming with their tax advisors. Under the list-maintenance regulations, the procedures for asserting a claim of attorney–client privilege with respect to information that is subject to the list-maintenance requirements only applies to “[c]opies of any additional written materials, including tax analyses or opinions . . . that are material to an understanding of the purported tax treatment or tax structure of the transaction” and that are provided by the material advisor to a person who may or does “acquire an interest in the transaction[]” or that person’s “representatives, tax advisors, or agents.”183 By implication, the IRS takes the position that other information required to be kept pursuant to the list-maintenance regulations is not privileged, including the name of each person required to be on the list, the amount invested, and a “detailed description of each reportable transaction that describes both the tax structure of the transaction and the purported tax treatment of the transaction.”184

These list-maintenance and disclosure requirements should be removed, as they ultimately serve to undermine the efficacy of the lawyer’s gatekeeping function.185 A client in a close or aggressive case needs to feel

2003) (finding that the party “failed to establish a legally protected interest in preventing the disclosure of the documents revealing their identifies as individuals who participated in tax shelters”); United States v. Frederick, 182 F.3d 496, 502 (7th Cir. 1999) (“Throwing the cloak of privilege over this type of audit-related work of the taxpayer’s representative would create an accountant’s privilege usable only by lawyers.”); United States v. KPMG LLP, 237 F. Supp. 2d 35, 39 (D.D.C. 2002) (“[T]he privilege does not protect communications between a tax practitioner and a client simply for the preparation of a tax return.”). 182 Linda M. Beale, Tax Advice Before the Return: The Case for Raising Standards and Denying Evidentiary Privileges, 25 VA. TAX REV. 583, 593 (2006) (“To make returns fully transparent in ways that will permit enforcement . . . , pre-return advice should be subject to the more transparent regime that applies to tax return preparation, including inapplicability of attorney–client and work-product privileges for pre-return tax planning advice.”); Richard Lavoie, Making a List and Checking it Twice: Must Tax Attorneys Divulge Who’s Naughty and Nice?, 38 U.C. DAVIS L. REV. 141, 144 (2004) (arguing that “the policies underlying the attorney–client privilege require limiting the client-identity privilege in all tax planning situations”). 183 Treas. Reg. § 301.6112-1(b)(3)(iii)(B) (as amended in 2007). 184 See id. §§ 301.6112-1(b)(3)(i)–(ii). 185 But see Alex Raskolnikov, Revealing Choices: Using Taxpayer Choices to Target Tax Enforcement, 109 COLUM. L.


like the advisor is on his side such that he is willing to disclose fully to the advisor his intentions—without fear that the advisor will mark his name down on a “naughty” list somewhere, which may get turned over to IRS authorities.186 The system needs to give the proposed gatekeeping process a chance to operate correctly. In order to do that, the tax advisor needs to have all of the relevant information possible to counsel the taxpayer most effectively into a compliant transaction.

V. CONCLUSION

The gatekeeping phenomenon has already taken hold in the securities and corporate law areas, in large part as a response to the widely publicized downfalls of Enron and WorldCom. The principles behind and the uses for gatekeepers can also help the equally troubled and ineffective tax system by officially installing tax advisors as gatekeepers of the tax system. While direct taxpayer penalties and IRS audits should continue to serve as a primary line of defense against taxpayer wrongdoing, tax lawyers should also play a part in ensuring the sanctity and effectiveness of the tax system.

Gatekeeping responsibilities are properly imposed on those who can and will prevent misconduct reliably and at a reasonable cost. Tax lawyers can fill such a role. Current tax laws already empower tax lawyers with quasi-gatekeeping responsibilities, albeit rather ineffectively. In addition, corporations and high-income taxpayers presently spend millions of dollars on tax advisors in the course of their tax planning efforts. While many of these dollars are spent on pure compliance efforts, significant amounts are spent working with tax advisors to develop strategies and methods to reduce the taxpayer’s overall tax liabilities. A tax advisor’s existing presence in many taxpayers’ tax planning and return processes ideally situates him or her to be a gatekeeper in the tax system.

As this Article suggests, such a system can be put in place without unduly infringing on the tax lawyer–client relationship, while at the same time improving reporting compliance by taxpayers. Raising reporting standards to more-likely-than-not for undisclosed positions, requiring more REV. 689, 724–25 (2009) (supporting the elimination of the tax preparer privilege on the grounds that rule-abiding taxpayers “will have no reason to worry about concealing interactions with the preparer from the government”). 186 See I.R.C. § 6111(a) (West 2010) (requiring tax advisors to file an information return with IRS identifying and describing certain reportable transactions and the “potential tax benefits expected to result from the transaction”); I.R.C. § 6112(a) (2006) (requiring a material advisor to keep a list identifying each person for whom the advisor acted as a material advisor for the transaction, whether or not that transaction must be reported to the IRS); I.R.C. § 6707A (West 2010) (establishing penalties for failure to disclose reportable transactions under I.R.C. § 6111); see also discussion supra Part III.E.


complete information with respect to those transactions that do require disclosure, shoring up the tax-diligence and opinion-writing process, and eliminating the whistle-blowing duties of tax lawyers should all make meaningful strides toward improving taxpayer compliance and restoring the sanctity of the tax system.

Documents

THE TAX LAWYER AS GATEKEEPER...the tax lawyer’s primary role is, and should remain, that of an advisor (or in the case of an adversarial proceeding, an advocate), the tax lawyer