Deconstructing Canal Corp. v. Commissioner – Part I

By Jonathan Prokup and Dustin Covello

Many practitioners were taken aback by the recent Tax Court decision in Canal Corp. v. Commissioner, where Judge Kroupa issued a stinging opinion that not only recast a leveraged partnership distribution as a disguised sale, but also upheld penalties against the taxpayer for what the judge characterized as the taxpayer’s unreasonable reliance on the opinion of its tax advisor.  Judge Kroupa’s analysis, which should be on the forefront of every tax advisor’s mind, raises a number of interesting, if thorny, questions, including:

  1. Should a fixed and/or contingent fee arrangement necessarily render tax advice unreliable for purposes of avoiding a substantial understatement penalty under the “reasonable cause and good faith” exception?
  2. Has the enactment of section 6694 undercut the rationale for prohibiting taxpayers from relying on advisors that have a conflict of interest?
  3. When (if at all) should courts defer to the opinion of a reputable tax advisor in deciding whether to uphold an assessment of penalties against a taxpayer?

Today, we tackle the first of these three questions.

Judge Kroupa focused a great on the fixed and contingent nature of the tax advisor’s fee, suggesting that the taxpayer had effectively purchased an “insurance policy” regarding the tax consequences of the transaction rather than receiving an objective legal opinion about its merits.  Thus, according to the court, the tax advisor had an “inherent and obvious conflict of interest” that should have prevented the taxpayer from relying on its advice.

In practice, though, attorneys in a variety of substantive areas receive fixed and/or contingent fees for their work on transactional matters, from run-of-the-mill mergers and acquisitions, as well as purely internal reorganizations that are designed to maximize the tax efficiency of a company’s corporate structure.  In fact, an increasing number of clients are insisting on the use of such alternatives to the traditional hourly rate structure as a way to better align the incentives of attorneys with the clients’ business needs.  Notwithstanding this trend, Judge Kroupa’s analysis seems to suggest that such arrangements should be forbidden per se in the context of rendering an opinion on the federal tax consequences of a transaction.

To be fair, a more nuanced reading of the Canal Corp. decision (and the authorities cited therein) suggests that reliance on an advisor who is earning a fixed and/or contingent fee may be inappropriate only where (i) the transaction is recharacterized or disregarded by a statutory, regulatory, or judicial anti-abuse rule, and (ii) the advisor was a promoter of the transaction being recharacterized or disregarded.  See, e.g., New Phoenix Sunrise Corp. v. Comm’r, 132 T.C. No. 9 (2001) (finding no reasonable reliance on the opinion of a law firm that was a promoter of a tax shelter); see also Murfam Farms, LLC v. United States, No. 06-245T (Fed.Cl. 2010) (finding no reasonable reliance on an advisor who was “selling” the subject transaction).

Under this reading of Canal Corp. and the cited authorities, reliance on the advisors’ opinions was unreasonable not because of the advisors’ fee structures but because the underlying transactions were sufficiently aggressive – as some courts have phrased it, “too good to be true” – that reliable advice could not be given, even if supported by reasoned analyses.  Of course, if the court intended to draw such a distinction, it was certainly silent on that point.

Irrespective of the transaction being examined, the court’s analysis on the penalty issue is somewhat troubling because of its emphasis on the advisor’s fee structure as the source of its conflict of interest.  At some level, advisors always have a conflict of interest because the party to whom the advisor is providing the opinion is the party who is also paying the bills.  (Hasn’t this been the very criticism of the securities rating agencies in the aftermath of the financial crisis of 2008?)

At least to us, it seems inappropriate for courts to step between clients and their advisors and declare that certain fee arrangements necessarily undermine the ability of a client to rely on its advisor.  Especially when sophisticated consumers of legal advice are involved, the merits of the opinion itself should determine whether or not the taxpayer is able to rely upon the advice for protection from penalties.  If, as Judge Kroupa found here, the analysis in an opinion is insufficient to warrant reasonable reliance, then that fact alone should be sufficient to undermine a “reasonable cause” defense to penalties.

In sum, although Judge Kroupa may have properly concluded that the taxpayer could not reasonably rely on the substance of its advisor’s opinion, the added focus on the fee arrangement between the taxpayer and its advisor seems unnecessary at best.  The taxpayer in this case (judging by the advisors chosen to structure the transaction and defend it in court) was a sophisticated consumer of legal advice.  Surely, it cannot be the case that a client who desires an alternative to the traditional hourly-based billing model forgoes any ability to rely upon that advisor (or to hold that advisor accountable for dispensing bad advice).

For our further discussion, see Deconstructing Canal Corp. v. Commissioner – Part II and Part III

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5 Comments on “Deconstructing Canal Corp. v. Commissioner – Part I”

  1. Richard G. Jacobus Says:

    Your post raises most of the issues that ought to be addressed in this area of tax law. But you say that Judge Kroupa’s opinion in Canal raises three questions; that the third is “when (if at all) should courts defer to the opinion of a reputable tax advisor in deciding whether to uphold an assessment of penalties against a taxpayer”; and that you apparently plan to address this question in a later post (since today’s post is limited to the first question of three you pose).

    Next, however, at the very end of a thoughtful exposition on the first of the three questions you pose, you state:

    “The taxpayer in this case (judging by the advisors chosen to structure the transaction and defend it in court) was a sophisticated consumer of legal advice.”

    Apparently this is a claim that the PwC opinion in the Canal case was entitled to some deference due to PwC’s reputation. Let me respectfully suggest that tax opinion writers, whether the tax bar or the major accounting firms, need to cease trading on their credentials as a weak substitute for good tax opinions that are based on an independent reading of the facts and objective professional skepticism.

    This is not hard stuff, fellow tax practitioners.


  2. Mr. Jacobus,

    Thank you as always for your commentary. You have anticipated both the issue we intend to spotlight regarding question #3 and the answer that we intend to give, which is that the merits of an opinion letter typically must stand on their own. An opinion letter must generally earn respect on the basis of its analysis, not on the basis of its author’s reputation.

    Thanks again.

  3. Julian A. Fortuna Says:

    I find it very strange that the only tax opinion entered into evidence in this case was a draft (which the judge severely criticized both in substance and form). Initially, I thought maybe the final tax opinion was never issued or that perhaps it was issued after the taxpayer filed its tax return was therefore excluded from evidence as irrelevant to the penalty issue. However, I noticed a finding of fact that the final, signed tax opinion was issued on the date the transaction was closed. It probably would not have carried the day on the penalty issue in this case, but the taxpayer would have had a better chance of avoiding the penalty if the final, signed tax opinion was entered into evidence and the tax advisor who signed that opinion was better prepared (or more cooperative) in his testimony.


    • Mr. Fortuna,

      Thank you for reading the TaxBlawg. We, too, were curious about why a draft, rather than the final version, was submitted into evidence; unfortunately, we can only speculate about the possible reasons. In any event, unless the final, signed opinion was materially different from the draft that was introduced as evidence, you are right that it probably would not have swayed the court’s decision.


  4. [...] Tax Blawg Tax Talk for Tax Pros « Deconstructing Canal Corp. v. Commissioner – Part I [...]


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