Deconstructing Canal Corp. v. Commissioner – Part III

By Jonathan Prokup and Dustin Covello

We now tackle the third question raised by our original post about Canal Corp. v. Comm’r: 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?

To be clear, deference in this context does not mean that courts should defer to an advisor’s opinion regarding the substantive merits of a transaction.  If penalties are at issue, the substantive merits (or lack thereof) of a transaction have already been decided.  Instead, deference in this context refers to whether courts should presume that a taxpayer’s receipt of an opinion written by a reputable advisor is sufficient to avoid the imposition of penalties on a transaction, notwithstanding a perceived conflict of interest on the advisor’s part.

As a starting point, an opinion must earn deference on the strength of its analysis, not the credentials of its author.  This is perhaps the primary reason why a focus on conflicts of interest and fee structures seems misguided.  If the primary purpose of the penalty provisions is to encourage compliance (or at least reasonable efforts at compliance) with federal tax law, then a well-reasoned opinion that stands on its own merits should render irrelevant fee structures or ostensible conflicts of interest.

At the same time, federal tax law is filled with many dark corners where few court decisions – let alone revenue rulings, technical advice memoranda, or any other forms of guidance – have tread.  Some of these dark corners stand ready to trap unwary taxpayers, while others create opportunities for creative minds to produce beneficial tax results.  In these dark corners, reasonable minds can often disagree about the strength of an advisor’s analysis.  That being said, courts seem to give taxpayers and their advisors a much wider berth when they stumble into the former case, as opposed to planning into the latter, precisely because the former seems to reflect more of a good faith effort to comply with federal tax law.

In Canal Corp., the taxpayer spent $800,000 to have a respected advisor render an opinion about a fairly complex area of federal tax law.  At first glance, it would seem anomalous that a court would not respect the taxpayer’s reliance on advice about the tax treatment of the transaction at issue.  How could that not constitute the kind of good faith “effort to assess the… proper tax liability” that the regulations consider to be “the most important factor” to establishing reasonable cause and good faith?  Treas. Reg. § 1.6664-4(b)(1).

The trouble that taxpayers seem to face in cases like Canal Corp. (i.e., where courts recharacterize transactions under a judicial or regulatory anti-abuse rule) is not that courts think the taxpayers haven’t made enough of an effort to understand the relevant tax laws.  To the contrary, courts seem to be suggesting that the taxpayers and their advisors have made too much of an effort to seek out the dark corners of the law to the point that, in the courts’ view, the advice has crossed the line from promoting tax compliance to promoting tax avoidance.

From the practitioner’s perspective, this distinction may be understandable; but, to the extent the distinction accurately reflects the dynamic at play, it creates an unsettling concern about whether and when to impose penalties against taxpayers.

It would be easy to suggest that a taxpayer who participates in an ostensibly non-economic transaction (or a transaction that is recharacterized under some anti-abuse rule) deserves to be penalized on the theory that the tax treatment of the transaction was “too good to be true.”  Thus, under that theory, deference to a taxpayer’s receipt of advice for such a transaction would never be owed because the taxpayer should have known better.

Nevertheless, transactions that the IRS seems to consider to be per se non-economic can be upheld by courts.  See, e.g., Consolidated Edison Co. v. United States, 90 Fed. Cl. 228 (2009); see also Shell Petroleum, Inc. v. United States, 102 AFTR 2d 2008-5085 (S.D. Tex. 2008).  Such cases would seem to suggest that taxpayers can receive well-reasoned and defensible opinions even on transactions that the IRS considers to be non-economic “tax shelters.”

Therefore, if we start from the proposition that even ostensibly non-economic transactions (or transactions otherwise susceptible to recharacterization) can be respected under the right facts and circumstances, we fall back into the same quandary raised above.  In the case of a concededly aggressive transaction, how is a taxpayer to determine whether its particular facts and circumstances fall on the right side of the law?  If the taxpayer receives a well-reasoned opinion from a reputable advisor, shouldn’t that be sufficient to avoid penalties?

Put another way, when a taxpayer receives the advice of a reputable tax advisor in deciding whether a transaction is actually “too good to be true,” hasn’t the taxpayer shown the good faith reliance necessary to avoid penalties under Treas. Reg. § 1.6664-4(b)(1)?  The point for the courts should not be whether the court should defer to reputation of the advisor, but whether the taxpayer was reasonable in doing so.

In the end, it is difficult (and perhaps pointless) to argue about what deference a court “should” give to the opinion of a reputable tax advisor.  Clearly, courts will scrutinize advisors’ opinions more closely in cases where it appears that taxpayers are attempting to use the opinions as swords rather than shields.  This is a dynamic of which both taxpayers and their advisors need to be aware; and it means that advisors must be especially diligent (and clients especially cautious) in those contexts.

The practice of law is largely a practice of persuasion.  Whether writing an opinion letter for a transaction or a brief for litigation, we earn our keep through the strength of our analyses and the wisdom of our advice.  At the risk of sounding self-righteous, if our analyses fail to persuade a court of the reasonableness of our opinions (and, by extension, the reasonableness of our clients’ positions), then we have little basis to expect any deference.

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