33 Tax Notes 501

Tax Notes

NOVEMBER 6, 1986

LENGTH: 3570 words

DEPARTMENT: Special Reports (SPR)

CITE: 33 Tax Notes 501

HEADLINE: 33 Tax Notes 501 - TAX RETURN POSITIONS IN CONTEMPT OF CIVIL PENALTIES.

AUTHOR: Johnson, Calvin H.

University of Texas Tax Analysts

TEXT:

Calvin H. Johnson is Arnold, White & Durkee Centennial Professor of Law at the University of Texas in Austin, Texas.

In this article, Johnson supports the recently Proposed Treasury Regulation (Prop. Reg. section 10.34) proscribing a professional from advising or preparing a tax return that would lead to the imposition of the penalty under section 6661 of the Internal Revenue Code. He argues that the 'some realistic possibility' standard urged by the American Bar Association is built on the faulty premise that the filing of an income tax return is like a complaint or a brief. He argues, however, that the proposed regulation should be clarified to allow a taxpayer to take a return position that he reasonably believes is more likely than not to prevail. This article was first written as a letter to the Director of Practice of the IRS.

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Table of Contents

Introduction ..................... 501

The ABA Position ................. 502

Possible Clarifications .......... 504

Right to the Law .............. 504

Dual Standards ................ 504

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Introduction

The Treasury Department has proposed regulations (Proposed Treasury Regulations, section 10.34) that would prohibit a practitioner entitled to practice before the Treasury Department from preparing a tax return or advising a taxpayer to take a position on a tax return if the position would subject the taxpayer to a penalty under section 6661 of the Internal Revenue Code. Section 6661 imposes a penalty on a substantial understatement of tax unless the taxpayer either had substantial authority for the return position or else disclosed the relevant facts concerning the position on the return. If the position relates to a tax shelter, specially defined as a plan having the principal purpose of avoiding or evading tax, the taxpayer must also reasonably believe that the position taken on the return is more likely than not to prevail. In short, the Treasury would proscribe the preparation of returns or the giving of advice in connection with the preparation of returns if the preparation or advice connected to a position were not supported by substantial authority, or if tax shelters were involved, were not believed (by the taxpayer) to be more likely right than wrong.

This article is written in support of the basic Treasury position. The taxpayer and his representative have a legal duty not to take positions that would lead to imposition of the penalty under section 6661. The American Bar Association in Formal Opinion 85-352 has put forth a weaker standard, that a tax return may legitimately take a position for which there is 'some realistic possibility of success.' But the ABA position is built on the mistaken premise that the filing of a tax return is like a complaint or a brief in an adversarial proceeding and the ABA has thus understated the duty owed by the taxpayer and his representative to the government.

The Legal Duty of a Representative

A lawyer, accountant, or other representative of the taxpayer steps into the shoes of the taxpayer, deriving his legal duties from the taxpayer's duties. Nothing in the lawyer-client relationship contracts the client's duties to, nor expands his rights against, outsiders. Symmetrically, the lawyer is an agent of the taxpayer and as an agent, no matter how zealous, he is bound by the client's duties to outsiders. A lawyer is not relieved of discharging the taxpayer's legal duty to the government, even if the taxpayer separately breaches his duty. An agent, for instance, who is 'only following orders' still is in breach of his legal duties if the orders are to breach the client's legal duties. Lawyers are disbarred, for instance, for suborning perjury, even if the perjury was done at the client's express request.

When the Congress penalizes conduct it announces, with the power of law, that the conduct is unethical and censurable and no longer a matter of sport. Section 6661 of the Code imposes a penalty addition to tax for a substantial understatement of income, unless the position has a substantial authority for it or is specially disclosed on the return. The purpose of section 6661 is to provide a downside risk for taxpayers taking questionable undisclosed positions on their tax return, so that taxpayers would be deterred from playing the audit lottery on positions not amounting to fraud. (Staff of the Joint Committee on Taxation, General Explanation of the Tax Equity and Fiscal Responsibility Act of 1982, at 216-217. See also Roberts, Opening Remarks in the Tax Simplification Symposium, 34 Tax Rev at 9 (1978), regretting the denigration of the practice of tax law that arises from the tax lottery.) Section 6661, by imposing a penalty addition to tax, creates a legal duty that is stronger than just the ordinary legal duty to pay proper tax.

A lawyer, accordingly, should not be permitted to advise a taxpayer to take a position that would be subject to the penalty if all of the facts were known, including facts about the state of mind of the client and his advisers. It is not a proud or public defense that the section 6661 penalty was worth risking, that the law might possibly be changed in the client's favor, or that the representative was just following the client's orders. It is, however, a responsible, ethical position and it should be a defense against penalty that the lawyer reasonably thought that the law was in the client's favor, that is, that the lawyer reasonably thought that an enlightened court fully informed as to the facts and relevant law would be more likely than not to find in favor of the client's reported position.

The rule proposed in Treasury Regulation section 10.34 is appropriate to carrying out the function of Circular 230. Circular 230 was first promulgated to protect the Treasury against inflated claims (for compensation for horses), and the Proposed Regulations would protect the Treasury from inflated tax claims. The proposed rules are no more onerous than legal duties already appropriately imposed on practitioners. Treasury Regulations section 10.23, for instance, requires the practitioner to exercise due diligence to determine the correctness of any oral or written representation made by the practitioner or his client to the IRS. Treasury Regulations section 10.33 (upheld against Constitutional challenge in Joslin v. Secretary of the Department of Treasury, 616 F. Supp. 1023 (D. Utah 1985)) requires a practitioner rendering a tax shelter opinion to exercise due diligence as to the value of property offered and to provide an overall evaluation as to whether the material tax benefits offered are more likely than not to be realized. The legal duty created by section 6661 and carried over to the practitioner in Treasury Regulation section 10.34 is appropriate and well within the range of the duties already imposed on practitioners.

The penalty in section 6661, increased to 25 percent in the 1986 Act, is still small enough that it is commonly in the client's economic interest to risk the penalty and clients will accordingly sometimes knowingly and willfully risk and bear the penalty. We live in an individualistic society where a citizen's duty to his country is relatively low. Outlaws are often heroes. The 'Indians' who dumped the tea into Boston harbor were acting illegally, but are remembered as patriots. Nonetheless, the Service has the duty to enforce legal duties as to tax. The Service can reasonably expect that representatives authorized to practice before it not act in contempt of a penalty that the Congress has mandated, even if the representative will be under economic pressure to breach the legal duty.

The ABA Position

The Ethics Committee of the American Bar Association has rendered an opinion inconsistent with Proposed Treasury Regulation section 10.34, but the opinion considerably understates the duty of the taxpayer and his representative with respect to the tax return. Formal Ethics Opinion 85-352 would allow a lawyer to advise his clients to take a favorable position on his tax return, even though the position would subject the client to the section 6661 penalty, as long as there is some 'realistic possibility of success' if the matter were litigated:

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A lawyer may advise reporting a position on a return even where

the lawyer believes the position probably will not prevail,

there is no 'substantial authority' in support of the position,

and there will be no disclosure of the position in the return.

However, the position to be asserted must be one which the

lawyer in good faith believes is warranted in existing law or

can be supported by a good faith argument for an extension,

modification, or reversal of existing law. This requires that

there is some realistic possibility of success if the matter is

litigated.

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The 'some realistic possibility' standard is intended to restate in differentlanguage the 'reasonable basis' standard promulgated in 1965 by Ethics Opinion No. 314. The change is in response to attacks on the old standard as contributing to the audit lottery, but the change is intended to effect no substantive change, except clarity.

Both the 'reasonable basis' and the new 'some realistic possibility' standard are litigation standards, arising from and legitimated if at all by an analogy between a tax return and a complaint or brief in contested litigation. Opinion 314 argues that the duty on a tax return is analogous to a lawyer's duty to his opposing lawyer: 'A lawyer is under no duty to disclose his weaknesses to the Internal Revenue Service on a tax return any more than he would be to make such disclosures to a brother lawyer.' As characterized by Elliot Cheatham, the duty of attorney to his adversary is 'to tell the truth, nothing but the truth, but not necessarily the whole truth.'

It is hard to take seriously the ABA's argument that a tax return is like the pleadings or brief in a law suit because the documents and duties are so different. The duties to opposing counsel in a law suit are minimal for good reasons, which, however, are inapplicable to a tax return. A taxpayer's obligation to his government to pay tax and avoid penalties is logically independent of his right to litigate.

The function of a complaint and brief are to allow a party a right to a day in court. Restrictions on an attorney's legal arguments before a court would chill a basic right of a citizen to seek redress in court for what he considers to be a wrong. There is 'an obvious public interest in affording every citizen freedom of access to the courts.' Godfrey Pontiac Inc. v. Roloff, 630 P.2d 840, 848 (Ore. 1981) (holding that opposing attorneys are not liable for the injury of being hauled into court) and authorities collected therein.

The function of a tax return, however, is decidedly not to achieve a day in court. A tax return does not establish jurisdiction in any court and, conversely, penalties for erroneous positions taken on a return would not deny a day in court. If harsh penalties were imposed every time a taxpayer was found to have reported less tax on his return than he owed, then a taxpayer would rationally report more tax than he owed under law just to have a margin of safety, but the taxpayer could still achieve his day in court by suing for refund of tax not due. Before 1924, suit for refund was the exclusive means for judicial review of the propriety of any collection of tax./1/ The fact that the taxpayer now has a right to contest a deficiency without paying tax does not change the logical independence of his right to litigate from his obligation to pay.

If a tax return were supposed to achieve a day in court, taxpayers would object if the Service deprived them of their right to a day in court by failing to audit. (See, e.g., Lambert v. Kurtz, 41 AFTR 2d 1050 (D. Colo. 1978), dismissing a suit, 'a little different from run-of-the-mill case,' to force IRS to audit the plaintiff.) A taxpayer's more likely motive in filing his tax return is not to achieve his day in court, but to avoid any and all days in court. The ABA position calls on the right to a full and open hearing as a value to justify a taxpayer's gaining hidden advantage through the audit lottery.

The low standards for a complaint or brief, moreover, make sense only in the context of a contested proceeding. A complaint is not supposed to be the final determination of truth; it is the opening round. The complainer makes a 'statement of position,' the responder responds, and the truth is to be shaped between the hammer and anvil of the adversary system. The function of a law suit is to determine the merits of a claim, so there is no real harm in allowing a nonmeritorious suit to go to the next stage where it will be dismissed for failure to state a claim or where summary judgment will be rendered. Dismissal is a sufficient sanction. In any event, sanctions against civil proceedings brought without the requisite merit or intent are rare. (Wright & Miller, 'Fed. Prac. & Procedure' section 1334, p. 503 (1969).)

A tax return, by contrast, is not meant to be a contested proceeding. Less than two percent of all returns are audited and even then most audited returns are just spot checked. A tax return is the final resolution of tax liability in all except the unusual case; it is not just a claim to be met by opposing counsel. Audits of tax returns are intrusive, unpopular, and decidedly not the norm, whereas answers and opposing briefs are legitimate and expected in all litigation. 'The premise of the adversary system,' in sum, 'that two adversaries will be in an equal position to uncover and present the facts, is unrealistic as applied to the current tax system.' (Rowen, When May a Lawyer Advise a Client That He May Take a Position on a Tax Return?, 29 Tax Lawyer 237, 248-49 (1976).)

We rely on a sample of audits to keep unaudited returns basically honest. Rather than meet every erroneous argument on a tax return, our tax system penalizes some erroneous arguments. The taxpayer is required to certify that his tax return is true, correct, and complete 'to the best of my knowledge,' and it is a criminal felony for a taxpayer willfully to file a return which the taxpayer does not 'believe to be true and correct as to every material matter.' Some audited returns are penalized so that unaudited taxpayers are encouraged or intimidated into reporting their tax correctly.

The wildly different functions of tax returns and of briefs or complaints create a number of other differences. Novel theories are permissible in briefs (see, e.g., Resinger, Honesty in Pleading and its Enforcement: Some Striking Problems with Federal Rule of Civil Procedure 11, 61 Minn. L. Rev. 1, 57 (1976) arguing that 'today's frivolity may be tomorrow's law'), but a return which intentionally or negligently disregards current rules and regulations is subject to penalty. (IRC section 6653(a).) A complaint may be used just to investigate the facts or to find records held by an adversary (see Resinger at 56), but a taxpayer is required to maintain his own records to support deductions he claims and tax he reports. Perhaps the attorney in court need not give his adversary the whole truth, but material omissions from a tax return are penalized. A 'voluble' but intelligible complaint may keep the law suit open (Dioguardi v. Durning, 139 F.2d 774 (2d Cir. 1944)), but 'a taxpayer cannot simply deposit a conglomerate of papers with the Internal Revenue Service and expect them to be treated as a tax return.' (Lonnie Ray Akes, T.C. Memo 1980-233.) A court-appointed criminal lawyer has a duty to make arguments in his brief even if he believes the arguments are wholly without merit. (Anders v. California, 386 U.S. 738 (1967).) That certainly does not give a taxpayer a right to make arguments on his tax return that are wholly without merit.

The ABA's 'some realistic possibility' standard, in sum, is not legitimated by its articulated rationale. The premise is not sound.

Finally, as a matter or jurisdiction, the duties of a practitioner eligible to represent a taxpayer before the Internal Revenue Service are determined under Circular 230 and not by the American Bar Association. The ABA Ethics Committee has been justifiably criticized, outside of the tax area, as a nonadversarial process that adopts illogical rationales that overvalue the self interest of lawyers and undervalue the interests of third parties. (Finman & Schneyer, The Role of Bar Association Ethics Opinions in Regulating Lawyer Conduct: A Critique of the Work of the ABA Committee on Ethics and Professional Responsibility, 29 U.C.L.A. L. Rev. 67 (1981).) Within the tax area, the ABA can be expected to require 'warm zeal' to the client when it is in the lawyers' interests to do so, but it cannot be expected to value fully the interests of the government. The legal duties to government on a tax return are drawn from congressionally mandated duties. The ABA, AICPA, or other trade groups do not write their own rules. The Internal Revenue Service has the authority and duty to protect itself against lawyer and client, working in concert, by enforcing legal duties with respect to tax returns.

Requests for Clarification

Notwithstanding the basic soundness of Proposed Treasury Regulation section 10.34, there is need for clarification of the application of section 6661 to practitioners:

Right to the law. -- In the end, the law is a prediction as to what an enlightened court would decide if it were fully apprised of the facts of the case and applicable statutes and precedents. A taxpayer should accordingly have the right to the law, that is, he should be able to report his tax on his return according to a reasonable belief as to what the outcome of a litigated case is most likely to be. That does not mean that he can report his tax without penalty according to some self-serving claim as to what the law might be, where he does not believe a favorable outcome is most likely.

Section 6661 in spirit supports the taxpayer's right to the law. The 'substantial authority' standard was thought to be a standard less than 'more likely than not,' although greater than 'reasonable basis.' Only tax shelters, that is, plans the principal purpose of which was to avoid or evade Federal tax, were held to the higher 'more likely than not' standard.

The technical difficulty is that it is possible for a taxpayer to have a reasonable and good faith belief that he is more likely than not to prevail, possibly without having 'substantial authority' as technically defined. Wise and experienced practitioners cannot possibly rely just on binding statutes, regulations, and precedents to predict outcomes, because the truly binding authorities do not settle most cases that lawyers see. The 'Bluebook' staff General Explanations of a major tax act, the published, disinterested opinions of highly respected commentators, and the reasonable positions taken by a number of technical advice memorandums or private letter rulings are the kinds of 'quasi-law' sources which a reasonable tax adviser would rely on in predicting outcomes, where no binding authority exists. A sound theoretical understanding of tax theory and tax history, moreover, is often a far better predictor of outcomes than is a decided case in one's own Circuit. It is probable that the congressional intent behind section 6661 was to allow all taxpayers to rely on the law, according to a reasonable prediction of the likely outcome. But if the regulations under section 6661 do not incorporate that idea, then the rules of practice under Circular 230 should depart from the section 6661 regulations.

The final Regulations section 10.34, accordingly, should allow the taxpayer to report his tax and allow his representative to advise a tax position according to a reasonable and good faith estimate that the outcome before a fully informed court is more likely than not to be in the taxpayer's favor.

Dual standards. -- Where there is no audit lottery and there is no advantage to be gained by nondisclosure, the duty imposed on the taxpayer and his representative can be lower. The ABA position arises from a litigation role and it seems an appropriate standard for a suit initiated by the taxpayer for a refund of tax. Since the ABA position has confused the roles of a tax return and of a complaint or brief, it is appropriate to reaffirm that there are procedures other than a tax return by which a taxpayer achieves a day in court. Accordingly the final Regulations section 10.34 should allow a taxpayer and his representative to achieve a day in court by allowing a refund claim and suit even though he could not predict that he will prevail, as long as there is a reasonable basis for the taxpayer's position. Ethics Opinion 314.

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FOOTNOTE

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/1/ The prohibition against judicial review prior to paying tax is an ancient doctrine arising because taxes are 'the very existence of the government.' Cheatham v. United States, 92 U.S. 85 (1875).

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