Circular 230,1 the Internal Revenue Service's pronouncement regulating written tax advice, applies to all tax practitioners, including estate planners like me — much as I might wish it affected only nefarious sellers of dubious tax shelters. Here is my analysis of how Circular 230 applies to my standard tax advice regarding two common estate-planning devices, credit shelter trusts and qualified personal residence trusts (QPRTs).2

Every tax practitioner must read and study Circular 230; there are no shortcuts. I hope my analysis will help other practitioners confirm or test their own conclusions, or inspire them to let me know where I've gone wrong.

Unlike some commentators, I assume the IRS is not trying to criminalize day-to-day estate planning practice, and that my adopting a more formal and thoughtful approach to providing tax advice (as required by Circular 230) is not a bad idea.

TYPES OF WRITTEN ADVICE

Under Circular 230, a practitioner may provide only two, or possibly three, types of written tax advice: “covered opinions,” “other written advice,” and (the possible third category) “preliminary advice.” Any written tax advice the practitioner provides (including emails) must fall into one of those categories (and meet the requirements applicable to that category).

The gist of Circular 230 is that any written tax advice must take the form of a “covered opinion” unless, under the standards of the regulation, it fits into the definition of preliminary advice or other written advice. Since a covered opinion requires substantial labor, which the typical estate-planning client does not want to pay for, my goal is to avoid writing covered opinions to the maximum extent possible.

COVERED OPINION

Circular 230 contains lengthy requirements for a covered opinion. According to Section 10.35(c), the practitioner must “identify and ascertain the facts” and “not base the opinion on any unreasonable factual assumptions.” The opinion must identify all factual assumptions and representations, statements or findings relied on by the practitioner; relate the applicable law to the facts; “consider all significant Federal tax issues”; and “provide the practitioner's conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each significant Federal tax issue considered in the opinion.”

The practitioner “must be knowledgeable in all aspects of Federal tax law relevant to the opinion.” However, provision is made, in Section 10.35(d), for relying on other professionals' opinions (subject to certain requirements). A covered opinion can be of limited scope — again, subject to various requirements (Section 10.35(c)(3)(v)); and must contain various elaborate disclosures (see Section 10.35(e)).

This brief summary gives the flavor of the covered opinion requirements, but is not a complete list. If I find that I am required to provide a covered opinion, I will have to slog through the details of Section 10.35(c) to (e) line by line. The first covered opinions I prepare will take quite a bit of time. I am hopeful that, because so many estate-planning transactions are repetitive, I'll be able to re-use my covered opinions (adapting them for each client, just like a will or trust form), thus saving more time.

But mainly I want to avoid having to write covered opinions for my routine estate-planning transactions in the first place.

OTHER WRITTEN ADVICE

Although I have some hope of never having to write a covered opinion, I cannot avoid the requirements of Section 10.37, which applies to “other written advice.” Any written advice I give concerning a federal tax issue must meet the requirements of Section 10.37, unless it meets the stricter standards of a covered opinion under Section 10.35, or (possibly) it is just preliminary advice. Fortunately, the four requirements for other written advice are not onerous. They represent reasonable precautions I probably should be observing anyway. They are:

  • I must not base the advice on unreasonable factual or legal assumptions. Thus, if a business purpose is essential to the tax success of the transaction, I cannot simply assume a business purpose exists.

  • I may not unreasonably rely upon anyone's representations. So, if the valuation of illiquid property is essential to my tax advice, I must insist on an appraisal (meeting IRS standards) of such property.

  • I must consider all relevant facts; and my evaluation of the tax effects must not take 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 settled.

Complying with these modest requirements should not be unduly burdensome.

PRELIMINARY ADVICE

“Written advice provided to a client during the course of an engagement” need not be in the form of a covered opinion if, says Section 10.35(b)(2)(ii)(A), the practitioner “is reasonably expected to provide subsequent written advice to the client that satisfies the requirements of” Section 10.35. The Treasury's “Explanation” refers to this as the “exclusion for preliminary advice.”

For example: a client asks me for tax-saving ideas for his estate plan. I send him a letter recommending that he consider a credit shelter trust, an irrevocable insurance trust, and a QPRT. I describe each device in summary fashion, explaining how it works and estimating the potential tax savings. I expect to provide subsequent Circular 230-compliant written advice regarding each idea the client decides to adopt. I do not plan to provide further advice regarding any proposal the client is not interested in pursuing.

I believe that my letter is exempted from Section 10.35 as “preliminary advice” even though:

  1. My later more formal advice may be in the form of “other written advice” (under Section 10.37) rather than a “covered opinion” (under Section 10.35). If my subsequent advice is exempted by Section 10.35 from the definition of covered opinion, then, in my opinion, it “satisfies the requirements” of Section 10.35 even though it is not a covered opinion.

  2. I will not provide subsequent written advice regarding ideas the client does not wish to pursue. Because I assume the IRS is not insane, I also assume the Service does not expect me to provide the client with a covered opinion regarding a transaction the client is not going to enter into.

I propose to include the following statement in any written communication that I consider preliminary advice: “The ideas in this letter should be considered merely preliminary tax advice. If you decide to go ahead with any of these ideas, or if you want more information before deciding, I will provide you with a more complete and formal description of the tax effects of the transaction. Since preparation of that more formal tax advice may require additional facts and research regarding your situation, you should not rely on this letter in engaging in any transaction.”

Though not required by Circular 230, labeling the letter as preliminary advice will help me later to remember where this letter stands on the continuum of Circular 230 tax advice.

Now the caveat: It is not clear to what extent, if any, “preliminary advice” must meet the requirements for “other written advice.” A reasonable interpretation would be that preliminary advice is subject to the requirements for “other written advice” (such as not evaluating a tax idea based on the likelihood of audit), but that the standards would be much lower than for non-preliminary advice. Section 10.37 provides that “[a] ll facts and circumstances, including the scope of the engagement and the type and specificity of the advice sought by the client will be considered in determining whether a practitioner has failed to comply” with Section 10.37. This suggests to me that when a client has asked for estate-planning ideas, I can describe how a QPRT works without demanding an appraisal of his house, provided I follow up later with appropriate appraisals and investigations if the client decides to go ahead with the idea.

C.O. REQUIRED IF…

My tax advice must be in the form of a covered opinion if it falls within one of six categories: it deals with a listed transaction; it has confidentiality conditions or contractual protection; it is a marketed opinion; it deals with a principal purpose transaction; or it is a reliance opinion. Only the last two of these are at all likely to arise in my practice.

Four of the covered opinion categories don't apply to me:

  • Listed transactions — Section 10.35(b)(2)(i)(A) — Popularly known as “tax shelters,” listed transactions are tax avoidance transactions the IRS has identified under 26 C.F.R. Section 1.6011-4(b)(2).3 There are no estate-planning devices on the list.

    Confidentiality conditions — I do not impose limitations on the recipient's ability to disclose my advice or the tax structure of the proposed transaction, so my advice is not subject to confidentiality conditions as described in Section 10.35(b)(6).

  • Contractual protection — I do not make my legal fee contingent on the intended tax consequences' being sustained, so my advice does not involve contractual protection as described in Section 10.35(b)(7).

  • Marketed opinion — Finally, my advice is not a marketed opinion because, as Section 10.35(b)(5)(i) puts it: I do not “know or have reason to know” that the advice “will be used or referred to” by someone else “in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to one or more taxpayer(s).” My advice is for the client's own use only.

    Some commentators fear that the definition of marketed opinion is so broad it will apply to seminar materials for a CLE program. I assume the IRS is not planning to lead the Heckerling Institute speakers off the stage in handcuffs, but anyone worried about the scope of this definition can easily avoid having a marketed opinion (in most cases) by including the disclosures listed in Section 10.35(b)(5)(ii).

    If you are concerned that your advice might fall into any of these four categories, by all means study the cited sections. My conclusion is that my standard estate-planning advice will never involve any of these categories.

    Two types of covered opinions might apply to me. In fact, where most estate planners are more likely to enter covered opinion territory is through the “principal purpose” or “reliance opinion” gate. I believe that the vast majority of routine estate-planning tax advice will not require a covered opinion, but any possible exceptions are likely to be found here.

  • Principal purpose transactions — A covered opinion is required for advice regarding tax issues arising from an entity, plan or arrangement “the principal purpose of which is the avoidance or evasion of any tax imposed by the” IRC. However, the principal purpose category does not include an entity, plan or arrangement that, as Section 10.35(b)(10) puts it “has as its purpose the claiming of tax benefits in a manner consistent with the statute and Congressional purpose.”

    Some commentators argue that all tax-avoidance schemes claim to be based on some statutory provision, and therefore the exclusion for claiming statutory tax benefits is so overly broad as to be meaningless. I disagree. While there are certainly gray areas, most standard estate-planning advice is removed from the principal purpose category by the exclusion for claiming statutory tax benefits.4

    For example, a married couple adopts credit shelter trusts, usually, for the sole purpose of avoiding federal estate tax on the second spouse's death. However, this is not a principal purpose transaction, because they are merely claiming a statutory tax benefit (the federal estate tax exemption) in a manner consistent with Congressional purpose. I conclude that the credit shelter trust arrangement is consistent with Congressional purpose because such trusts have been widely used for many decades, and neither Congress, the IRS nor the courts have ever raised the slightest objection to this technique.

    No one would give a house to a QPRT for any reason other than avoiding federal estate taxes. However, the IRC5 exempts a trust funded with a personal residence from the special valuation rules of Chapter 14, so the QPRT donor is merely claiming tax benefits in a manner consistent with the statute and Congressional purpose.

    One commentator pointed out that the QPRT is a creature of regulation,6 not of the “statute,” and therefore might be considered a “principal purpose” transaction after all. Well, yes, if you make the absurd assumption that the IRS's regulation creating QPRTs is not consistent with Congressional purpose. Folks, the IRS has issued a model QPRT form;7 the Service is not going to argue that a QPRT is a principal purpose entity!

    There are aspects of a QPRT that are not so clearly “blessed” by the statute and regulations. For example, if the donor funds the QPRT with a fractional interest in the residence (rather than the entire residence), the donor will want to take a valuation discount for such a fractional interest, due to its lack of marketability. However, the value of the property transferred to the QPRT should not be part of my tax advice. Under Circular 230, the valuation of property for federal tax purposes is a factual issue, and must be established by an appraisal that meets IRS guidelines.8

  • Reliance opinions — The final, and trickiest, category of advice that requires a covered opinion is the reliance opinion. The convoluted definition in Section 10.35(b)(4) boils down to this: the combination of three “significants” results in a reliance opinion. Conversely, if any of the three is lacking, there is no reliance opinion.

Written advice is a reliance opinion if:

  1. It involves an entity, plan or arrangement of which tax avoidance is a significant purpose (not the principal purpose);9

  2. It “concludes at a confidence level of more likely than not…that one or more significant Federal tax issues would be resolved in the taxpayer's favor.” A federal tax issue is “significant” if the IRS “has a reasonable basis for a successful challenge” on the issue;10 and

  3. Resolution of the issue “could have a significant impact…under any reasonably foreseeable circumstance, on the overall Federal tax treatment of the” matters addressed in the opinion.11

Even if all three “significants” are present in your case, you may usually avoid issuing a covered opinion for the transaction by including a disclosure that the opinion cannot be relied upon to avoid penalties. See Section 10.35(b)(4)(ii) for details regarding the contents and format of the disclosure, and when it may be used.12

The good news is that most estate planning advice does not involve issues on which the IRS has any chance of successful challenge. For example, in my credit shelter trust, if the trust gives the surviving spouse life income, the right to principal based on an ascertainable standard relating to her health or support, and a limited power to appoint at death among the decedent's issue, and I advise that the trust will not be included in her estate despite these rights and powers, what chance does the IRS have of successful challenge? None. Accordingly, such advice does not involve a “significant federal tax issue” and can be provided to the client as “other written advice” without the formalities of a covered opinion.

However, things become murkier if the advice involves an unclear tax issue, where I may have to assume the IRS has some chance of successful challenge. I then need to determine whether the tax impact of the issue is significant. Circular 230 does not define “significant impact” and this term appears nowhere else in the Code or regulations according to my tax service's word search function. The IRS in other contexts considers 10 percent to be a “substantial” portion.13 Is a significant impact less or more than a substantial impact?

In a QPRT, the drafter must draft to avoid the imposition of a generation-skipping transfer (GST) tax if a child of the donor dies after the QPRT term commences, a circumstance which is reasonably foreseeable. Some techniques used to deal with that problem involve undecided federal tax issues.14 To measure the tax impact if the question is resolved adversely, do I measure only against the total expected GST taxes, or against all transfer (and income?) taxes paid in connection with the QPRT? Do I treat the amount of the donor's gift tax credit used as a tax paid? Do I weigh the “face amount” of the potential future GST tax, or do I discount that amount to reflect the actuarial likelihood of occurrence of the event?

It seems to me that any reasonable method I come up with to measure whether an impact is significant should satisfy the IRS, because the IRS has provided absolutely no standards, examples or other guidance of any kind regarding the meaning of this phrase.

However, the bottom line is that if my otherwise garden-variety QPRT involves any unclear federal tax issues I will probably have to provide the client with a separate opinion (containing the no-reliance disclosure) on that issue. The opinion will be separate, so that I do not have to make the entire QPRT tax explanation a covered (or no-reliance) opinion. The effect of the separate opinion will be to heighten the client's (and my) awareness of the undecided tax aspects of the transaction and the risks involved. In the past I might not have highlighted those aspects due to a desire to protect the client from considering every possible arcane tax issue. Perhaps now I will have to put all the ugly possibilities up front. And perhaps that is not such a bad idea.

WHAT'S NEXT

Advisors who offer family limited partnerships (FLPs) to their estate-planning clients may have to use covered opinions to advise the clients regarding such issues as the ability to withstand an IRC Section 2036 challenge. In contrast to the credit shelter trust and QPRT, the IRS has attacked such partnerships repeatedly, so this is clearly an area in which the IRS thinks it has a reasonable chance of successful challenge. The number of IRS victories suggests that some advisors and clients are not properly designing and implementing these partnerships to achieve their hoped-for results, and need to be more cautious than they apparently have been in offering FLPs as an estate-planning technique. If the effect of Circular 230 is to impose such caution, where's the harm?

This is merely the beginning, not the end, of the effort to review my standard estate planning offerings in light of Circular 230. I must perform the same step-by-step analysis regarding every estate-planning device I offer clients. I expect that when I finish I will find that most tax advice I give will (like my advice regarding credit shelter trusts and QPRTs) usually not require a covered opinion, because it involves either claiming a statutory benefit in a manner consistent with Congressional purpose or a non-controversial issue on which the IRS has no reasonable chance of successful challenge.

Endnotes

  1. 31 C.F.R. 10; see T.D. 9165 (Dec. 20, 2004), as amended by T.D. 9201 (May 18, 2005). Circular 230 is issued under the Treasury's authority to regulate practice before the Treasury Department (31 U.S.C. Section 330). Most citations to sections of Circular 230 will be placed in the body of the article; other citations will be in the endnotes. I thank my Bingham McCutchen colleague Harry Lee for his helpful comments on this article.
  2. This article is fictional. Because I work in a law firm, and Circular 230 requirements apply on a firm-wide basis, I will have to comply in whatever manner my law firm dictates. Section 10.36.
  3. See IRS Notice 2004-67, 2004-41 I.R.B. 600, for the most recent list of “listed transactions.”
  4. See Treas. Reg. Section 1.6662-4(g)(2)(ii) for meaning of “principal purpose” of tax avoidance, and examples of statutory benefits (such as qualified retirement plans and tax-exempt municipal bond interest) that are not considered principal purpose devices, in the income tax context.
  5. IRC Section 2702(a)(3)(A)(ii).
  6. Treas. Reg. Section 25.2702-5(c).
  7. Rev. Proc. 2003-42, 2003-23 C.B. 993.
  8. For appraisal requirements in connection with valuation for gift tax purposes, see Treas. Reg. Section 301.6501(c)-1(f)(3).
  9. Circular 230, Section 10.35(b)(2)(i)(C).
  10. Circular 230, Section 10.35(b)(4)(i).
  11. Circular 230, Section 10.35(b)(3).
  12. One approach to Circular 230 compliance is to put the no-reliance disclosure on every written communication that mentions taxes. While this approach has obvious appeal to the firm's head-of-practice (who envisions otherwise having to review every communication his firm issues), it does not “solve” the Circular 230 compliance problem. The no-reliance disclosure does not eliminate the requirement of a covered opinion if the matter involves either a principal purpose or a listed transaction (Section 10.35(b)(4)(ii)), and does not eliminate the need for firm-wide compliance with the four requirements for “other written advice.”
  13. See for example, Treas. Regs. Section 1.141-3(g)(7) and Section 1.6662-4(b)(1).
  14. See Natalie B. Choate, The QPRT Manual, Chap. 5 (Ataxplan Publications, 2004; www.ataxplan.com).

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