July 5, 2005 - Phil Hodgen

Client letter explaining Circular 230

The IRS has new rules in effect (“Circular 230”) Government regulations inexorably introduce bureacracy and risk-avoidance into business. A business will over time change from an entrepreneurial activity creating value for its customers into a risk-avoidance paper factory. We’re seeing a little of this happen right now in the tax realm.

After the jump you’ll find a copy of a letter that will be going out to all of our clients in the next few days.

Dear _____________:

In a fit of “throwing out the baby with the bathwater,” the IRS has issued new rules. Yes, I know. The IRS burps out new rules almost daily. These new rules are different, though. They are aimed at stopping tax shelters (good) but apply to everyday normal tax advice as well (bad).

Life will go on, as it usually does, with some new interesting stuff:

  • Less protection for you against tax penalties, and
  • Some new boilerplate language in letters, faxes, and emails you receive from us.

I’ll explain.

The old rules

Before June 21, 2005, you had a possible way out of tax penalties. If you were audited but you said you reasonably relied on professional advice, the odds were that the IRS would waive penalties in the audit.

The new rules

The new rules (“Circular 230” for you tax jargon aficionados) say that a taxpayer—you—won’t be able to get relief from penalties just because you relied on professional advice, unless you bought a very expensive tax opinion. Almost no one will buy that opinion, of course.)

The new rules also say that a tax advisor who doesn’t play by the new rules can effectively lose his or her ability to make a living—the advisor can be barred from practicing before the IRS.

Repeat after me, “Tax shelters are very, very bad”

The new rules are motivated by the Federal government’s crusade against tax shelters. Here’s how the game worked. Tax shelter promoters paid lots of money for a impressive-looking tax opinion. Pure boilerplate. I’ve read plenty of them.

The promoter would tell a prospective customer, “If you’re audited, tell the IRS that you reasonably and in good faith relied on this novelette of an opinion letter and you won’t have to pay the IRS any penalties.” And it worked, a lot of the time.

The IRS hated that.

No more boilerplate opinions

The new rules say that you (the taxpayer) cannot rely on a tax opinion for protection from penalties, unless I (the advisor) provide a comprehensive opinion letter.

I’ll spare you the details. Basically the IRS requires legal engineering on par with constructing a Boeing 747. Translate, please? Highly customized, highly expensive opinions are the only things that work to prevent penalties. No one will spend that kind of money for an opinion letter. IRS’s problem solved. (Aha! Using market forces—pricing—is the new government strategy!)

The new rules apply to . . .

Well, that’s fine for tax shelter promoters. They are Very Bad People. Right?

But the way the new rules are written, they’ll apply to anything that has a “significant purpose” of tax avoidance. This is deliberately vague. Except for a few things, the IRS has refused to say what they mean by this.

Examples? Routine estate planning has a “significant purpose” of reducing estate tax. Forming a corporation has a “significant purpose” of controlling income tax. Are you giving the Salvation Army that old lawnmower because you want to get a tax write-off? Hmm. That’s a “significant purposes,” isn’t it?

You get the picture. At some point all of this normal, everyday stuff will remain unaffected by the new tax opinion rules. But where, exactly, is the line between “no problem” and “we have a problem?” No one really knows, and the IRS isn’t telling.

So far, the IRS response has been “Trust us, the new rules won’t apply to normal stuff like that but we’re not going to put that in writing. And we’re nice people, just ask our mothers, so we’re not going to use this giant club we’re holding behind our back.”

Results to you
You would like to do these normal, everyday things and have some assurance as to the tax results. That includes relief from penalties if things go sour.

Now, unless you get a comprehensive opinion (not worth the cost, 99.6% of the time), you don’t necessarily have that assurance.

That’s the impact of the intentional ambiguity in the new rules.

Hello, disclaimer!

The new rules say that every time an advisor writes something to a client, that little piece of writing must either be a full-blown over-engineered opinion letter, or it must contain a disclaimer. Do neither? Then the advisor risks getting banned from practicing before the IRS—a career-killer for someone like me with 23 years of tax practice.

The only sane approach is to include the disclaimer. Accordingly, effective immediately, this firm will routinely include the following language in written communications:

“This written advice is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.”

Life goes on

As I said, life goes on. We will put the same care and attention into your projects as we did before the new rules became effective, and do everything we can to save you taxes.

If you have any questions about this, please give me a call or pop me an email. It’s your government at work.

Very truly yours,

Philip D. W. Hodgen


US Real Estate Investments