Avoiding fallout from aggressive tax strategies

By Deborah K. Rood, CPA

BOSS. Son of boss. Syndicated conservation easement transactions. Microcaptive insurance companies. What do these tax planning strategies have in common? They all appeared "too good to be true," and the IRS, upon examination of related tax returns, agreed. Taxpayers were assessed substantial penalties, and CPAs were penalized as well. CPAs acting as promoters of syndicated conservation easements pleaded guilty to criminal conspiracy charges, and a Big Four firm admitted to criminal wrongdoing, paying $456 million in fines, restitution, and penalties to defer prosecution related to son-of-boss strategies.

While the risk of creating, promoting, and selling aggressive tax strategies is understood by most CPAs, significant risk remains for those CPAs who "just make introductions," provide tax consulting services, or prepare returns that reflect too-good-to-be-true tax strategies. Consider these scenarios:

After attending a law firm seminar about a new tax planning strategy, a CPA identifies clients for whom the strategy may apply, provides them an overview, and facilitates an introduction to the law firm. Several clients subsequently implement the strategy.

Alternatively, other clients may identify and implement a tax planning strategy on their own without the CPA's involvement.

Irrespective of the scenario, the strategy is ultimately reflected on the client's tax return prepared by the CPA. If a taxing authority subsequently disputes the merits of the tax strategy, regardless of the extent of the CPA's involvement, the client may bring a claim against the CPA for penalties, interest, loss of the anticipated tax benefit, and other mitigation expenses.

CHARACTERISTICS OF TOO-GOOD-TO-BE-TRUE TAX PLANNING STRATEGIES

If a planning strategy has one or more of the following characteristics, it may be too good to be true.

  • A promoter is involved. Promoters often receive commissions, which may incentivize them to operate in their own interest, not the client's or CPA's.
  • A signed confidentiality agreement is required to learn about the strategy. Confidentiality agreements create an aura of exclusivity, but they may also be an attempt to prevent the IRS from getting wind of a potential strategy.
  • The strategy appears to run afoul of one or more judicial doctrines. Federal court decisions have established various judicial tax doctrines. If a transaction does not withstand scrutiny under one or more of these doctrines, it is less likely to be upheld upon examination.
    • The substance-over-form doctrine allows the IRS to ignore the legal form of a transaction and examine whether its substance results in tax avoidance.
    • The step-transaction doctrine treats a series of separate steps as a single transaction to determine the underlying intent.
    • The business-purpose doctrine invalidates a transaction if it appears that it has no substantial business purpose other than to obtain tax benefits.
    • The sham-transaction doctrine identifies transactions where the economic activities purported to give rise to the tax benefits do not occur.
    • The economic substance doctrine invalidates a transaction if the transaction lacks economic substance independent of the tax considerations.
  • Professionals associated with the strategy are paid a higher-than-customary fee. While the professionals may have invested considerable time and resources in developing the tax planning strategy, fees should be similar to those for other strategies.
  • The strategy is overly complex. Is the "loophole" the strategy is trying to fit through so narrow that a complex structure must be created to meet the exception? If many attorneys, CPAs, and other advisers are involved, maybe.
  • Contracts with the promoter attempt to limit damages. Beware of provisions purporting to limit recoverable damages if the transaction fails under scrutiny and have all such contracts reviewed by legal counsel prior to execution. Check for disciplinary actions or complaints against the promoter.

MANAGING THE RISK

The best way for a CPA to mitigate risk is to decline to provide services to clients who have invested in too-good-to-be-true planning strategies. However, this approach is not always practical. Instead, proceed with caution and consider the following practices.

Referrals to other professionals

Referring any client to a professional to assist with a too-good-to-be-true tax strategy is risky, but for a client who lacks financial sophistication, it is imprudent. Unsophisticated clients may be quick to blame the referring CPA, regardless of the CPA's risk management practices.

Financially sophisticated clients should understand and acknowledge the risk that a taxing authority may challenge and overturn the strategy and have the financial wherewithal to pay if this occurs. If a referral is made, follow the protocols outlined in the article "Professional Liability Spotlight: Unintended Consequences of Professional Referrals," JofA, Nov. 2020, and consider adding a recommendation that the client also engage a tax attorney to evaluate the strategy.

Consulting engagements

CPAs are often asked for off-the-cuff advice, especially related to tax savings opportunities. Avoid the temptation to respond. Such limited advice is fraught with professional liability risk, especially when related to a high-risk tax strategy. Instead, offer to perform a separate engagement to research the strategy and summarize its merits in a tax memorandum for the client.

Obtain a separate engagement letter for this service, and work with the client to define the specific scope of the services. In addition, include limitation-of-liability and limitation-of-damages risk allocation provisions, where permissible.

The deliverable should be a written memorandum to the client, summarizing the strategy's potential benefits and risks, and level of authority as discussed in AICPA Statements on Standards for Tax Services (SSTS) No. 1, Tax Return Positions.

If it is a transaction that has been specifically identified by the IRS, such as a tax shelter, and disclosure to a taxing authority is required, include specific and direct language in the memorandum informing the client of such. Include other important disclaimers such as:

  • The likelihood of tax authority examination, if known; and
  • Potential additional costs the client may incur if a taxing authority audits the client's return, such as the cost to amend tax returns; additional tax, penalties, and interest; and audit defense costs. Indicate that the client will be responsible for all such costs.

Finally, document that the client received the memorandum to help reduce the risk of the client asserting that they were not fully informed of the risks.

Tax compliance engagements

If a tax compliance client has implemented a too-good-to-be-true tax planning strategy, consider your responsibilities under Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), Section 10.34, Standards With Respect to Tax Returns, Affidavits and Other Papers, and SSTS No. 1, both of which may require the firm to research the position's authority and determine whether disclosure to the IRS is required. If the inclusion of Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, with the return is necessary, notify the client in writing of this requirement as soon as possible and how this affects the client's audit risk.

CLOSING

The IRS's Dirty Dozen list of tax scams typically includes items currently on the IRS's radar. But what about strategies not yet identified by the IRS? How can you manage risk related to the unknown? Trust your gut. If a new strategy sounds too good to be true, it probably is.

Deborah K. Rood, CPA, is a risk control consulting director at CNA. For more information about this article, contact specialtyriskcontrol@cna.com.

Continental Casualty Company, one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program. Aon Insurance Services, the National Program Administrator for the AICPA Professional Liability Program, is available at 800-221-3023 or visit cpai.com.

This article provides information, rather than advice or opinion. It is accurate to the best of the author's knowledge as of the article date. This article should not be viewed as a substitute for recommendations of a retained professional. Such consultation is recommended in applying this material in any particular factual situations.

Examples are for illustrative purposes only and not intended to establish any standards of care, serve as legal advice, or acknowledge any given factual situation is covered under any CNA insurance policy. The relevant insurance policy provides actual terms, coverages, amounts, conditions, and exclusions for an insured. All products and services may not be available in all states and may be subject to change without notice.

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