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June 05, 2014 The Tax Lawyer

Dysfunction Junction: Avoiding Penalties by Relying on Tax Advisors with Conflicts of Interest

Volume 67, No. 3 - Spring 2014

Michelle M. Kwon


    Taxpayers who underpay their taxes may be liable for accuracy-related penalties if the underpayment is attributable to negligence or the careless, reckless, or intentional disregard of rules or regulations. Understatements of tax liability resulting from participation in certain types of tax avoidance transactions are also subject to penalties. Taxpayers who comply with the relevant rules and regulations are nonetheless subject to accuracy-related penalties if the discrepancy between their correct and reported tax liability is sufficiently large.

    Taxpayers may, however, avoid accuracy-related penalties by relying on a reasonable cause defense. The reasonable cause defense may be satisfied by relying on professional tax advice even if the advice concludes that the taxpayer’s chance of prevailing on the underlying merits is uncertain, the advice turns out to be incorrect, and the taxpayer is found liable for the underlying tax. Reliance on professional tax advice is not, however, a fail-safe escape from penalties. Courts have repeatedly held that taxpayers cannot rely on advisors “they know to be burdened with an inherent conflict of interest.” But courts have not clearly articulated the circumstances under which the common law conflict of interest rule applies, making its application unpredictable and inconsistent.

    A statutory conflict of interest rule now exists to prohibit taxpayers from relying on advisors who participate in the organization, management, promotion, or sale of certain tax avoidance transactions. Tax advisors who are tax return preparers may be subject to penalties, and those who provide written tax advice are potentially subject to censure, monetary penalties, suspension or disbarment from practice before the IRS for violating the covered opinion rules in Circular 230. These developments ostensibly would enhance the quality of written tax advice, which would lessen the import of the common law conflict of interest rule and support its abrogation. The article explains why the common law conflict of interest rule remains relevant despite these developments. The article also proposes several regulatory changes to mitigate advisor conflicts of interest.

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