In a Section 1031 Exchange, does it really matter if tax reduction is a significant purpose or the principal purpose? (Part 3 of 3)

Inside this newsletter issue:

• What is Circular 230 and how does it apply to professional advisors?
• What rules apply to the written tax advice?
• What is a Principal Purpose Transaction?
• What is a Significant Purpose Transaction?
• Can disclaimers be used?
• Reliance Opinion versus Covered Opinion
• When does Safe Harbor apply?

What is Circular 230?  Circular 230 provides a standard of conduct for professional advisors and their firms providing tax advice to clients. The standards of conduct have been revised recently by the IRS to oppose what the IRS views as an overly aggressive position of certain law firms and accounting firms in creating and promoting schemes to reduce, defer or eliminate income taxes. The Standards of Conduct are designed for three purposes: 

(1) to encourage compliance with the Tax Rules and Regulations;

(2) to provide (un) clear standards on how and under what circumstances tax advice is provided to tax payers; and

(3) to provide monetary as well as practice sanctions for professionals and firms who practice before the IRS, for failure to adhere to the standards of conduct.  

How does this apply to Section 1031 Exchanges?  The purpose of Section 1031 Exchanges is to defer income taxes on the sale or transfer of property held for investment or in the taxpayer’s trade or business in exchange for property that is like kind to the property sold or transferred.  In determining what kind of transactions are covered under these new rules, one of the examples used in the applicable regulations provides the example of “ whether the transfer of property is treated as taxable or not”.  Clearly, these rules apply to a run of the mill Section 1031 exchanges as well as very sophisticated Section 1031 Exchanges.

What rules apply to the written tax opinion of professional advisors?  As we noted in earlier newsletters, these rules apply to advice provided to taxpayers used to prepare their tax returns, whether or not the advisor is the tax preparer as well as advice regarding the audit or amendment of a tax return.  As we know, all exchanges are reported on the client’s tax returns, hence all advice concerning an Exchange would be covered here.

However, in addition where written advice is requested by a client on a federal tax issue where either (1) a significant purpose or (2) the principal purpose is to avoid or evade of any taxes, this written advice is subject to Section 10.35 of Circular 230 as well as Section 6662 of the Internal Revenue Code. As I elaborate below, it is more difficult than it initially appears for an Advisor to determine whether a transaction falls within the significant purpose or principal purpose or both. Before your know it, you are up to your hip boots in alligators.  

A federal tax issue is a question concerning the federal tax treatment of an item.  It includes a question concerning the existence or absence of a taxable transfer property, or the value of property for federal tax purposes. 

What does Principal Purpose mean?  Principal purpose is tersely defined as that purpose that exceeds any other purpose. The parameters of principal purpose are inherently uncertain, given its focus on the client's subjective motivation.  It requires the Advisor to make a difficult determination as to the client’s purpose for entry into the transaction.  Of course, in the vast majority of Section 1031 Exchanges, the client's desire to reduce or avoid tax will be apparent.  After all, the very fact that the client is inquiring about tax consequences suggest that a tax related motive is present.

What does Significant Purpose mean? A federal tax issue is significant if, the IRS has a reasonable basis for a successful challenge to the taxpayer’s position, and its resolution could have a significant impact, whether beneficial or adverse, on the overall federal tax treatment of the transaction. However, without the opportunity to actually delve into the facts, the Advisor would be unable to determine whether the IRS has a reasonable basis for successful challenge. With that consideration in mind, how confident can an Advisor be at the IRS has no reasonable basis for successful challenge?  A threshold for factual reliance must be complied with when providing a covered opinion.

• Can a disclaimer be used?  In both cases, the confidence level as to the proper tax treatment of the tax issue must be greater than a 50% likelihood that the federal tax issue would be resolved in the taxpayer’s favor.  Neither principal purpose nor significant purpose transactions can contain a disclaimer as to its use to avoid civil tax penalties.  A Disclaimer on a reliance opinion renders it invalid while a disclaimer on a covered opinion is merely ineffective.
• Reliance Opinion versus Covered Opinion.  It is at this point, however, that their paths diverge.  A Significant Purpose transaction may be handled with a reliance opinion.  A Principal Purpose transaction must be dealt with as a covered opinion or, if under a certain safe harbor, not at all. However, in order to avoid penalties and potential loss of livelihood, a Practitioner must choose the form of opinion wisely.  Erring on the side or caution, generally written tax advice should take the form of a covered tax opinion.

For example, if the Advisor initially determines that the transaction is a Significant Purpose transaction, but later determines that it is really a Principal Purpose Transaction, then the final opinion MUST take the form of a covered opinion.

Conversely, if the Advisor determines that a Principal Purpose transaction is really a Significant Purpose Transaction, then the tax opinion SHOULD still take the form of a covered opinion because either

(1) the material risk that the safe harbors do not apply,

(2) that  if the  taxpayer is able to claim a non-controversial tax benefit under the safe harbor, then that would seem to negate that there is a significant federal tax issue involved, thereby extinguishing the reliance opinion;

(3) that the opinion does not reach a more likely than not opinion on a significant federal tax issue or

(4) the opinion contains a disclaimer with regards to the client's ability to rely on it for penalty protection purposes. 

When does safe harbor apply? The safe harbor provides that, in the case of a principal purpose transaction, where the tax benefits claimed are consistent with the statute and Congressional purposes, Section 10.35 is NOT applicable.

Safe harbor DOES exist for principal purpose transactions, but safe harbor does NOT exist for a significant purpose transaction.

Should the Tax Advisor risk choosing the wrong form of the opinion based on a subjective safe harbor? If it is based on subjective criteria, is it really a safe harbor? Further, the safe harbor would invariably not apply in the case where the meaning of the Code Section is unsettled, has not been determined, or where the determination must be made on the basis of case law or administrative law.

The examples in the Treasury Regulations seem to indicate that the safe harbor would apply only when the issue is entirely non controversial.  In addition, if the issue becomes settled in the future, then the Practitioner may be precluded from invoking the safe harbor in a Circular 230 disciplinary context, because, as it turns out, the tax benefit was not claimed in a manner consistent with the Code and Congressional purpose. As a consequence, conservative Practitioners will likely NOT rely on the safe harbor in any case where the issue is unsettled.

• What happens to professional advisors who fail to comply with the minimum standards of conduct for professional advisors?  Penalties can include suspension, disbarment and monetary penalties.

What’s an Advisor to do? That’s where we, at Strategic Property Exchanges, LLC, can help you and your clients. As a full time practicing tax attorney that is Board Certified as a Federal Tax Specialist, we provide, at no additional charge, a covered tax opinion to provide civil tax penalty protection for your clients and Circular 230 protection for you and your firm. We work closely with you and your clients to provide tax strategies for your client, provide active monitoring of the 1031 Exchange to keep you and your client informed, fiduciary insurance to protect your clients funds, errors and omission insurance to safe guard the exchange and a tax opinion to safe guard you, your firm and your client from IRS penalties. We provide the highest level of security, safety and assurance in the industry.

Stephen L. Robison, J.D., LL.M.

What Makes Strategic Property Exchanges Different?

Our 7 Service Guarantees!

#1 - Exchange funds fully insured

#2 - Unlimited consultation and tax planning

#3 - Protection with Errors and Omissions policy

#4 - Covered tax opinion protects client and advisor

#5 - Complies with Circular 230, FASB FIN 48, Section 6662, Schedule M-3, and Sarbanes Oxley 404

#6 - Advisor protection from IRS sanctions and penalties relating to Circular 230

#7 - IRS "audit-proof" reporting package included

The most complete protection and security in the industry!

Coming in next months issue:

Helping you and your clients understand the hidden 80%