1031 Exchanges & Tax Opinions
There is a lot of grey area in the tax law. There are also fairly sizeable penalties for getting something wrong on a tax return, depending on how wrong it was. So, when a transaction arises that may lead to significant tax consequences but the rules are unclear, tax opinions can function not only to assure a taxpayer that a transaction will indeed have the tax consequences it is or was intended to have, but also to protect the taxpayer from penalties imposed by the IRS if it turns out the tax consequences were not what they were proposed to be.
To that end, tax opinions can be used in a wide range of situations and purposes. For purposes of 1031 exchanges, the value of our tax opinions lie in the ability to provide clients with confidence in the legal veracity of their transaction and protect clients from penalties in the event the exchange fails pursuant to an examination by the IRS or a court of law.
We apply the current law to the facts and assumptions surrounding the transaction and come up with a level of confidence that the transaction will be upheld by the IRS or a court of law if it were to be audited.
Section 1031 Exchanges as Tax Shelters
Circular 230. Section 10.35 of Circular 230 establishes certain standards as to what constitutes a covered opinion.
- Tax Shelter defined. A tax shelter is any plan or arrangement from which a tax benefit may be derived. The tax benefit may be in the form of a deduction, credit, excludability of income, increase in basis or otherwise. Section 6662 defines a tax shelter as a transaction, a significant purpose of which is to avoid or evade federal income taxes.
- The significant purpose, [if not the primary purpose], of a Section 1031 Exchange is to avoid the imposition of income taxes on the gain resulting from the sale of certain investment and business use property.
- Any and all written advice regarding the structure and implementation of a Section 1031 must comply with the covered opinion rules of Circular 230. This covered opinion can be delegated to a Federal Tax Expert who will comply with the requirements of Circular 230.
Covered Opinion Requirement.
- A covered opinion is written advice, on or after June 30, 2005, including electronic communications, concerning one or more Federal tax issues arising from:
- A Listed transaction;
- A transaction whose principal purpose is the avoidance or evasion of taxes;
- A transaction, a significant purpose of which is to avoid or evade taxes
A Covered opinion must:
- Make reasonable efforts to identify and ascertain the facts;
- Not base findings on unreasonable factual representations;
- Not contain internally inconsistent findings;
- Relate the law to the facts;
- Not assume favorable resolution of any federal tax issues;
- Not take into account that the return will not be audited, the issue will not be raised on audit or that the issue will be resolved through settlement, and
- Provide the practitioner’s overall conclusion as to matters considered in the covered opinion.
- Be provided by a Tax Practitioner who is knowledgeable in all areas of federal tax law
- A Federal Tax issue is a question concerning the federal tax treatment of an item of income, gain, loss, deduction, or credit, the existence or absence of a taxable transfer of property.
Avoidance defined. The Internal Revenue Manual at 18.104.22.168.2.1 provides that avoidance by a taxpayer occurs when he shapes events to reduce or eliminate tax liability, and upon the happening of the events, makes a complete disclosure.
Malpractice Issues may be raised for the following:
Written advice that is not a covered Opinion
- Cannot be based on unreasonable assumptions;
- Cannot unreasonably rely on information from others;
- Does not consider all the facts that the practitioner knows or should know;
- May not account for the possibility that the return may not be audited, the issue may not be audited or settled.
- If the practitioner willfully, recklessly or through gross incompetence violates the above provision
- If written advice is a series of written memos, it must either conform as a whole to the covered opinion requirements or a formal opinion must be written.
- A Practitioner may rely upon the opinion of others who are knowledgeable in all areas of Federal Tax Law.
- A Practitioner with oversight responsibility for the firm must take reasonable steps to ensure that the firm has adequate procedures in place to comply with Circular 230.