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May 15, 2006
Tax Shelter Opinions Threatened the Tax System in the 1970s
Dennis J. Ventry, Jr.

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Tax Shelter Opinions Threatened the Tax System in the 1970s

Dennis J. Ventry Jr. is a visiting scholar in taxation at the UCLA School of Law and an assistant professor of law at the American University Washington College of Law (beginning fall 2006).

Copyright 2006 Dennis J. Ventry Jr. All rights reserved.

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In early 1980 the IRS reported that tax shelter activity was threatening the tax system. The tax shelter industry was bilking the government out of billions of dollars in revenue, overloading the court system, and undermining the voluntary nature of the U.S. federal income tax. IRS Commissioner Jerome Kurtz told the Institute on Federal Taxation at the University of Southern California in January 1980 that abusive tax shelters amounted to a tax administration problem "of major proportions."1 Nearly 200,000 individual returns representing 18,000 shelter schemes were clogging the examination and appeals process. Those returns, Kurtz said, involved almost $5 billion "in questionable deductions."2 IRS emissaries spread similar messages. Robert Mundheim, Treasury's general counsel, told a group of securities lawyers in January 1980 of the growing administrative burden associated with abusive shelters, calling it "one of IRS' most serious compliance problems."3 Turning to the backlog of court cases, tax shelters accounted for more of the increased caseload of the U.S. Tax Court than any other kind of controversy. From 1980 through 1982, tax shelter cases tripled in number from 5,000 to more than 15,000, representing approximately one-third of the entire Tax Court docket.4 "The great abuse we are finding in this area," Kurtz warned, "could result in a serious decline in taxpayers' perception of the fairness and evenhandedness of our administration of the tax system and consequently in the level of voluntary compliance."5 Mundheim shared similar fears, saying that the "widespread nature" of tax shelters "undermines the public's confidence in the fairness of the tax system" and ultimately "may affect the level of voluntary compliance."6

Tax lawyers were complicit in the proliferation of tax shelters. Their written tax opinions legitimized questionable schemes, protected investors from fraud penalties, and encouraged taxpayers to participate in transactions that were likely to be disallowed if challenged. "At a minimum," Mundheim explained, "the tax opinion is viewed as fraud insurance" whereby "the investor is protected against loss" with respect to statutory fraud penalties.7 Kurtz believed that the penalties themselves needed to be strengthened and that that was a job for Congress.8 The taxpayer was induced to play the "audit lottery" because an insufficient penalty structure and low audit coverage meant "little or no risk or cost in playing and losing."9 If the taxpayer claimed questionable deductions and avoided an audit, "he has won."10 In the event of an audit, "he may still have won because he has deferred his tax payment at a favorable rate of interest."11 Tax lawyers owed "a particular responsibility to the Treasury" because their legal opinions propped up the tax shelter industry.12 The marketed product was not the transaction itself but the lawyer's opinion providing the "free ticket to the audit lottery."13

Treasury characterized four particularly troublesome kinds of opinions.14 The first was the intentionally false or incompetent opinion, which "knowingly or recklessly" misstated facts or law, or ignored or minimized substantial legal risks to the advertised tax shelter benefits. The second opprobrious opinion was the "don't bother me with the facts" opinion. Those opinions stated hypothetically that the taxpayer would obtain the tax benefits of the shelter, as long as the facts of the shelter transaction were represented fairly by the promoter. The opinion writer took no responsibility for verifying the accuracy of the facts supporting the opinion. Third, the "nonopinion" had the appearance of a legitimate legal opinion because it discussed the law applicable to tax shelters. But it never related the law to specific facts of the transaction. Those opinions were long and rambling, were bereft of analysis of critical facts, and failed to opine on the transaction's ultimate tax consequences. Treasury identified a variant of that opinion, the "hypothetical opinion," which analyzed the consequences of some facts but never offered a conclusion as to the relevance of the hypothetical to the tax shelter at issue. The last problematic opinion was the "reasonable basis but you'll probably lose" opinion. Those opinions, sanctioned by ethical guidelines in American Bar Association Formal Opinion 314,15 explained that while there was a reasonable basis for the claimed tax benefits under the shelter, the taxpayer would probably lose if the IRS challenged the position. Treasury objected to that kind of "negative opinion," because they gave the impression that the taxpayer's position could be sustained on audit, however unlikely. The very existence of an opinion, positive or negative, provided a cloak of legitimacy to abusive transactions and could dupe unwary or unsophisticated investors.

Attacking tax shelters meant attacking the troublesome opinions, which in turn meant attacking the opinion writers. According to Mundheim, Treasury was "increasingly concerned" about the role of tax attorneys in the tax shelter industry.16 "Much like securities lawyers in the sale of letter stock," Mundheim analogized, "tax attorneys through their opinions control access to the market place."17 By virtue of that power and "the privileged position given the attorney by our system of law and government," the tax lawyer shouldered professional responsibilities that were "not sufficiently appreciated in the tax shelter area."18 Treasury undertook to remind tax lawyers of their responsibilities, both to their clients and to their government.

Treasury Hints at Its Antishelter Strategy

Treasury's strategy for raising the professional bar regarding legal opinions for tax shelter transactions began to emerge in the late 1970s. The Tax Reform Act of 197619 curtailed many of the known tax shelters with a suite of antishelter provisions, including enactment of the at-risk rules,20 significant tightening of the depreciation recapture rules,21 revision of the partnership special allocation rules,22 limitations on investment interest,23 inclusion of the prepaid interest subsection in the rules regarding the tax year of deduction,24 and enactment of section 6694, the tax return preparer understatement penalty.25 "But no sooner were the apparent leaks in the dike plugged than new ones appeared," Kurtz observed in late 1977.26 The shelters that were emerging "indicated that some promoters are pushing harder and harder against the edges of the tax law to produce new shelter products and in some cases may be passing the bounds of tax avoidance and entering the world of tax evasion."27 Combating tax shelters required constant vigilance and an aggressive counterattack.

The IRS undertook an ambitious, multipronged strategy to combat the persistent tax shelter market. Attacking tax shelters required more stringent reporting requirements.28 Raising disclosure standards for tax practitioners to, say, those required of lawyers in Securities and Exchange Commission offerings, Kurtz ventured, would alert Treasury to aggressive reporting positions, encourage the use of competent and ethical counsel,29 and facilitate a nonadversarial relationship between the IRS and tax lawyers.30 Attacking tax shelters also required increasing the audit coverage of all partnership returns (from 1.5 percent to 3 percent) and auditing higher percentages of partnership returns (nearly one-quarter) with losses of $25,000 or more.31 Also, Kurtz announced that the IRS would seek legislation requiring disclosure of claimed deductions or credits that were contrary to administrative or court proceedings. Taxpayers would be required to report "questionable positions" on their returns, flagging them for IRS inspection.

Kurtz explained the questionable-position proposal at a meeting of the ABA Section of Taxation in 1978.32 Taxpayers felt too comfortable taking questionable positions -- which Kurtz defined as positions inconsistent with regulations, rulings, or case law -- because of low audit coverage. Even for corporate taxpayers subject to annual audits, the audit itself examined only a sampling of transactions. Thus, there was a "good chance" that the taxpayer would prevail on uncertain issues because the return would never be examined, or if it were examined, questionable positions would escape detection.33 Kurtz said it seemed inappropriate that under a voluntary compliance system, taxpayers "take positions gambling on the fact that their number won't be drawn in the audit process."34 Also, Kurtz noted that the reasonable basis standard in Opinion 314 allowed taxpayers to resolve questionable positions in their favor without disclosure.35 Those practices prevented the IRS from closing "perceived loopholes or perceived improprieties by rulings with any great effect because a taxpayer is free under existing law, by and large, to ignore a ruling on the ground that he believes, or can make an argument, that the ruling does not accurately reflect the law."36

The reasonable basis standard authorized not only nondisclosure of questionable positions, but the assertion of any plausible position. Only a matter of conscience stopped a taxpayer from taking a position with a scintilla of a chance, commented former ABA Tax Section Chair Harry Mansfield during the Tax Section's discussion of Kurtz's questionable-position plan.37 According to Henry Sellin, even among tax lawyers, it was the adviser's conscience that must govern.38 Such a reporting standard yielded the lowest common denominator, Kurtz agreed in reply: "The one with the least conscience gets the best result."39

Other commentators also considered the reasonable basis standard a bottom-feeder boon. It allowed a tax lawyer "leeway to fit his actions to his conscience except in those cases where conduct is plainly and irretrievably unlawful," said law professor George Cooper.40 "The line for which there is a reasonable basis (which can be taken under 314)," tax lawyer James Rowen explained, "and one which is frivolous (which cannot be taken [according to ABA Model Rules]) is not an easy one to draw."41 Too often, former Chief Counsel Seymour Mintz said, the line was dictated by personal taste rather than a matter of ethics.42 "Too many believe that professional ethics is chiefly a matter of individual conscience and therefore individual choice," lamented Frederic Corneel.43 "The difficulty with this 'situation ethics' approach," Corneel wrote before promulgation of Opinion 314 but with equal relevance to the post-Opinion 314 era, "is that it leaves the practitioner unprepared for temptation."44 And, because "tax obscenity, as other kinds, is in the eye of the beholder," few temptations went unrequited, Cooper wrote.45

Devilish enticements aside, relying on one's conscience to divine appropriate tax positions and disclosure thresholds was too heavy a burden, both moral and administrative, for the system to bear.46 The prevailing ethical guidelines promulgated by the ABA, Cooper said, "unavoidably grapple with the tension between duty to the client and duty to something higher -- the law or one's conscience. By picking on the client-oriented side of the dilemma you can justify all manner of low conduct."47 Indeed, there was "no enforceable obligation on the tax bar to serve as a protector of the tax environment."48 In fact, if the individual tax lawyer wanted to act "more ethically" than Opinion 314, he probably had an obligation under existing rules to reveal his enlightened (that is, less zealous) attitude to his client.49

It was time to raise the ethical bar on tax lawyers. "Congress could change the rule of Opinion 314," Rowen wrote, by providing that a tax adviser could recommend a reporting position only if the adviser believed the position to be correct or believed there was a reasonable basis for the position and advised the client to fully disclose the issues and facts surrounding the position.50 Congress could also impose a penalty on deficiencies attributable to some items that were not disclosed on the return.51 Others believed the IRS should lead the charge. Mansfield argued that the ABA's reasonable basis for the position notion ought to be "knocked out completely" and that the IRS should impose a uniform standard requiring disclosure "where the taxpayer does not in good faith believe that he has the better of the argument."52 Kurtz also believed that Treasury and the IRS should improve the ethical landscape. While discussing Kurtz's questionable-position proposal at the ABA Tax Section meeting, former section Chair Mac Asbill Jr. warned Kurtz about getting too far ahead of the ethical curve and invoked Prof. Boris Bittker: "When they demand too much, legal and ethical systems fall of their own weight in practice, even though they may linger on to be invoked on ceremonial occasions."53 Asbill elaborated, saying "I fear that the full disclosure theory of the federal tax return asking, in effect, that the taxpayer identify every item that the Government might reasonably seek to treat differently, goes beyond what can reasonably be expected."54 Kurtz didn't flinch. "I don't agree with you, because I don't agree with Bittker," he responded.55 Ethical rules could be elevated, he believed.56 And the IRS, unlike the ABA or Congress, was prepared to do the job.

Treasury Asks the Organized Bar to Help

In January 1980 Kurtz announced that Treasury had begun "an exploration . . . into the ethical and legal standards which should govern" participation by tax attorneys in the tax shelter industry.57 Treasury preferred that ethical guidance come from the bar itself, and in fact it had been discussing the issue with the organized bar for several months.58 It expressed hope that the discussion would result in the publication of a formal ABA opinion on tax shelters. Existing Opinion 314 dealt only with the preparation of individual returns and provided confusing signals regarding the participation of lawyers in the promotion of tax shelters. It was not enough for the ABA to issue an opinion, however. The organized bar also had to be willing to discipline those practitioners who failed to meet the new standards of conduct. History offered little reason to be optimistic. Enforcement of ethical rules in tax practice had "not been as vigorous or effective as those of us who believe in self-regulation would like," Mundheim wrote.59 Treasury needed help in its tax shelter effort, particularly in restraining tax lawyers from issuing questionable tax shelter opinions. Although Treasury wanted the ABA to provide the necessary restraints, should the bar fail to respond, Treasury would be forced to act on its own.

The organized bar responded. The ABA Tax Section's Committee on Standards of Tax Practice began drafting a suggested ethics opinion on tax shelter opinions.60 State bar associations responded, too. The Tax Section of the New York State Bar Association established a committee in early 1980 to formulate ethical standards for tax shelter opinions.61

The response was not fast enough for Treasury. In September 1980, only eight months after soliciting the organized bar, Treasury released proposed amendments to Circular 230 setting practice standards for legal opinions used in the promotion of tax shelters and outlining harsh disciplinary rules for practitioners failing to meet the new standards.62 The 1980 amendments to Circular 230 represented Treasury's first attempt to govern the standards of practice for tax shelter opinions. Treasury had decided, in the words of two observers, that "neither the organized Bar nor the SEC and state securities regulators could be relied upon to curb the issuance of such opinions."63 Treasury's preemptive move infuriated the organized bar and its member practitioners. But the inability of professional organizations to rein in the misconduct of its members participating in the tax shelter market indicated that the preemptive strike was justified.

In the next installment of Policy and Practice: "Anything You Can Articulate Without Laughing": "Reasonable Basis" and Ethical Standards Before the 1980 Proposed Amendments to Circular 230.


1 Jerome Kurtz, "Kurtz on 'Abusive Tax Shelters,'" Tax Notes, Feb. 18, 1980, p. 213.

2 Id. By September 1980 Treasury had identified another 7,000 shelter schemes, and the total lost revenue from abusive tax shelters had exceeded $5 billion. See Proposed Amendments, Tax Shelters; Practice Before the Internal Revenue Service, 45 Fed. Reg. 58,594 (Sept. 4, 1980) at supplementary information.

3 Robert H. Mundheim, "Mundheim on 'Abusive Tax Shelters,'" Tax Notes, Feb. 18, 1980, p. 213.

4 In September 1982, 15,105 tax shelter cases were included on a docket of 50,968 cases. New York State Bar Association (NYSBA) Tax Section, "Managing the Tax Court Docket," 85 TNT 146-93 (July 24, 1985).

5 Kurtz, supra note 1, at 213. That was not the first time Kurtz connected tax shelter activity to tax equity and voluntary compliance. See, e.g., Kurtz, "Remarks to the American Institute of Certified Public Accountants," 103 Daily Tax Report J-3 (May 26, 1977); "Kurtz Outlines Service Attack on Tax Shelters," Tax Notes, Nov. 7, 1977, p. 24.

6 Mundheim, supra note 3, at 213. Commentators saw a similar relationship between tax shelter activity and reductions in voluntary compliance writ large. See James B. Lewis, "The Treasury's Latest Attack on Tax Shelters," Tax Notes, Oct. 13, 1980, p. 723 (tax shelters produce "impairment to the fairness of the income tax, the perception of unfairness by the rest of the taxpaying public, and the feared adverse impact on the level and temper of voluntary compliance"). But see John André LeDuc, "The Legislative Response of the 97th Congress to Tax Shelters, the Audit Lottery, and Other Forms of Intentional or Reckless Noncompliance," Tax Notes, Jan. 31, 1983, p. 363 at 366 (questioning the theory that the perceived inequity of tax shelters leads to an across-the-board decline in voluntary compliance rates). Some commentators challenged the very notion of the U.S. federal income tax as a voluntary tax. "There is a myth," Henry Sellin wrote, "nurtured by a long series of Commissioners of Internal Revenue, that ours is a self-assessing system." Sellin, "Professional Responsibility of the Tax Practitioner," 52 Taxes 584 (October 1974). Judge Learned Hand called taxes "enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant." Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947).

7 Mundheim, quoted in Laurence Goldfein and Stanley Weiss, "An Analysis of the Proposed Changes Under Circular 230 Affecting Tax Shelter Opinions," 53 Journal of Taxation 340, 345 (December 1980).

8 Jerome Kurtz, "Professional Opinions as 'Tickets to the Audit Lottery,'" Tax Notes, Feb. 9, 1981, p. 262.

9 Id. For earlier discussions of the audit lottery and its effects on tax fairness, see NYSBA Committee on Tax Policy, "A Report on Complexity and the Income Tax," 27 Tax L. Rev. 325, 330 (1972); John Nolan, "Audit Coverage and Private Tax Planning," 37 Nat'l. Tax J. 425, 427-428 (1974).

10 Kurtz, supra note 8, at 262.

11 Id. See also Mundheim, supra note 7, at 345 (noting that "the deferral benefits of deductions taken, even if ultimately disallowed some years hence, will generally protect the investor from losses on the shelter").

12 Id. But see Goldfein and Weiss, supra note 7, at 345-346 (arguing that while "reasonable reliance on the advice of an expert sufficed to avoid the negligence penalty, no less the fraud penalty," it was difficult to prove actual reasonable reliance, and in the event such reliance was proven, negligence on behalf of the tax lawyer could negate penalty protection for the client (emphasis in the original)).

13 Kurtz, supra note 8, at 262.

14 The foregoing is from Mundheim, supra note 3, at 214.

15 ABA Committee on Professional Ethics, Formal Opinion 314 (Apr. 27, 1965).

16 Mundheim, supra note 3, at 214.

17 Id.

18 Id.

19 P.L. 94-455 (Oct. 4, 1976).

20 IRC section 465; P.L. 94-455, title II, section 204(a), 90 Stat. 1531.

21 IRC section 1250; P.L. 94-455, title II, section 202(a)-(c)(1), (2); title XIX, sections 1901(b)(3)(K), (31)(A), (B), (E), 1906(b)(13)(A), 1951(c)(2)(C); title XXI, sections 2122(b)(4), 2124(a)(3)(D), 90 Stat. 1527, 1529, 1530, 1793, 1799, 1800, 1834, 1840, 1915, 1918.

22 IRC section 704(b) and (d); P.L. 94-455, title II, section 213(c)(2), (3)(A), (d), (e); title XIX, section 1906(b)(13)(A), 90 Stat. 1548, 1834.

23 IRC section 163(d); P.L. 94-455, title II, sections 205(c)(3), 209(a); title XIX, sections 1901(b)(3)(K), (8)(C), 1906(b)(13)(A), 90 Stat. 1535, 1542, 1793, 1794, 1834.

24 IRC section 461(g); P.L. 94-455, title II, section 208(a); title XIX, section 1901(a)(69), 1906(b)(13)(A), 90 Stat. 1541, 1775, 1834.

25 P.L. 94-455, title XII, section 1203(b)(1), 90 Stat. 1689.

26 Kurtz, supra note 5, at 24.

27 Id.

28 James Byrne, "Kurtz Sets Reform Agenda for Internal Revenue Service," Tax Notes, June 6, 1977, p. 3.

29 See Kurtz and panel, "Discussion on 'Questionable Positions,'" 32 Tax Law. 13, 17 (1978-1979) (arguing that SEC requirements mandating that "every wart and pimple" be reported encouraged clients "to use more competent people because they want to make sure they get everything out because there is a penalty").

30 Id. at 26 (positing that "if there were a notion that everybody was completely open and above board with everybody else that some of the adversary nature of the system . . . might be dissipated").

31 Jerome Kurtz, "Auditing Partnerships," Tax Notes, May 29, 1978, p. 581. Kurtz and the IRS chose not to republish proposed regulations issued in late 1976 that would have treated many limited partnerships -- which the Service recognized as the basic vehicle for syndicated tax shelters -- as corporations for tax purposes. The regulations were aimed at ending the typical tax shelter by preventing individual partners from claiming business deductions incurred by the operating syndicate. Byrne, supra note 28, at 4. Treasury Secretary William E. Simon withdrew the regulations as one of his last official actions. See "Simon Withdraws Partnership Regulations," Tax Notes, Jan. 10, 1977, p. 2.

32 Supra note 29.

33 Comments of Jerome Kurtz, supra note 29, at 15.

34 Id. at 20.

35 Id. at 15.

36 Id.

37 Comments of Harry K. Mansfield, supra note 29, at 24.

38 Sellin, supra note 6, at 592.

39 Comments of Jerome Kurtz, supra note 29, at 24.

40 George Cooper, "The Avoidance: A Tale of Tax Planning, Tax Ethics, and Tax Reform," 80 Colum. L. Rev. 1553, 1582 (1980).

41 James R. Rowen, "When May a Lawyer Advise a Client to Take a Position on His Tax Return?" 29 Tax Law. 237, 243 (1975-1976). See ABA Model Rules of Professional Conduct, Rule 3.1, "Meritorious Claims and Contentions" ("A lawyer shall not bring or defend a proceeding, or assert or controvert an issue therein, unless there is a basis for doing so that is not frivolous, which includes a good faith argument for an extension, modification or reversal of existing law.").

42 Comments of Seymour Mintz, in Brian H. Holland (with panelists Mortimer M. Caplin, Crane E. Hauser, Dean J. Barron, Seymour S. Mintz, Hugh F. Culverhouse, T.T. Shaw, and Paul F. Icerman), "What Is Good Tax Practice: A Panel Discussion," 21 N.Y.U. Inst. Fed. Tax. 23, 36-37 (1963).

43 Frederic G. Corneel, "Ethical Guidelines for Tax Practice," 28 Tax L. Rev. 1 (1972-1973).

44 Id.

45 Cooper, supra note 40, at 1584.

46 See, e.g., comments of Harry K. Mansfield, supra note 29, at 27 (commenting that "when you have to search your own mind to see whether or not you have thought about a question properly, and how you have ultimately assessed it, that kind of inquiry is simply going to help tear down the system").

47 Cooper, supra note 40, at 1581.

48 Id. at 1588.

49 See Corneel, supra note 43, at 5 ("If a tax practitioner concludes that he wishes to adhere to what he believes to be a 'higher' ethical standard and present all information whether favorable or unfavorable, is it not clear that he owes his client the obligation of cautioning him in advance, so that the client may then choose whether that is the type of representation that he desires?"). See also Rowen, supra note 41, at 240 (adopting Corneel's analysis).

50 Rowen, supra note 41, at 262.

51 Id. at 262-263.

52 Comments of Harry K. Mansfield, supra note 29, at 27.

53 Comments of Mac Asbill Jr., supra note 29, at 26. For Bittker quotation, see Boris I. Bittker, Professional Responsibility and Federal Tax Practice (New York: New York University Press, 1965), at 24.

54 Id.

55 Comments of Kurtz, supra note 29, at 26.

56 Some legal theorists endorsed an aggressively enlightened agenda for tax lawyers, arguing that the law of legal ethics involved "not only what the lawyer has a duty to do in the administration of law, but also what he has a right to do in the interest of justice." Ray Patterson, "Tax Shelters for the Client -- Ethics Shelters for the Lawyer," 61 Tex. L. Rev. 1163, 1183 (1982-1983).

57 Kurtz, supra note 1, at 213.

58 Mundheim, supra note 3, at 214 (explaining that Treasury had discussed the problem in detail with several bar groups in the summer of 1979 and that it was encouraged by preliminary work of the ABA Tax Section's Committee on Standards of Tax Practice in formulating new guidelines).

59 Id.

60 ABA Tax Section, "Statement on Proposed Rule Amendment Circular 230 With Respect to Tax Shelter Opinions," 34 Tax Lawyer 745, 748 (Spring 1981).

61 NYSBA Tax Section, "Circular 230 and the Standards Applicable to Tax Shelter Opinions," Tax Notes, Feb. 9, 1981, p. 251.

62 Proposed Amendments, 45 Fed. Reg. 58,594, supra note 2, at supplementary information.

63 Goldfein and Weiss, supra note 7, at 340. Laurence Goldfein and Stanley Weiss were partners in the law firm of Roberts & Holland, one of the nation's premier tax boutiques.