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June 30, 2011
Canal: Casting Stones

Full Text Published by Tax Analysts®

By James R. Browne

James R. Browne is a partner with Strasburger & Price LLP in Dallas. The views expressed in this article do not necessarily represent the views of his firm or any client.

In this report, Browne argues that the Tax Court in Canal erred in holding that reliance on a tax adviser is per se unreasonable when the adviser was involved in planning the transaction and had a financial interest in its outcome. He argues that the Tax Court should have applied a facts and circumstances test and more carefully evaluated whether the evidence supported a finding that the taxpayer did not reasonably rely on the adviser's legal opinion.


Table of Contents

I. Background

II. Reasonable Cause and Good Faith

III. Analysis of the Cases


    A. Mortensen

    B. Pasternak

    C. Neonatology Associates

    D. New Phoenix

    E. CMA Consolidated

    F. Stobie Creek

    G. Summary


IV. Should Conflict of Interest Be Dispositive?

V. Conclusion

In Canal Corp. v. Commissioner,1 the Tax Court held that the taxpayer could not rely on the advice of its regular tax adviser, PricewaterhouseCoopers LLP, to avoid penalties, because PwC was actively involved in planning the transaction at issue and had a financial interest in the outcome of the advice (that is, PwC's tax opinion fee was contingent on issuing a favorable opinion and the closing of the transaction). The Tax Court criticized PwC's legal analysis, finding that "the opinion was riddled with questionable conclusions and unreasonable assumptions."2 As others have pointed out, the court's criticisms are arguably unjustified, and the court's opinion has its own shortcomings.3

This report examines one specific shortcoming of the Tax Court's opinion: The cases cited by the court to support its thesis -- that it is per se unreasonable for a taxpayer to rely on advice from a tax adviser that planned a transaction and has a financial interest in its implementation -- do not support that thesis. This report also examines why, apart from any lack of precedent, such a per se rule should not be adopted by the Tax Court or other courts.


I. Background

Chesapeake Corp. wanted to sell its tissue business, which was conducted by a subsidiary (WISCO). Chesapeake entered into negotiations to sell the business to a competitor, GP. The parties could not agree on a price, and as a way to bridge the gap, Chesapeake's advisers (Salomon Smith Barney and PwC) proposed a leveraged partnership arrangement in which WISCO would contribute its assets to a joint venture with GP in exchange for a minority interest and cash. PwC advised Chesapeake that the joint venture arrangement could be structured so that Chesapeake would not be taxed currently on the receipt of the cash from the joint venture. Chesapeake concluded that the deferral of tax on cash received under the joint venture arrangement was a sufficient benefit to offset the relatively low implied valuation for the WISCO business, and it agreed to the transaction on the condition that PwC issue a should-level tax opinion on the tax benefits of the transaction. The joint venture transaction closed in 1999, with PwC issuing the agreed-on tax opinion. The IRS challenged the transaction and assessed a deficiency for 1999 on the theory that the transaction constituted a disguised taxable sale of the WISCO business.

The PwC partner who wrote the tax opinion for the transaction was actively involved in structuring the joint venture arrangements, in setting the terms of the WISCO financial guarantee that was critical to the tax analysis, and in reviewing and approving the legal agreements effecting the transaction. Chesapeake agreed to pay PwC an $800,000 fixed fee for issuing the tax opinion on the transaction, to be paid at the closing of the transaction. Chesapeake's receipt of a PwC should-level tax opinion was a condition to the closing. The Tax Court appears to have assumed that PwC would not be paid anything unless the transaction closed.4

The Tax Court first held that the transaction did not achieve the intended tax benefits, and it sustained the IRS's proposed underpayment of tax. It then addressed whether Chesapeake was liable for a substantial understatement penalty under section 6662, and in particular whether Chesapeake had reasonable cause for its underpayment of tax and acted in good faith regarding the underpayment.5 The court concluded that Chesapeake did not act with reasonable cause or in good faith in relying on PwC's opinion.


II. Reasonable Cause and Good Faith

In discussing the legal principles applicable in determining whether Chesapeake acted reasonably and in good faith, the Tax Court's opinion states:

    Courts have repeatedly held that it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. See e.g., Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279; Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C. Memo. 1991-181; Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), affd. 299 [F.3d] 221 (3d Cir. 2002). A professional tax adviser with a stake in the outcome has such a conflict of interest. See Pasternak v. Commissioner, supra at 903.6

Later, in addressing whether Chesapeake acted reasonably and in good faith, the opinion cites three other cases to support the proposition that a taxpayer may not rely on a tax adviser that has an interest in the underlying transaction:

    Chesapeake acted unreasonably in relying on the advice of PwC given the inherent and obvious conflict of interest. See New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 192-194 (2009) (reliance on opinion by law firm actively involved in developing, structuring and promoting transaction was unreasonable in face of conflict of interest); see also CMA Consol., Inc. v. Commissioner, T.C. Memo. 2005-16 (reliance not reasonable as advice not furnished by disinterested, objective advisers); Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636, 714-715 (2008), affd. ___ Fed. 3d ___ (June 11, 2010).7

The discussion below analyzes whether the facts and analyses of the cases cited in the portion of the Tax Court's opinion quoted above support the proposition for which the Tax Court cited them. The analysis in this report ignores the court's criticism of the factual and legal analysis in the PwC tax opinion, because those criticisms, apart from being of dubious validity,8 appear to be merely an alternative ground for the holding in the case.9 Under the Tax Court's thesis, even if PwC's opinion made no unreasonable factual or legal assumptions and reached an entirely reasonable but incorrect legal conclusion, Chesapeake still would not be entitled to rely on the opinion to establish reasonable cause and good faith. PwC's role and financial interest in the transaction would apparently render Chesapeake's reliance on PwC's advice unreasonable regardless of the quality of PwC's analysis.

III. Analysis of the Cases

A. Mortensen

In Mortensen v. Commissioner,10 the taxpayer invested in a tax shelter partnership involved in cattle operations. The offering circular for the investment partnership disclaimed providing tax advice and recommended that investors seek independent tax advice. However, the offering circular also suggested that investors engage the partnership manager (Walter J. Hoyt III) to file their personal returns. The taxpayer followed that recommendation and hired Hoyt to prepare his returns. Before filing his 1991 tax return, the taxpayer received a letter from the IRS stating that Hoyt was supplying incorrect legal advice and recommending that the taxpayer have the matter reviewed by an independent accountant or attorney. The taxpayer simply forwarded the IRS communication to Hoyt and made no effort to question the positions Hoyt reported on the taxpayer's personal returns. The Tax Court and Sixth Circuit had no trouble finding the taxpayer liable for the negligence penalty under section 6662(a).

The Sixth Circuit's analysis in Mortensen begins with a sweeping statement that implies that reliance on advice of a promoter is always unreasonable:


    The Supreme Court has held that good faith reliance on professional advice concerning the tax laws may be a defense to negligence. In order for reliance on professional tax advice to be reasonable, however, the advice must generally be from a competent and independent advisor unburdened with a conflict of interest and not from promoters of the investment.11

Despite this sweeping statement, the actual facts of the case support a narrower proposition: that reliance on a promoter/adviser is unreasonable when the taxpayer is on notice from the IRS that the promoter/adviser is supplying inaccurate advice. The facts in Mortensen are readily distinguishable from the Canal facts.

B. Pasternak

In Pasternak v. Commissioner,12 the taxpayers invested in various master recording tax shelters. The arrangements used overstated values for the master recordings to generate deductions and tax credits equal to several multiples of the taxpayers' investment. The Tax Court disallowed the tax benefits on the grounds that the investments lacked economic substance. The Tax Court also sustained negligence penalties on the grounds that the taxpayers, even as laymen, could reasonably be charged with knowledge that one may not claim deductions or credits for transactions not entered into with the objective of making an economic profit and that the taxpayers invested in the tax shelter with complete indifference as to the potential for economic profit. The taxpayers did not claim that they reasonably relied on the promoters for tax advice. Rather, the taxpayers claimed they relied on the promoters to successfully generate a pretax profit (a claim the Tax Court rejected).

The essence of the Tax Court's holding is as follows:


    While we recognize that some provisions of the Federal income tax are complex, the rule that one may not claim deductions or credits for transactions not entered into with the objective of making an economic profit is well established and is not beyond the comprehension of the layman. Petitioners all claim that they expected to make an economic profit from their investment because they were dealing with individuals who were well established in the recorded music industry. At the same time, they claim that they were aware that the venture they were buying into involved a high level of risk. Their conduct indicates such indifference to this risk that we are convinced that they did not care whether they made an economic profit.13

The Sixth Circuit affirmed both the holding and the reasoning of the Tax Court, adding:

    Although petitioners argue that they relied on the advice of "financial advisors, industry experts, and professionals," the purported experts were either the promoters themselves or agents of the promoters. Advice of such persons can hardly be described as that of "independent professionals."14

The Canal opinion cites Pasternak for the proposition that reliance on an adviser for tax advice is conclusively unreasonable when the adviser is involved in promoting the transaction and is tainted by a conflict of interest. But Pasternak involved a different issue: whether alleged reliance on an adviser for financial advice was sufficient to establish a pretax profit motive. Moreover, the Pasternak trial court found as a fact that the taxpayers did not rely on the advisers but were instead indifferent as to the investment's pretax profit potential. Therefore, Pasternak is readily distinguishable from Canal.

C. Neonatology Associates

The taxpayers in Neonatology Associates PA v. Commissioner15 caused their professional corporations to make contributions to voluntary employees' beneficiary association plans designed and sponsored by an insurance agent. The VEBAs were designed to permit deferral of corporate taxes through the purchase, at inflated prices, of life insurance policies through the sponsoring insurance agent. The court held that to the extent the contributions exceeded the actual insurance benefits provided by the VEBAs, the excess contributions constituted disguised dividends to the principals.

In addressing the taxpayers' liability for a negligence penalty, the court said:


    Petitioners assert that they were "approached by various professionals" who introduced petitioners to the VEBA's and that they invested in the VEBA's relying on "tax opinion letters written by tax attorneys and accountants and discussions with insurance brokers." Petitioners assert that the accountants who prepared their returns agreed with the reporting position taken as to the contributions, as evidenced by the fact that the accountants prepared the returns in the manner they did.16

The Tax Court found that none of the taxpayers relied on the advice of a competent tax adviser. The insurance agent that induced the taxpayers to enter into the VEBA arrangements never represented himself as a tax professional, and they knew he stood to gain financially from the taxpayers' investment. The court rejected their alleged reliance on tax opinion letters because they failed to introduce any evidence that "such a tax opinion letter exists, let alone that any of them ever read or relied on one." And their alleged reliance on the CPAs that prepared their returns also was rejected, because there was no evidence that the CPAs opined on the legitimacy of the tax treatment of the arrangements or that the taxpayers relied on any such advice.

The Third Circuit affirmed the Tax Court's holding regarding negligence, noting that it was not deciding whether reliance on an adviser with a conflict of interest is conclusively unreasonable:


    It well may be that reliance on the advice of a professional should only be a defense when the professional's fees are not dependent on his opinion. For example, it is not immediately evident why a taxpayer should be able to take comfort in the advice of a professional promoting a tax shelter for a fee. After all, that professional would have an interest in his opinion. Consideration of this point, however, will have to wait for another day.17

Neonatology Associates is a case in which the taxpayer failed to produce any evidence that it sought tax advice from a competent tax adviser. It bears no resemblance to the fact pattern in Canal, and the Third Circuit's opinion cautions that it does not support the proposition for which it was cited in Canal.

D. New Phoenix

New Phoenix Sunrise Corp. v. Commissioner18 involved a corporate taxpayer that entered into a basis-leveraged investment swap spread (BLISS) tax shelter transaction designed and promoted by the Jenkens & Gilchrest law firm (J&G). The objective and effect of the BLISS transaction was to produce an artificially inflated tax basis in assets that could be sold at a loss to offset other taxable gains. The court sustained the IRS's assertion that the BLISS transaction was an economic sham and disallowed all tax effects of the transaction.

In defending the transaction against penalties, the taxpayer asserted it had reasonable cause and acted in good faith because its tax reporting of the transaction was based on a J&G tax opinion. However, at the time the taxpayer reported the transaction, the taxpayer and its regular advisers were aware that the IRS considered the J&G position unacceptable. Also, the taxpayer failed to disclose the transaction as required by applicable IRS regulations, even though J&G advised that the disclosure requirements applied to the transaction and that failing to disclose was "aggressive." The court also said that the taxpayer should have known that "Jenkens & Gilchrist had a personal stake in the BLISS transaction and could not be relied upon to provide independent advice."

In summary, the Tax Court in New Phoenix rejected the taxpayer's reasonable cause and good-faith defense because the taxpayer was on notice that the IRS specifically rejected the position being advocated by the tax adviser, the taxpayer failed to act in good faith regarding disclosing the position on the tax return, and the tax adviser had a conflict of interest.

On appeal, the Sixth Circuit affirmed on the basis of the Tax Court's factual finding that "the attorneys of Jenkens & Gilchrist 'were promoting' the tax shelter when they met" the taxpayer. Citing its prior decision in Mortensen, the Sixth Circuit summarily said that reliance on the promoters of an investment is insufficient to support a good-faith defense.

The Sixth Circuit's opinion in New Phoenix comes closest to supporting the Tax Court's thesis in Canal. However, the Sixth Circuit's casual summary statement that reliance on a promoter for tax advice is never reasonable is dictum. The actual facts in New Phoenix reveal that the transaction was a widely marketed tax shelter transaction having no relation to the taxpayer's regular business operations, the transaction was promoted by a firm with which the taxpayer had no prior relationship, the taxpayer was on notice that its regular advisers and the IRS questioned the validity of the promoter's tax advice, and the taxpayer failed to properly disclose the transaction. None of those facts existed in Canal. The Chesapeake joint venture transaction was a customized financing arrangement structured around a legitimate business transaction; it was designed for Chesapeake by PwC, its long-time adviser; there was no prior notice that the IRS or any of Chesapeake's other advisers questioned PwC's tax advice; and there was no evidence that Chesapeake tried to conceal the transaction or otherwise failed to disclose the transaction according to applicable tax reporting rules. Therefore, while the Sixth Circuit's summary statement in New Phoenix superficially supports the Tax Court's proposition in Canal, the actual facts of New Phoenix undercut any such support.

E. CMA Consolidated

CMA Consolidated Inc. v. Commissioner19 involved a lease strip tax shelter transaction20 entered into by a taxpayer engaged in the equipment leasing business. The taxpayer had arranged a lease strip transaction for a customer (CFX) in January 1995, and CFX had received a tax opinion in connection with that transaction. The taxpayer commenced arrangements for a second lease strip transaction in August 1995 with the expectation of remarketing it to another taxpayer. The IRS's issuance of Notice 95-5321 in October 1995 challenging the tax benefits of the transaction scuttled the remarketing plans, and the taxpayer retained the transaction for its own benefit with the tax benefits being realized on the taxpayer's 1996 tax return.

In seeking to establish that it had reasonable cause for, and acted in good faith regarding, the 1996 underpayment of tax resulting from the leasing transaction, the taxpayer attempted to rely on the tax opinion issued to CFX in the first lease strip transaction. The Tax Court concluded that the taxpayer's reliance on the CFX tax opinion was not reasonable "as that advice, among other things, had not been furnished by disinterested, objective advisors but by advisors involved in marketing the first lease strip deal to CFX."22 The Tax Court also pointed out that the taxpayer was an expert in equipment leasing transactions and was warned that the IRS would challenge the transaction when it chose to proceed with the transaction.

CMA Consolidated is distinguishable from Canal on the ground that the taxpayer in CMA Consolidated attempted (1) to rely on a tax opinion issued to another taxpayer (2) after the taxpayer had notice that the IRS disagreed with the advice in the tax opinion. While the court notes the financial interest of the adviser in the first transaction, that is not the sole basis for the decision.

F. Stobie Creek

Stobie Creek Investments LLC v. United States23 involved substantially the same tax shelter transaction addressed in New Phoenix: a widely marketed transaction involving offsetting options designed to produce artificially inflated tax basis in assets that could be sold at a loss. The transaction had no relation to the taxpayer's ordinary business operations and was entered into without any reasonable expectation of profit. In Stobie Creek, the taxpayer relied on an opinion from J&G and on an independent review of J&G's opinion by the taxpayer's regular outside counsel, Shumaker, Loop & Kendrick LLP (SLK). The taxpayer was aware that SLK had reviewed other transactions promoted by J&G and agreed that SLK's fee for its review would be based on a percentage of the tax savings.

The trial court held that the taxpayer did not reasonably rely on the J&G tax opinion, because the opinion contained assumptions that the taxpayer knew to be incorrect. The opinion assumed the accuracy of taxpayer representations that the steps in the transaction were each pursued with substantial nontax business purposes and that an objective investment analysis indicated a substantial profit potential. The trial court found that the taxpayer knew that those representations were false. The trial court also said that both J&G and SLK were tainted by a conflict of interest that "diminished" the reasonableness of the taxpayer's alleged reliance on those advisers. Finally, the trial court noted that the taxpayer was well aware that the tax results were "too good to be true," and that the taxpayer was fully capable of distinguishing between structuring a real transaction in a tax-efficient manner and structuring a transaction having no business purpose other than creating a tax benefit.24 The trial court's holding is thus predicated on an analysis of all the facts and circumstances (including lack of business connection and purposes, factual misrepresentations, and implausible tax results), and did not rely solely on the fact that the advisers had a financial interest in the implementation of the transaction.

On appeal, the Federal Circuit affirmed on the basis that "the trial court did not clearly err in finding it objectively unreasonable for [the taxpayer] to rely on the advice of J&G and SLK because J&G was a promoter of the shelter and SLK was an agent of the promoter" and in finding that the taxpayer knew or should have known of that conflict of interest.25 The Federal Circuit also said that even if the taxpayer did not know of the conflict of interest, its reliance on J&G and SLK was still unreasonable because it knew the strategy they were promoting was too good to be true.

The trial court's holding in Stobie Creek rests on a comprehensive analysis of all the facts and circumstances of the case, which are readily distinguishable from the facts and circumstances in Canal. While the Federal Circuit's opinion does not exhaustively review all the supporting analysis, its opinion cannot reasonably be read to stand for the proposition that a tax adviser's conflict of interest is alone a sufficient basis to find that a taxpayer acted unreasonably in relying on the adviser.

G. Summary

In Canal, the Tax Court declares a broad and unqualified rule of law: that it is per se unreasonable for a taxpayer to rely on tax advice furnished by an adviser that is "tainted by an inherent conflict of interest"26 (that is, the adviser was involved in structuring the transaction and has a financial interest in its implementation). Not one case cited in the Tax Court's opinion supports that proposition. The court's opinion casually cites isolated statements from the cases without noting the factual context. The citation of Neonatology Associates is especially inept given that the Third Circuit affirmatively stated that it was not deciding the legal proposition for which the Tax Court cites the case. The Tax Court's failure to undertake a careful analysis of the cases represents precisely the type of "dubious legal reasoning" of which the court so harshly accuses PwC.

To be fair, a tax adviser's conflict of interest is undeniably a significant factor in evaluating whether the taxpayer reasonably relied on the adviser. But the Tax Court's proposition that it is a dispositive factor is not supported by the cases it cites.


IV. Should Conflict of Interest Be Dispositive?

Even if the cases cited in the Canal opinion do not support the proposition for which the Tax Court cites them, a logical question is whether the Tax Court's thesis is a reasonable interpretation of the law and should be followed in other cases. Should a taxpayer's reliance on a tax adviser be per se unreasonable when the tax adviser has an inherent conflict of interest? For the reasons discussed below, a per se rule for cases of conflict of interest seems to be an unwarranted extension of current law and should not be followed. Rather than adopting a per se rule that a taxpayer may never reasonably rely on an adviser having a conflict of interest, a better approach is to apply a facts and circumstances test taking into account the adviser's conflict of interest as one relevant fact in the analysis.27

Applicable Treasury regulations support this approach. The regulations state generally that "the determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances."28 Likewise, concerning whether a taxpayer reasonably relied on the advice of a tax professional, the Treasury regulations again state that "all facts and circumstances must be taken into account."29

The regulations identify three circumstances in which reliance on advice of a tax professional is unreasonable: when the advice is not based on all pertinent facts and circumstances and the law as it relates to those facts and circumstances; when the advice is based on unreasonable factual and legal assumptions or unreasonably relies on facts supplied by third parties; and when the advice is that a regulation is invalid (unless the position is properly disclosed).30 The regulations do not contain any admonitions against reliance on advice provided by an adviser who has assisted in planning the transaction or whose fee is contingent on the closing of the transaction or delivery of a favorable opinion. That omission is significant given the rules denying reasonable cause relief for reportable transaction understatements when the taxpayer seeks to rely on an opinion of a "disqualified" adviser (generally defined as an adviser who has participated in the organization, management, promotion, or sale of the underlying transaction or who has a financial interest regarding the transaction or their advice).31 If Treasury intended to prohibit reliance on advisers having a conflict of interest, it certainly knew how to draft those rules. Its failure to do so must be presumed to have been intentional.

In summary, Treasury must be presumed to have intended a facts and circumstances test in all cases other than the three exceptions identified in the regulations. The courts should not frustrate that intent by writing their own exceptions. In cases such as Canal, applying a facts and circumstances test -- one in which the tax adviser's conflict of interest is a factor to be considered but is not dispositive -- is intended by the regulations and is in harmony with the cases that have considered the issue. The Tax Court's adoption of a new per se rule in Canal was unwarranted and should not be followed in other Tax Court decisions or by other courts.

At least one court seems to agree with this approach. In American Boat Co. v. United States,32 the taxpayer engaged a tax adviser to develop and implement a general restructuring of the taxpayer's business. As part of the restructuring, the adviser proposed a tax shelter transaction and provided an opinion on the tax consequences of the transaction. In seeking (unsuccessfully) to sustain penalties against the taxpayer, the government urged a bright-line rule that any time an adviser incorporates a potential tax shelter into a restructuring plan, the taxpayer may not reasonably rely on that adviser's legal advice and must obtain a second opinion. The Seventh Circuit responded:


    We find no such bright-line rule in the case law and decline to implement one here. . . . To accept the government's argument would mean that a taxpayer may never rely upon the legal advice of the same adviser who counsels the individual on restructuring. The reasonable cause determination depends on the particular facts and circumstances of each case . . . and we trust that our district courts can apply the reasonable cause standard accordingly.33
V. Conclusion

The Tax Court had harsh words for the quality of PwC's legal analysis in Canal. One may legitimately question whether those criticisms were justified. Moreover, as demonstrated above, the Tax Court's own legal analysis is deficient.

Had the Tax Court undertaken a more careful analysis of all the facts and circumstances relating to Chesapeake's reasonable cause defense, it is not entirely clear that the outcome would have been different. Perhaps there were facts in the record or that Judge Kroupa could have reasonably inferred that would have supported a conclusion that Chesapeake knew or should have known that PwC's opinion contained unreasonable factual or legal analysis. The point of this report is that PwC's conflict of interest was, standing alone, insufficient to justify a conclusion that Chesapeake acted unreasonably or in bad faith in relying on PwC's advice. More analysis was needed. If the penalty issue had been appealed,34 it seems likely that the case would have been remanded for further factual findings consistent with the guidance in the regulations that reasonable cause and good faith must be based on an analysis of all the facts and circumstances and not solely on the basis of conflict of interest.

Until Treasury or the courts definitively resolve whether a taxpayer can reasonably rely on an adviser having a conflict of interest, the Tax Court's outlier opinion in Canal will likely mean that many taxpayers will decide that it is prudent to obtain a second opinion from a disinterested adviser when the primary adviser has participated in structuring or recommending the transaction or has a financial interest in the implementation of the transaction or in the advice given. While that should not be necessary as a legal matter, it seems prudent as a practical matter.


FOOTNOTES

1 135 T.C. 199 (2010), Doc 2010-17535, 2010 TNT 151-9.

2 Id. at 219.

3 Richard M. Lipton and Todd D. Golub, "The Tax Court Drains Canal Corporation's Leveraged Partnership Transaction," 113 J. Tax'n 340 (2010); Blake D. Rubin et al., "Tax Court Goes Overboard in Canal," Tax Notes, Jan. 10, 2011, p. 185, Doc 2010-25511, 2011 TNT 7-6. See also David T. Moldenhauer, "Penalty Protection Opinions and Advisor Conflicts of Interest" (Apr. 25, 2011), available at http://ssrn.com/abstract=1822386 (penalty issue only).

4 Although there are no facts in the court's opinion on what, if anything, PwC would be paid if the transaction did not close, this report assumes that PwC would be paid nothing. That seems to be what the court assumed, which magnifies PwC's conflict of interest, thereby presenting the case in the light most favorable to the court's holding.

5 See section 6664(c). The court appears to have concluded either that there was no substantial authority for the reported tax position, eliminating the opportunity for relief under section 6662(d)(2)(B)(i), or that the transaction was a tax shelter as described in section 6662(d)(2)(C)(ii) so that substantial authority relief was not available.

6 Canal, 135 T.C. at 218.

7 Id. at 221.

8 See supra note 3.

9 Reg. section 1.6664-4(c)(1)(ii) states that reliance on advice of a tax adviser is not reasonable if the advice is based on unreasonable factual or legal assumptions. The Tax Court's criticism of the PwC opinion seems directed at that requirement. However, at no point does the court cite specific evidence that Chesapeake knew or should have known that PwC based its advice on unreasonable factual or legal assumptions. The court simply concludes, "we find it inherently unreasonable for Chesapeake to have relied on an analysis based on the specious legal assumptions." Canal, 135 T.C. at 220. The Tax Court appears to hold that a taxpayer is responsible for the reasonableness of an adviser's factual and legal analysis, regardless of whether the taxpayer has any knowledge (or reason to know) that the analysis is unreasonable. In my opinion, this is an incorrect interpretation of the law. Accord Moldenhauer, supra note 3, at 25-26. But that issue is beyond the scope of this report.

10 440 F.3d 375 (6th Cir. 2006), Doc 2006-3918, 2006 TNT 40-10.

11 Id. at 387 (citations omitted).

12 Donahue v. Commissioner, T.C. Memo. 1991-181, aff'd sub nom., Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), Doc 93-4831, 93 TNT 88-10.

13 Donahue, T.C. Memo. 1991-181, at 53.

14 Pasternak, 990 F.2d at 903.

15 115 T.C. 43 (2000), Doc 2000-20409, 2000 TNT 148-3.

16 Id. at 97.

17 299 F.3d 221, 324 n.22 (3d Cir. 2002), Doc 2002-17616, 2002 TNT 147-9.

18 132 T.C. 161 (2009), Doc 2009-8186, 2009 TNT 67-6.

19 T.C. Memo. 2005-16, Doc 2005-1941, 2005 TNT 20-9.

20 In a lease strip transaction, the rental income associated with a leasing transaction is separated or "stripped" from the ownership of the underlying property. The objective is to cause the rental income to be taxed to a tax-indifferent accommodation party and to cause the depreciation and other deductions associated with the underlying property to be allocated to the owner without any offsetting income.

21 1995-2 C.B. 354, Doc 95-9426, 95 TNT 201-5.

22 T.C. Memo. 2005-16 at 154 (emphasis supplied).

23 82 Fed. Cl. 636 (2008), Doc 2008-16870, 2008 TNT 149-5.

24 Id. at 716 n.72.

25 608 F.3d 1366, 1376 (Fed. Cir. 2010), Doc 2010-12971, 2010 TNT 113-15.

26 Canal, 135 T.C. at n.16.

27 For a more comprehensive discussion of the arguments against a per se rule, and a suggested framework for assessing the impact of a conflict of interest on the reasonable reliance inquiry, see Moldenhauer, supra note 3, at 30-35. The Moldenhauer paper also contains an analysis of cases discussing reliance on an adviser having a conflict of interest.

28 Reg. section 1.6664-4(a).

29 Reg. section 1.6664-4(c)(1).

30 Id.

31 Section 6664(d), added by P.L. 108-357 (2004), effective for tax years ending after October 22, 2004.

32 583 F.3d 471 (7th Cir. 2009), Doc 2009-21746, 2009 TNT 189-10. See also Allison v. United States, 80 Fed. Cl. 568 (2008), Doc 2008-4465, 2011 TNT 42-17 (rejecting a per se rule that would treat as conclusively unreasonable a taxpayer's reliance on a financial adviser regarding the profit potential of an investment when the financial adviser has a conflict of interest).

33 Am. Boat, 583 F.3d at 483. The Tax Court's failure to acknowledge or address this case in the Canal opinion is an additional shortcoming of the opinion.

34 The case was not appealed because of Chesapeake's bankruptcy in December 2010.

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