Monte A. Jackel (firstname.lastname@example.org) is a contributing columnist to Tax Notes and the president and sole member of Monte A. Jackel Federal Tax Advisory Services LLC, an independent federal tax advisory firm. He is also of counsel to the Law Offices of Michael J. Desmond, which specializes in federal tax litigation matters.
In this now-monthly column on current tax policy and issues, Jackel examines the state of the tax practice in taking either aggressive or conservative positions on a tax matter. He also discusses the conundrum facing those who comment on government-proposed guidance and are forced to choose between client interests and sound tax policy.
Copyright 2012 Monte A. Jackel.
All rights reserved.
A common dilemma in tax practice arises when the client asks the question you know is coming: "At what level of comfort are you on this issue?" Of course, this question concerns whether the practitioner is at a "should," "more likely than not," "substantial authority," or other position on an issue.
These concepts, although phrased in terms of objective standards of analysis,1 are really quite subjective and lead to a division of camps among tax practitioners: the aggressive camp and the conservative -- or meek -- camp. Those in the aggressive camp will push against that mythical line between what is legitimate taxpayer behavior and what is not. Those in the meek camp shy away from the line on matters that push or even cross the line; they stay well within the bounds of clearly permissible taxpayer behavior for fear of being chastised for stepping over the line.
The problem is that the line between legitimate and improper taxpayer behavior is often fuzzy given the many gray areas in the tax law. Because the issues are not black and white, it is often unclear exactly where the line is. Competitive pressure from peers (from within the same firm or from different firms) who will give the client the desired opinion cannot be discounted as a motivating factor. I believe it is this pushing against the line that creates much of the tension in the practice of tax law today. Is it good or bad to be in one camp or the other, and who judges what is good and what is bad?
Underlying those fundamental questions is another equally important question in tax practice: Is the practitioner under any duty to the tax system to see that it functions in a manner that furthers the interests of taxpayers generally, or is the practitioner's sole role zealous representation and advocacy for the client-taxpayer at all times and at all costs?
This issue comes up most frequently when the tax practitioner appears to take off his "client" cap and participates in written or oral comments to the IRS, Treasury, or congressional staff on pending law or the implementation of regulatory or other type of guidance. Then, the question becomes whether the practitioner should offer up comments without regard to client interests if it is in the best interests of sound tax policy, or whether client interests can or should influence the practitioner's comments to the government, explicitly or implicitly.
I am not talking about situations in which the client retains the practitioner to write comments on its behalf. In those cases, the identity of interest will be apparent to all. Rather, I am talking about instances when, for example, a bar association report is being written and the statement is made that no drafter of the report has been compensated by a client to write the comments. Those reports also state that the standard conflict of interest policy of the organization precludes participation in the drafting of comments if client interest would interfere with the practitioner's independent judgment. Does that mean client interests are not being advanced because of the specific disclaimers in the comments, even though in the real world of economics and client retention, saying something in bar comments that would jeopardize a client's interests could spell trouble for the practitioner with his client or with his employer-firm?
After all, what happens to a practitioner who works on a comments project to the government and advocates a position that would harm his client or his firm's client? In the real world, where the First Amendment does not apply to speech in the workplace that is contrary to the employer's best interests, the answer appears readily apparent: There is and will continue to be enormous pressure on the tax practitioner to see that client interests are advanced, or at least not negatively prejudiced, by the pending guidance.
That said, there are many fine practitioners who will put themselves in the line of fire and speak their minds no matter the consequences. I am sure each of us can think of several practitioners who are known to do this very thing. However, I believe they are the exception and not the rule. We all have to eat after all, right?
B. A Case Study
Consider the scenarios below. The first is a classic example of a practitioner pushing against the line in tax practice. The second illustrates a situation in which private client interests that were contrary to sound tax policy may have interceded in practitioner comments to the government.
1. Pushing against the line. The son-of-BOSS transaction is now familiar to all.2 It was based on the supposition that a contingent obligation to make a payment is not a liability under section 752. As a government participant in the promulgation of Rev. Rul. 95-26,3 I must admit to having held the belief back then that the law was reasonably clear that contingent obligations could be liabilities under the tax law. Others in the tax bar strongly disagreed with that position.4 We now know that many courts have upheld an IRS challenge and held that the contingent obligations were liabilities in this transaction or, alternatively, that the transaction lacked economic substance.5
The point is that when the son-of-BOSS transactions were being planned and implemented, the law was unclear on whether a contingent obligation was a liability under section 752. Although one could easily convince oneself of the legal bona fides of the "no liability" conclusion, based on Helmer, Long, and LaRue,6 the end result of the transaction -- the creation of a very large tax basis without a corresponding expenditure of cash or its equivalent -- was too good to be true, at least in my view then.
However, there were those tax practitioners who believed one could construct a transaction with the predominant or even perhaps sole purpose of creating this excess tax basis. And there were some practitioners who believed that whatever the precise technical merits of the legal conclusion on what a contingent obligation really were, there was simply no way they could conclude favorably on the transaction given the so-called soft doctrines7 of the common law of taxation -- the sham transaction, step transaction, substance-over-form, business purpose, and economic substance doctrines.
To me, this illustrates the distinction between aggressive practitioners and conservative practitioners. The former looked to the technical and literal requirements of the law and advocated for a transaction that candidly would not have been done but for the creation of excess tax basis. Compare that with the conservative practitioners who looked to the outcome of the transaction and what they perceived as common sense and, as a result, refused to bless the transaction. Clients went away angry, but those practitioners could sleep well at night -- unless their employers took action against them for being too meek because another firm got the business.
As we all know, hindsight has proven the conservative practitioners correct in this particular case, but those situations occur frequently in tax practice. Is it best to err on the side of the conservative point of view and perhaps disadvantage the client you are representing, or should one instead push the line of permissible versus impermissible behavior and aggressively strive at all times to take positions that maximize the client-taxpayer's position, even when the result seems too good to be true? What if a "more likely than not" or "should prevail" tax opinion could be written on a transaction but you do not believe a judge in today's climate would approve of the transaction no matter the technical niceties of the situation?
These are difficult questions with no easy answers. The important point is that tax practitioners should constantly be asking themselves these questions. Only in that manner can the practitioner keep his balance and make the "right" decision for both him and his firm as well as for the taxpayer-client.
2. Commenting to the government. There are many occasions when tax lawyers submit comments to the IRS and Treasury in response to the government's request for comments on the issues presented in proposed guidance. The American Bar Association Section of Taxation and the New York State Bar Association Tax Section, for example, are two organizations that regularly comment on guidance projects.
It is standard practice for the organization's letter or report to state that no party participating in the comments has acted on the specific request of a particular client in preparing the comments or has been compensated for writing them. It is also common practice for the comments to state that the drafters of the comments may have clients who are or could be affected by the pending guidance but that the drafter is not representing a particular client in preparing the comments. These organizations may also have a standard policy that prohibits conflicts of interest for participants in comments projects.8
I am not questioning the sincerity of these boilerplate-type disclaimers in the bar comments or the organizations' soundly stated policies on conflicts of interest. Rather, I am asking whether it is really possible in most cases for those comment letters to the government to state positions that would or could be damaging to client-taxpayer interests. Again, the realities of the marketplace are (1) that there is no First Amendment right to free speech in the employer-employee relationship of a tax practitioner and his employer firm, and (2) that there is competition between firms to obtain business from a particular client on a particular issue. This, of course, goes to the point that even a tax partner in a law firm or a principal in an accounting firm can be subject to criticism or worse for taking positions contrary to the interest of the firm's clients, regardless of the potential negative tax policy consequences involved in advocating for a client interest in a given case.
A potential example of this conundrum is the comments on the proposed section 108(e)(8) regulations.9 Many commentators advocated for a bifurcated transaction when a creditor contributed to a partnership a debt instrument whose adjusted issue price exceeded the fair market value of the partnership interest received in exchange. If bifurcation had been allowed, the creditor-partner would have been treated as writing off the excess of the adjusted issue price over the partnership interest's FMV as a bad debt under section 166, and the balance of the debt, equal to the FMV of the partnership interest, would be treated as a section 721 transaction. That treatment would result in an ordinary, not capital, loss for the taxpayer. If, however, bifurcation was not allowed, the creditor would end up with a tax basis in its partnership interest equal to the built-in loss on the contributed debt instrument, leading to a later capital loss to the taxpayer.
The final regulations ended up not permitting bifurcation. But that is not the point of this discussion. The point is that there was little if any legal support for the proposed bifurcation treatment other than that it was beneficial to the taxpayer-creditor in this case, even though the tax policy involved clearly pointed to consistency of treatment of partnership and corporate creditors in a debt-for-equity exchange.10
Yet commentators still argued for the bifurcation position. Yes, bifurcation is seemingly much fairer to the taxpayer-creditor because the taxpayer can have an ordinary loss for the excess portion of the debt instead of a capital loss, which would have been the case if the creditor had written off the excess portion of the debt as worthless in a separate transaction before the debt-for-equity exchange. But given the legal reality, which was a lack of technical support for the advocated bifurcation position, why did the government still receive so many comments asking for bifurcation treatment of one sort or another?
There are many more examples of this type of situation that make the same fundamental point: Comments are indeed submitted to the government when there is little if any legal support for the position being advocated, and even when it is not -- or arguably is not -- in the best interests of the tax system11 to advocate for that position. Why? By now, the realities of competition with one's peers and the pressures of an unhappy client and an unhappy employer-firm should make the answer quite obvious.
The questions posed in this article are clearly difficult, but they need to be constantly asked and answered by the tax practitioner and his employer-firm if we all want a tax system that is as fair and objective as possible. Inserting self-interest into the equation is undesirable for the tax system as a whole. Unfortunately, economic reality and market compulsion push the tax practitioner in the opposite direction. Statements of policy in bar association standards of conduct go only so far. I hope that more of us can start or continue to ask these questions of ourselves every time we get a difficult question from a client or provide comments to the government on an important issue of the day. I believe that that behavior will benefit all of us in the long term.
1 See reg. section 1.6662-4(d)(2) ("The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts").
3 1995-1 C.B. 53, Doc 95-2759, 95 TNT 48-13. The ruling concluded that a contingent obligation to make payment was a liability under section 752: "A short sale creates an obligation on the part of the seller to return the borrowed securities. See, e.g., Deputy v. du Pont, 308 U.S. 488, 497-498 (1940), 1940-1 C.B. 118 (a short sale creates an obligation although not an indebtedness). In addition, the cash received in the short sale is an asset of the partnership. Thus, the basis of the partnership's assets is increased. Therefore, PRS's short sale creates a liability under section 752, and the adjusted bases of the partnership interests of A and B are increased under section 722 to reflect their shares of the liability under section 752."
4 This position was based mostly on case law regarding contingent obligations, which held on the facts that contingent obligations did not create tax liabilities. See Helmer v. Commissioner, T.C. Memo. 1975-160; Long v. Commissioner, 71 T.C. 1 (1978); and LaRue v. Commissioner, 90 T.C. 465 (1988). That position has now been rejected in administrative guidance. See reg. section 1.752-1(a)(4).
5 See Jackel and Crnkovich, supra note 2. There are also regulations on this issue today. See reg. section 1.752-6 and -7 and 1.752-1(a)(4). These regulations all derive from section 358(h), which was enacted in 1999.
6 See discussion at supra note 4.
7 "Soft doctrines" is an informal term of art that refers to the common law doctrines that could upset the result of a transaction whose elements meet all the technical requirements of the code.
8 For example, the NYSBA's conflicts of interest policy states: "A NYSBA Tax Section member may not participate in the preparation of a report if the member or the member's firm (to the member's knowledge) has been engaged by a client to influence a government policy relating to an issue directly addressed by the report. . . . A NYSBA Tax Section member may not participate in the preparation of a report for the purpose of advocating a result favorable to a client, an employer or the member's firm (an 'interested party'). . . . In determining whether a member has a potential conflict of interest, the member should consider whether the member's obligations to interested parties would impair the member's ability or willingness to express his or her personal views, whether the member or the member's firm is so closely associated in the legal community with particular interested parties that the member would be perceived as expressing the view of those interested parties, and whether the member can participate in the preparation of the report in a manner that comports with the goals of the Tax Section."
The ABA tax section's Guide to Committee Operations, section 1.2, similarly states: "Members of the Section of Taxation should always be mindful of their dual capacity; no member should permit the interest of a client to cause him or her to support or oppose within the Section a proposal that he or she would otherwise not support or oppose within the Section. This is not only a matter of ethical responsibility, but it is also a matter of enhancing the effectiveness and credibility of the Section. . . . Accordingly, when actively supporting or opposing a position within the Section, a member should determine that he or she acts out of personal conviction rather than client interest and should make disclosure where a client may benefit materially as a consequence of such support or opposition. . . . If a member (or the member's firm to the member's actual knowledge) has been engaged by a client to influence a government decision or policy determination on an issue that is also under consideration within the Section, such member shall not participate (or, upon receiving actual knowledge of such engagement, shall cease participation) in the preparation of Section material intended to be submitted to governmental personnel with respect to that issue."
9 REG-164370-05, Doc 2008-23074, 2008 TNT 212-10. Compare NYSBA, "Report on Proposed Regulations Under Sections 108(e)(8) and 721" (June 29, 2009), Doc 2009-14635, 2009 TNT 122-75 ("The ability to separately account for a creditor's built-in loss in connection with a debt-for-equity exchange raises issues that are not unique to partnerships. The same issue of loss deferral and possible character conversion raised by the application of Section 721 to a partnership debt-for-equity exchange also arises under Sections 351 and 354 when a corporate creditor surrenders a security in a debt-for-equity exchange"); with ABA tax section, "Comments on Proposed Regulations Under Section 108(e)(8)" (May 4, 2009), Doc 2009-10108, 2009 TNT 85-13 ("We acknowledge section 721 does not appear to allow for bifurcation of contributed property. . . . We further acknowledge that although Regulation section 1.166-6 provides an analogous rule, there is arguably some tension between this rule and the Supreme Court's decision in McClain v. Commissioner [footnote omitted]. Nevertheless, we urge the Treasury and the Service to consider whether such an approach is viable because it would achieve a uniformly equitable result"). The NYSBA comments seem to me to be very much policy-based whereas the ABA comments seem much more focused on client interests. This is not to say that one organization is more policy-based or more client-focused than the other. Other examples could be given in which these organizations switch positions on a different issue or in which their positions are aligned on one side or the other of tax policy versus client interest when the two positions do not coexist.
I acknowledge that I was a reviewer on the ABA comment letter referenced above and did not object to the recommendation of bifurcation in the report even though I knew it was wrong to make this recommendation based on sound tax policy and the applicable law. I recall thinking at that time that objecting to this proposal would have done no good because the report would make this recommendation regardless, and I have in the past made objections in these reports only to be overruled by those in the chain of command. I offer this only as an explanation and not as an excuse.
10 The ABA comment letter in this case argued that not permitting bifurcation allowed for an inside-outside basis disparity in which the creditor's outside basis in its partnership interest exceeded the inside basis of the partnership's assets because the cancelled debt no longer exists as an asset once the debtor and creditor positions merge in the debt-for-equity exchange but the excess debt is reflected in the creditor's partnership interest. At that point, it is impossible to apply section 704(c) because the asset, the contributed debt instrument, no longer exists. This is quite true. It is also true that the net inside basis of the partnership's assets have been increased because of the cancellation of the debt, although the gross basis of the partnership's assets remains the same. Although inside-outside basis conformity is usually desirable, it is created in this case by virtue of the nonrecognition granted to the basic debt-for-equity transaction under section 721. The same inside-outside basis situation exists in a corporate debt-for-equity exchange. After all, because of the application of section 108(e)(8), there is no cancellation of indebtedness (COD) income to the extent of the FMV of the partnership interest or stock issued in the debt-for-equity exchange. Had there been COD income in the debt-for-equity exchange instead of treatment of the transaction under section 721, there would have then been a creditor loss for the excess debt over the value of the equity issued, although the character of the income and the loss in the transaction could very well have been different because of the disparate application of sections 108 and 1271. This current disconformity in both timing and character of income and loss is, in my opinion, an issue for Congress to resolve and not one for the tax administrator to resolve through overreaching guidance.
11 For example, in the section 108(e)(8) regulations non-bifurcation was consistent with the general approach of section 351(d), when creditor interests treated as securities are subject to treatment under section 351 and the basis of the stock received by the creditor will reflect the excess of the adjusted issue price of the debt over the FMV of the stock. Why should the answer be different for partnerships as compared to corporations, other than that the answer was unpopular among tax practitioners looking to advocate for the client's position in this situation?
END OF FOOTNOTES
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