“Substantial Authority” and Taxpayer Reliance
Earlier this week, the NYTimes published an article on a tax strategy apparently used by Donald Trump in 1991 to reduce his taxable income. The ensuing commentary has focused heavily on the mechanics of the tax strategy, and has emphasized that though there was apparently “substantial authority” for the tax positions claimed by Trump, those positions did not satisfy a “more likely than not” standard for success.
Though their criticisms are couched in the language of tax ethics, commentators have largely failed to focus on Trump’s actual ethical responsibilities under the tax code. Instead, they have assumed that condemnation of the 1991 transaction automatically translates into condemnation of Trump. This unfortunate approach overlooks the fact that Trump was generally entitled to rely on his tax lawyers and likely did not violate the tax code’s ethical requirements.
Describing Trump’s ethical obligations under the tax code is a bit difficult, because the tax code does not announce a universal standard that a taxpayer must follow in filing his tax return, such as “Taxpayers can only claim positions on their returns that have a reasonable basis.” Ethical requirements must instead be determined through negative inferences. That is, we must look to what conduct will be penalized by the tax code and then go in reverse, to determine what will not be. Like everything else in the tax law, this task can be complicated, because different rules can apply in different contexts.
However, in defining the ethical obligations of a taxpayer, commentators frequently look at what it takes to avoid the accuracy-related penalty under Section 6662. Without going much into too much detail, the statute at the time of Trump’s transaction generally required that the taxpayer have a “reasonable basis” for his tax position or, in some contexts, including the one probably relevant here, “substantial authority” for his position.
The NYTimes article and some commentators have lamented that Trump’s law firm, Willkie Farr & Gallagher, advised him that elements of his transaction would satisfy only the “substantial authority” standard and not a higher, more-likely-than-not standard. But it’s difficult to understand this lamentation. Substantial authority reflects the highest standard that Congress, under the law at the time, specified in the statute for taxpayers to meet in order to avoid penalties. It’s no coincidence that the Willkie Farr opinion letter thus makes repeated references to “substantial authority.”
Of course, the fact that Trump’s law firm said that a position enjoys substantial authority does not make it so. Willkie Farr could have incorrectly analyzed the law, and whether substantial authority exists depends on objective legal analysis, not on whatever a private law firm might have said. See Treas. Reg. 1.6662-4(d)(3)(i). If Trump claimed on his tax return the position described in the opinion letter and litigated the issue, he may very well have lost.
However, even if a law firm provides bad advice, the taxpayer will face no penalty where the taxpayer had reasonable cause for taking a position and acted in good faith. See Section 6664(c). This presents a factual question, but a taxpayer who hired a sophisticated law firm to opine on a transaction would generally be well-positioned to show that he made a good faith attempt to determine the correct tax consequences of his transaction.
One might object that the standards in the tax code are too loose, and that taxpayers should hold themselves to a more-likely-than-not standard, regardless of whatever the law actually demands, or that Congress should enact such a higher standard. There would, however, be endless problems with applying that standard universally, especially given that even tax experts themselves frequently cannot agree which among two competing positions is the “more likely” one. Dealing with circumstances where there are (say) 4 equally plausible interpretations of a statute, as might be the case when applying a look-through rule, would present another head-scratcher for the hapless taxpayer attempting to determine how to fill out his tax returns.
Tax professionals who attack taxpayers for taking positions short of the more-likely-than-not standard should consider the consequences of their apparent proposal to re-define the tax code’s ethical rules. And if they are concerned about the legal reasoning underpinning the opinion letter given to Trump, they can properly examine whether the lawyers satisfied the relevant standards of professional conduct. But if they choose to make ethics-based arguments against a particular taxpayer, whether it’s Trump or someone else, the tax code’s ethical rules should be taken into account.
(This post was updated on 12/15 to remove some casual language.)