Friday, February 17, 2012
In Canal Corporation v. Commissioner, 135 T.C. 199 (2010), the taxpayer's subsidiary entered into a leveraged partnership arrangement pursuant to which it transferred its business assets to an LLC for a 5% interest in the LLC and a distribution of $755 million from the LLC that was financed by a loan to the LLC from an unrelated bank. Repayment of the loan was guaranteed by the “purchaser,” which had acquired the remaining interest in the LLC. The sub indemnified the purchaser with respect to the loan guarantee. As a result, the taxpayer argued that under the partnership tax regulations the sub's basis in the LLC was increased by the amount of the liability so that the distribution did not produce current recognition of the $524 million gain otherwise realized on the business assets transfer. The leveraged partnership structure had been suggested by PWC, an accounting firm, and was conditioned on PWC providing a “should” opinion to the effect that the structure would defer recognition of the gain, for which the court found that the taxpayer agreed to pay PWC $800,000, contingent on the transaction closing. However, modifications to the indemnity agreement (largely at the taxpayer’s request) so limited its potential application as to weaken the transaction’s tax viability. As a result, the court held that the transaction was a disguised sale of the sub's business assets and upheld imposition of a substantial understatement penalty on the taxpayer. The court rejected the taxpayer’s reliance on the PWC opinion as supporting a reasonable cause, good faith defense against imposition of the penalty, stating that PWC had an “inherent and obvious” conflict of interest and that the opinion was based on unreasonable assumptions. Matters within the ordinary business judgment of the taxpayer’s executives, under this view, are the taxpayer’s responsibility, such as an “obvious” conflict of interest and unreasonable assumptions at odds with the taxpayer’s own view of the indemnity agreement.
Canal Corp’s approach to the reasonable cause, good faith defense -- placing the burden on the taxpayer to be wary of a conflict on the tax advisor’s part -- is at odds with how both ethical rules and the law governing lawyers address conflict situations. Both the ethical rules and the applicable law require the tax advisor to inform the client of any significant conflict between the professional's personal interest and the client's interest, to determine whether the conflict is consentable, and to obtain the client's informed consent before proceeding with the engagement. Under either approach, the conflict of interest in Canal Corp was magnified by modifications to the indemnity agreement sought by the taxpayer, modifications which probably should have caused PWC to rethink its commitment to provide a “should” opinion. In this respect, the case illustrates how important it is for a tax advisor to exercise independent judgment when client suggested changes to a transaction may undermine its tax viability, even if the deal (and large fee) may fall through. If further reason for caution is needed, the conflict of interest may also indicate to a trier of fact in a malpractice action against the tax advisor a possible motive for the advisor to have provided advice that breached the duty of care to the taxpayer, making it easier for the trier of fact to find such a breach. The bottom line may well be that the taxpayer's loss of the reasonable cause, good faith defense may be the foundation for a malpractice action and/or a disciplinary proceeding against the tax professional.