Both subsection (a)(1) and subsection (a)(2) of Section 330 are linked to the “practice” of a “representative,” terms that are not defined by the statute and, until recently, had not been interpreted by the courts. In 2004, Congress amended Section 31 to add a new subsection (d), which provides a negative grant of authority for the Treasury Department and IRS to regulate the rendering of written tax advice with respect to certain potentially abusive transactions. American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418, §§ 822. Neither the 2004 statute nor its legislative history address the definition of “practice” or “representative” as those terms are used elsewhere in Section 330.

Although Section 330 and its predecessor statutes have been in place largely unchanged for over a century, the government’s reliance on the statute to regulate as “practitioners” individuals who directly and indirectly interact with the federal tax system had not been subject to serious challenges until recently. Amendments to Circular 230 finalized in 2011 attempted to regulate as “practitioners” persons whose only connection to the tax system was the preparation of tax returns for compensation changed that.

Loving and Ridgely

The D.C. Circuit’s decision in Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014) and the D.C. District Court’s decision several months later in Ridgely v. Lew, 2014 U.S. Dist. LEXIS 96447 (D.D.C. July 16, 2014) have introduced a new paradigm to Circular 230, calling into question key portions of the regulations and creating a watershed moment for the regulation of a broad range of tax advisor conduct. With the decisions in both cases now final, attention has shifted from the courts to Congress to address what are generally agreed to be serious compliance problems created by a system where hundreds of thousands of unregulated, unlicensed and in many cases untrained professionals assist tens of millions of taxpayers in paying and obtaining refunds of billions of dollars in taxes each year.

Summarizing Loving and Ridgely:

• In Loving, the D.C. Circuit considered the “precise question” of “whether the IRS’s statutory authority to ‘regulate the practice of representatives of persons before the Department of Treasury’ encompasses authority to regulate tax-return preparers.” Finding no ambiguity in Section 330, the court held that it did not, walking through “six considerations [that] foreclose the IRS’s interpretation of the statute.”
• While in Loving, the D.C. Circuit focused narrowly on newly promulgated provisions in Circular 230 that imposed testing and continuing education requirements on paid tax return preparers, the District Court’s decision in Ridgely v. Lew extends the D.C. Circuit’s holding in a context with potentially far broader consequences. While the only aspect of Circular 230 directly at issue in Ridgely was the limitation on contingent fees in Section 10.27 as applied to a CPA’s preparation of “ordinary refund claims,” the rationale of the case has wider application. The District Court equated paid tax return preparation to the preparation of “ordinary” refund claims and held that if—under Loving—the former does not constitute “the practice of representatives,” neither does the latter. And, if regulating the preparation of “ordinary refund claims” is beyond the scope of the IRS’s regulatory authority, so is regulating fee practices with respect to that activity.
• While Ridgely was, by its terms, limited to contingent fee practices for refund claims, its rationale can be applied broadly to a wide range of conduct that Circular 230 has long purported to regulate, including due diligence, standards for written tax advice and conflicts of interest – none of which necessarily arise in the context of direct representation of taxpayers before the IRS. In sum, were it passed in its current form, S. 137 would address Loving and authorize the IRS to regulate paid tax return prepared, but it would not address Ridgely or future cases that can be expected to arise attempting to extend Ridgely to other conduct that is only indirectly related to an interaction with the IRS.
• Although the Ridgely Court’s rationale may be a lineal extension of Loving, it does not necessarily hold up against the “six considerations” the D.C. Circuit walked through in Loving. For example, unlike paid return preparation, the IRS has historically taken the position that it can regulate a CPAs’ fee practices. Moreover, Loving does not specifically address the secondary argument rejected in Ridgely that the IRS has derivative authority to regulate all aspects of conduct for persons who are, in other contexts, admittedly agents or “representatives” of taxpayers before the IRS (i.e., lawyers, CPAs and enrolled agents who at some point have filed an IRS Form 2848, Power of Attorney). This raises an interesting theoretical question as to whether the outcome might have been different had Ridgely reached the D.C. Circuit before Loving. Regardless, the Ridgely court did extended Loving to invalidate the limitation on contingent fees in Circular 230 § 10.27 and no appeal was taken.

With the government having folded its tent, at least for the moment, on further litigation over the scope of authority under Section 330, the focus now shifts to Congress for a solution.  While the prospects for expanding the IRS’s regulatory authority in the current political environment are unclear, the need for an updated statute – even before Loving and Ridgely is not.

The Horse Act of 1884

A downside to using a statute enacted 130 years ago as the basis for any modern day regulation, much less regulation of a multi-billion dollar industry, is that the language of the statute may not be up to the task at hand. When the predecessor to Section 330 was enacted, the United States did not have a generally applicable income tax, much less an entire industry focused on paid return preparation. Reading the original statute, it is difficult to imagine that in 1884 Congress thought that it was authorizing anything remotely close to the regulation of tax return preparers. Rather, when the original statute was enacted as part of the Horse Act of 1884, Congress was focused on funding claims brought against the War Department “[f]or horses and other property lost” during the Civil War. In authorizing that funding, Congress qualified it with the proviso:

That the Secretary of the Treasury may prescribe rules and regulations governing the recognition of agents, attorneys, or other persons representing claimants before his Department, and may require of such persons, agents and attorneys, before being recognized as representatives of claimants, that they shall show that they are of good character and in good repute, possessed of the necessary qualifications to enable them to render such claimants valuable service, and otherwise competent to advise and assist such claimants in the presentation of their cases.   And such Secretary may after due notice and opportunity for hearing suspend, and disbar from further practice before his Department any such person, agent, or attorney shown to be incompetent, disreputable, or who refuses to comply with the said rules and regulations, or who shall with intent to defraud, in any manner willfully and knowingly deceive, mislead, or threaten any claimant or prospective claimant, by word, circular, letter, or by advertisement.

Act of July 7, 1884, ch. 334, 23 Stat. 236, 258-59.

Submission of claims to the Treasury Department having evolved in the past 130 years from dead horses to home buyer, health insurance and earned income tax credits, among myriad other tax expenditures, the statutory grant of authority is in dire need of an update. As the D.C. Circuit stated in Loving in holding that Section 330 did not authorize the regulation of paid preparers, “we are confident that the enacting Congress did not intend to grow such a large elephant in such a small mousehole.” 742 F.3d at 1021.

Prospects for a Legislative Response

The judicial framework of Loving and Ridgely and the historical background of the Horse Act of 1884 provide context for evaluating recent legislative proposals to amend Section 330 to authorize the regulation of return preparers. Legislation introduced in prior Congresses focused on mandating regulation where historically the IRS had been unwilling or unable to do so. See, e.g., H.R. 1528, The Tax Administration and Good Government Act , § 4 (108^th Cong.).   Those earlier legislative efforts met resistance on several fronts, including a concern expressed by the IRS that it lacked the resources to effectively regulate hundreds of thousands of paid preparers, a concern expressed by existing “practitioners” that the market value of their credentials not be eroded by a regulatory stamp of approval for all paid preparers, and a concern by unregulated paid preparers over the burden that would be imposed by any regulation. With no traction on the legislative front and a growing concern over unregulated preparers, Treasury and the IRS acted on their own with the promulgation of the 2011 amendments to Circular 230 making all paid return preparers “practitioners.” This shifted the target from Congress to the IRS, but did nothing to eliminate the underlying concerns. In short order, those concerns gave rise to litigation.

In the early days of the 114^th Congress, legislation was again introduced to authorize the Treasury Department and IRS to regulate paid return preparers, now with the contextual benefit of Loving and Ridgely.   On January 8, 2015, Senators Wyden (D-Ore.) and Cardin (D-Md.) introduced S.137, which would amend Section 330 to supplement the current authorization for regulating “the practice of representatives of persons before the Department of Treasury” by adding a new subsection specifically authorizing regulation of “the practice of tax return preparers” as defined in Code section 7701(a)(36). If enacted, S. 137 would overturn Loving and authorize (presumably on a prospective basis) the changes to Circular 230 finalized in 2011 that attempted to fold paid return preparers into the definition of “practitioners.” The Obama Administration takes a similar albeit less detailed approach in its Fiscal Year 2016 Revenue Proposals, which call for legislation that “would explicitly provide that the Secretary has the authority to regulate all paid return preparers.” Similar legislation was also introduced in the 113^th Congress without any meaningful action being taken on it. H.R. 4470, Tax Return Preparer Accountability Act of 2014, (113^th Cong. 2014); H.R. 4463, Tax Refund Protection Act of 2014, H.R. 4463, 113^th Cong. (2014); H.R. 1570, Taxpayer Protection and Preparer Fraud Prevention Act of 2013, 113^th Cong. (2013).

While S. 137 responds to Loving,it does not address the broader challenge to the authority of the Treasury Department and IRS to regulate conduct beyond return preparation that was called into question by Ridgely. This is a somewhat ironic result, given that the district court in Ridgely purported to simply apply the holding in Loving, interpreting the meaning of “practice of representatives of persons before the Department of the Treasury.” By adding a new subsection to Section 330 providing targeted authority for Treasury and the IRS to regulate paid return preparers, S. 137 would appear to leave untouched the Ridgely court’s holding (applying Loving) that “the practice of representatives” under current law is limited to persons having direct “representative” interaction with the IRS and does not extend broadly to fee practices for preparing amended returns even with respect to persons who, like the plaintiff in Ridgely, are admittedly “practitioners” in other contexts.

S. 137 follows a discussion draft of legislation released by then Senate Finance Committee Chairman Max Baucus in 2013 as part of a broader package of proposals to reform the administration of federal tax law. That draft “clarifies” Section 330 by adding a reference to “preparing and filing . . . tax returns” to subsection (a)(2)(D). The draft assumes the threshold conclusion that “practice of representatives” includes return preparation, an issue that would have to be addressed in light of Loving. Moreover, like S. 137, the draft legislation does not address the narrow interpretation of “practice of representatives” in Section 330(a)(1) adopted by the District Court in Ridgely.  Despite these issues, inclusion of a proposal to amend Section 330 in the prior discussion draft suggests that the issue will be addressed again by the Finance Committee as Chairman Hatch continues to push for broader tax reform in the current Congress.

Also on the legislative front, the ABA’s Section of Taxation recently issued a Report supporting a legislative response to Loving, although the Report has yet to be adopted by the ABA’s House of Delegates. Like S. 137, the Report recommends that Section 330 be amended to include “tax return preparers” (as defined by Code section 7701(a)(36)) within the scope of Sections 330(a) and (b). While the Report does not propose specific legislative language, its recommendation could be implemented by expanding the definition of “practice of representatives,” which would address the holdings of both Loving and Ridgely. The Report also recommends amendments to Section 330(d), originally enacted in 2004, to expand it beyond a negative grant of authority applicable only to written tax advice rendered in the context transactions that have the potential for abuse.

Conclusion

Although the near-term prospects for legislation expanding the IRS’s regulatory authority may be remote, there does seem to be a broad consensus that paid tax return preparers should be subject to some form of uniform regulation and that the IRS should be able to promulgate practice standards applicable to a broad range of advisor conduct.   Loving and Ridgely make clear, however, that the Horse Act of 1884 is not up to the task of supporting that regulatory initiative. Whether it comes as part of a broader tax reform effort, or with narrower legislation targeted at improving the administration of the tax law, legislative action at some point in time seems inevitable. Legislation introduced in the current and past Congresses provide a good start and, with some refinement, should help to ensure the shared goal of improving compliance and tax administration. Only the minor challenge of moving tax legislation stands in the way.

In repealing the covered opinion rules in former section 10.35, the Treasury Department and IRS replaced them in the final regulations with a strengthened, “principles based” rule in section 10.37 applicable to all written tax advice. While the principles-based approach eliminates much of the uncertainly and complexity associated with the former covered opinion rules, it also eliminates the benefit of a targeted rule that was intended to apply to a fairly circumscribed set of potentially abusive transactions. Under the principles-based approach, practitioners now have far more discretion to determine the form and content of their written tax advice and to tailor that advice to the particular circumstances of an engagement and to the factual and legal complexity of the underlying issues. That discretion (or, more specifically, abuse of that discretion) was the reason for first imposing targeted written advice rules in Circular 230 in 1984, when Circular 230 was amended to include heightened standards applicable to written advice rendered with respect to “tax shelters.”   While there is little question that repeal of the covered opinion standards in favor of a principles-based approach was the right thing to do, two aspects of the final regulations should be highlighted.

First, the final regulations are noteworthy in that they mark a sea change in the use of Circular 230 as a tool for targeting and, if possible, preventing the use of written tax advice to facilitate potentially abusive transactions. For 30 years, Circular 230 has included a rule targeted at “tax shelters” or some iteration thereof.   While there is little record of enforcement proceedings having been prosecuted by the IRS’s Office of Professional Responsibility under these targeted rules, they have been viewed by most practitioners as an effective deterrent, preventing at least some aggressive written advice from being issued and, in turn, preventing at least some taxpayers from entering into potentially abusive transactions. Since the covered opinion standards were promulgated in 2004, it has been widely believed, however, that any deterrent effect that those standards had was outweighed by the burden imposed. With the passage of time, that balance has continued to shift toward burden and away from deterrent.

Looking at the covered opinion rules (and their “tax shelter” forerunners) against the current compliance landscape, the wisdom of the decision to repeal those rules seems clear. While largely driven by factors independent of Circular 230 (e.g., the government’s criminal prosecution of practitioners and firms and taxpayer malpractice claims), imposing only a “principles-based” standard for written tax advice under Circular 230 raises a concern as to what will prevent the next round of aggressive tax planning. The short answer is robust enforcement of both the principles-based approach in new section 10.37 and the general due diligence standards in section 10.22, together with robust enforcement of parallel rules under the preparer penalty provisions of Code sections 6694 and 6695, among others.   However, the groundwork for problems with that approach is being laid already with recent cutbacks in the IRS’s enforcement budget. While repeal of the covered opinion rules was unquestionably the right thing to do, history will tell what the cost might be for abandoning the 30-year effort to adopt workable standards targeted at potentially abusive transactions.

The second aspect of the final regulations to highlight has to do with the ubiquitous “legend” that most practitioners have adopted in an effort to remove written tax advice from the old covered opinion rules. The legend originated from language in former section 10.35 that seemed to permit written advice to be carved out of the covered opinion rules if it included language that “prominently disclosed” that it could not be relied upon for penalty protection purposes. While the efficacy of the legend can be debated, in the preamble to the final regulations Treasury and the IRS recognized that its use might be “misleading.”

While not detailed in the preamble, use of the legend to escape from the covered opinion rules might have been misleading in the context of listed or principle purpose transactions or in the context of marketed opinions, none of which were subject to a “prominent disclosure” carve out. Use of the legend might also have been misleading in the context of tax issues other than income tax, where the applicable penalty rules are not always linked to the “more likely than not” standard that former section 10.35 was built around. More significantly, use of the legend was problematic and possibly misleading because it purported to act as a rule of evidence, making irrelevant advice and other communications from a practitioner that might otherwise be an important part of an “all facts and circumstances” defense to penalties under the reasonable cause rules of Code section 6694.   See Treas. Reg. § 1.6694-4(b)(1) (“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.”).   Circular 230 is, and properly should be focused on practitioners. If a practitioner fails to meet any standard imposed by Circular 230, the consequence should be on the practitioner in the form of a disciplinary proceeding and, if appropriate, a sanction, not on the taxpayer who reasonably relied on the practitioner irrespective of boilerplate legends and caveats. Because the covered opinion rules that gave rise to the “legend” have now been repealed, this problem and the legend that gave rise to it should disappear as well. In the preamble to the final regulations the Treasury Department and IRS say specifically that they “expect these amendments will eliminate the use of a Circular 230 disclaimer in email and other writings.”