Ethics of Taxation
Julie A. Roin
Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes. (Judge Learned Hand, Helvering vs. Gregory, 69 F.2d 809, 810 (2d Cir. 1934))
The code of conduct that passes for tax ethics in the United States has been described by one commentator as an ‘‘uneasy truce between notions of personal avarice and good citizen ship’’ (Holden, 1991). Perhaps because of the additional difficulties of arranging such a truce in the context of complex yet ambiguous tax rules, the parameters of acceptable taxpayer behavior have been more fully explored in the context of the federal income tax than any other. This entry focuses on the standards developed in the income tax context and allows readers to extrapolate from them to other situations.
Standards for Tax Return Reporting
Although the Internal Revenue Service has ex tensive audit powers, it has never had the re sources necessary to investigate more than a small fraction of the returns filed. The vast majority of taxpayers must therefore self assess their tax obligations. It is plainly illegal, and not simply unethical, to lie to the Internal Revenue Service by filing a tax return containing false statements. Fraud on, and making false statements to, the Internal Revenue Service are felonies which can lead to the imposition of substantial monetary penalties as well as incarceration. Similarly, taxpayers may on their returns take only positions that they believe in good faith to be correct. Though incorrectly reporting the tax consequences of transactions (as opposed to misreporting factual issues, such as the existence of transactions) rarely leads to criminal charges, substantial civil penalties can be invoked for ‘‘negligence’’ (which includes the failure to make a reasonable attempt to comply with the tax law) and the disregard of rules and regulations (including careless, reckless, and intentional disregard of the same). The traditional baseline for acceptable (and perhaps ‘‘ethical’’) tax behavior has been that necessary to avoid the imposition of this civil penalty.
Good faith does not require resolving all ambiguous questions in favor of the government. Taxpayers may take any position for which they believe in good faith a ‘‘reasonable basis’’ exists under the law. Because taxpayers often lack detailed knowledge of the tax laws, they may rely on a professional tax preparer’s conclusion as to the merits of a particular tax position. The professional organizations that regulate lawyers and accountants allow their members to advise tax reporting positions where there exists ‘‘some realistic possibility of success if the matter is litigated.’’ The professional need not believe that the position will prevail if the matter is actually litigated. A lawyer, for example, may advise the statement of positions most favorable to the client if the lawyer has a good faith belief that those positions are warranted in existing law or can be supported by a good faith argument for an extension, modification, or reversal of existing law. A lawyer can have a good faith belief in this context even if the lawyer believes the client’s position probably will not prevail (ABA, 1985).
In drafting its standards for enrolling and disciplining agents practicing before it, the Treasury Department concluded the realistic possibility standard would be satisfied if ‘‘a rea sonable and well informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits’’ (Circular 230, 10.34). A professional return preparer, according to these same standards, may sign returns incorporating such positions, as well as positions which, though not ‘‘frivolous,’’ fail the realistic possibility standard but are adequately disclosed to the Internal Revenue Service on the return. Preparers should not sign returns incorporating weaker positions in the absence of disclosure, nor should they advise taking such positions without first explaining to their clients the penalties they risk incurring, as well as any opportunities of avoiding such penalties through disclosure. Taxpayers seeking to avoid the negligence penalty are held to a slightly different standard than tax preparers. No penalty attaches to reporting positions supported by ‘‘substantial authority.’’ Treasury’s definition of ‘‘substantial authority’’ closely resembles that of the ‘‘realistic possibility of success’’ standard applicable to tax preparers (Treas. Reg. §1.6662–4(d)(2)). But tax payers have less leeway than preparers with respect to weaker claims. Whereas preparers can avoid penalties by disclosing all non frivolous claims, disclosure protects taxpayers only with respect to positions for which ‘‘a reasonable basis’’ exists. This ‘‘reasonable basis’’ standard is ‘‘significantly higher than not frivolous or not patently improper’’ (Treas. Reg. §1.6662– 3(b)(3)). Taxpayers, unlike tax preparers, thus run the risk of incurring a penalty when taking non frivolous positions that lack ‘‘a reasonable basis.’’ This statutory scheme may encourage taxpayers to take such positions without disclosing them to the Internal Revenue Service, creating a conflict of interest between them and their tax advisor or preparer – and raising ethical questions about the preparer’s duty of representation.
Post-Return Behavior
Concerns about acceptable behavior do not end with the filing of tax returns. One perennial issue is whether taxpayers who discover errors on previously filed returns are obligated to file correct, amended returns. There is no statutory or regulatory authority requiring taxpayers to file amended returns; nonetheless, lawyers believe that they have an ethical obligation to advise their clients to file such returns and that they may be required to withdraw from further representation with regard to the matter should the client decide not to file such a return. The precise extent of such a required withdrawal can be uncertain due to the multi year effect of some tax decisions.
Once unlucky enough to be the targets of audits, taxpayers and their agents should cooper ate with the tax authorities. Both taxpayers and their advisors should provide records and other information requested by the Internal Revenue Service unless they have reasonable cause to believe that such material is covered by a legal privilege. The criminal penalty against fraud and perjury continues in effect; furthermore, if a taxpayer is represented by an attorney, the attorney is prohibited by legal canons (as well as by the Treasury Department’s disciplinary rules which apply to all taxpayer agents, not just attorneys) from ‘‘mislead[ing] the Internal Revenue Service deliberately, either by misstatements or by silence or by permitting the client to mislead’’ (ABA, 1985). As attorneys are also forbidden from revealing client confidences, when confronted with a client intent on misleading or lying to the Internal Revenue Ser vice, an attorney must withdraw from representing the client. Whether a given course of conduct (or silence) rises to the level of ‘‘misleading’’ can be the subject of dispute.
It again bears repeating that the above discussion summarizes a minimalist definition of acceptable tax behavior. Those who ascribe to Justice Holmes’s aphorism that ‘‘taxes are what we pay for civilized society’’ believe that far more candor and cooperation is required before taxpayers can call their actions with regard to the tax system ‘‘ethical.’’ On the other hand, because tax laws are designed in part to influence behavior, even the most conscientious taxpayer will have trouble deciding when legal strategies to minimize taxes are appropriate responses to eco nomic legislation and when they merely exploit tax ‘‘loopholes.’’
Bibliography
American Bar Association (1985). Comm. on.Ethics and Professional Responsibility, Formal Op. 85 352. Available from ABA, 750 N. Lake Shore Drive. Chicago, IL.
American Institute of Certified Public Accountants (1985). Statements on Responsibilities in Tax Practice No. 1. Available from AICPA, 1211 Avenue of the Americas. New York.
Cooper, G. (1980). The avoidance dynamic: A tale of tax planning, tax ethics, and tax reform. Columbia Law Review, 80, 1553 1622.
Holden, J. P. (1991). Practitioners’ standard of practice and the taxpayer’s reporting position. Capital University Law Review, 20, 327 44.
Holden, J. P. and Friedman, R. E. (1992). Income tax return accuracy: Taxpayer responsibility and practitioner responsibility. USC Law Center Tax Institute series on Major Tax Planning, 44 (1), 10-1 10-22. (Slightly expanded version of first article.)
Schenk, D. H. (1991). Conflicts between the tax lawyer and the client: Vignettes in the law office. Capital University Law Review, 20, 387 420.
US Treasury Department Circular No. 230. Available from the Treasury Dept., Main Treasury Building, Washington, DC.