Dysfunction Junction : Reasonable Cause and Good Faith Reliance on Tax Advisors with Conflicts of Interest

Taxpayers who underpay their taxes may be liable for accuracy-related penalties if the underpayment is attributable to negligence or the careless, reckless, or intentional disregard of rules or regulations. Understatements of tax liability resulting from participation in certain types of tax avoidance transactions are also subject to penalties. Accuracy-related penalties may be imposed even with respect to innocent mistakes if the discrepancy between a taxpayer's correct and reported tax liability is sufficiently large.Taxpayers may, however, avoid accuracy-related penalties by relying on a reasonable cause defense. The reasonable cause defense may be satisfied by relying on professional tax advice even if the advice concludes that the taxpayer's chance of prevailing on the underlying merits is uncertain, the advice turns out to be incorrect, and the taxpayer is found liable for the underlying tax. Reliance on professional tax advice is not, however, a fail-safe escape from penalties. Courts have repeatedly held that taxpayers cannot rely on advisors “they know to be burdened with an inherent conflict of interest.” But courts have not clearly articulated the circumstances under which the common law conflict of interest rule applies, making its application unpredictable and inconsistent.A statutory conflict of interest rule now exists to prohibit taxpayers from relying on advisors who participate in the organization, management, promotion, or sale of certain tax avoidance transactions. Tax advisors who are tax return preparers may be subject to penalties, and those who provide written tax advice are potentially subject to censure, monetary penalties, suspension, or disbarment from practice before the Service for violating the covered opinion rules in Circular 230. These developments ostensibly enhance the quality of written tax advice, which would lessen the import of the common law conflict of interest rule and support its abrogation. This Article explains why *404 the common law conflict of interest rule remains relevant despite these developments. This Article also proposes several regulatory changes to mitigate advisor conflicts of interest.After an introduction in Part I, Parts II through IV offer helpful background information to provide a context for the academic discussion that occurs in the remainder of this Article. Readers familiar with the landscape of tax opinions and accuracy-related penalties may wish to skip ahead to Part V