Trusts & Trustees, Vol. 25, No. 1, February 2019, pp.
69–74
IRS weapons against aggressive tax
planning1
Michael G. Pfeifer* and Sae Jin Yoony
Abstract
The long-standing principle that taxpayers are
generally free to creatively engage in tax planning
is not without limits. In fact, with the creation of
increasingly sophisticated and complex tax plan-
ning structures by taxpayers and tax practitioners,
there has been pushback with equally strong force
from tax enforcement authorities and the courts
against tax planning that goes a step too far. This
article explores the ethical obligations of tax pro-
fessionals advising clients without overstepping
the boundaries of legitimate tax planning, as well
as judicial doctrines frequently employed by the
Internal Revenue Service and the US courts to
keep aggressive taxpayers in check.
Introduction
One may so arrange his affairs so 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 . . . there is
nothing sinister in so arranging affairs as to keep taxes
as low as possible. Everyone does it, rich and poor
alike and all do right, for nobody owes any public
duty to pay more than the law demands2
As can be seen from the famous endorsement by
Judge Learned Hand of taxpayers’ broad freedom to
reduce their taxes through legal means, the USA has
* Michael G. Pfeifer, Member, Caplin & Drysdale, Chartered, One Thomas Circle NW, Suite 1100, Washington, DC 20005, USA. Tel: þ1 202 862 5085;
Fax: þ1 202 429 3301.
y
Sae Jin Yoon, Associate, Caplin & Drysdale, Chartered, One Thomas Circle NW, Suite 1100, Washington, DC 20005, USA. Tel: þ1 202 862 5058; Fax: þ1 202 429 3301.
1. This article is a further elaboration of the authors’ prior article titled ‘The Ethical Limits of Tax Planning’, published on 6 January 2016 in Volume 22, Issue 1
of Trusts & Trustees.
2. Gregory v Helvering, 69 F 2d 809, 810 (2d Cir 1934), aff’d, 293 US 465 (1935).
ß The Author(s) (2019). Published by Oxford University Press. All rights reserved.
69
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historically taken a liberal view of the extent to which
taxpayers may engage in tax planning.
However, this general principle, though once
widely accepted, is being questioned and challenged
more and more frequently in recent years. In fact,
with the creation of increasingly sophisticated and
complex tax planning structures by taxpayers and
tax practitioners, there has been pushback with
equally strong force from tax enforcement authori-
ties and the courts against tax planning that goes a
step too far. This article explores the ethical obliga-
tions of tax professionals advising clients without
overstepping the boundaries of legitimate tax
planning, as well as the judicial doctrines frequently
employed by the Internal Revenue Service (IRS)
and the US courts to keep aggressive taxpayers in
check.
In fact, with the creation of increasingly sophis-
ticated and complex tax planning structures
by taxpayers and tax practitioners, there has
been pushback with equally strong force from
tax enforcement authorities and the courts
against tax planning that goes a step too far
Ethical obligations of tax professionals
When advising taxpayers of potential tax minimiza-
tion strategies, taxpayer representatives are limited by
doi:10.1093/tandt/tty170
70 Articles
their ethical obligations under state and local Bar
rules of professional conduct to avoid fraudulent or
illegal transactions. Tax practitioners in the USA are
also required to follow Treasury Department Circular
230 (‘Circular 230’), which mirrors and overlays their
broader ethical obligations.
Rules of Professional Conduct
Perhaps the most widely recognized set of rules that
provide ethical guidance not only for tax practitioners
but for all lawyers are the Model Rules of Professional
Conduct (MRPC). Under several provisions of the
MRPC, lawyers are expressly prohibited from provid-
ing legal advice to assist taxpayers in furtherance of
fraud or a crime:
 Rule 1.2(c): ‘A lawyer shall not counsel a client to
engage, or assist a client, in conduct that the lawyer
knows is criminal or fraudulent . . .’
 Rule 8.4(a)–(d): A lawyer commits professional
misconduct by (a) violating, or attempting to vio-
late, the Rules of Professional Conduct or
by inducing another to engage in such violation,
(b) engaging in a criminal act that demonstrates
a lack of honesty, trustworthiness, or fitness as
a lawyer, (c) engage in dishonest, fraudulent,
or deceitful behaviour, or (d) engage in con-
duct that is prejudicial to the administration of
justice.
Since the MRPC is adopted and administered on a
state-by-state basis, the applicable rule in a given situ-
ation may vary depending on the particular jurisdic-
tion. Upon a breach of a provision of the rules, the
state Disciplinary Board(s) with administrative au-
thority may sanction a lawyer for the violation,
including license suspension and disbarment. A law-
yer’s obligation to obey and adhere to the rules of
professional conduct is not limited to observing
only the rules of those jurisdictions in which the
lawyer is licensed, but also extends to the rules of
sister states and US federal laws.
Trusts & Trustees, Vol. 25, No. 1, February 2019
Treasury Department Circular 230: rules of
tax practice
Another well-established rule of professional con-
duct is Circular 230 issued by the US Treasury
Department. This set of rules sets forth the special
and particularized duties and obligations of
tax professionals who practice before the IRS—eg
attorneys, certified public accountants, and enrolled
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agents. Some notable provisions include the
following:
 section 10.22(a): A practitioner must exercise due
diligence:
 In preparing; approving; and filing documents,
affidavits, and other papers;
 In determining the correctness of oral or writ-
ten representations made by the practitioner to
the Department of the Treasury; and
 In determining the correctness of oral or writ-
ten representations made by the practitioner to
clients with reference to any matter adminis-
tered by the IRS.
 section 10.51(a)(4): A practitioner may be sanc-
tioned for (among others) knowingly giving false
or misleading information—including facts or
other matters in testimony, federal tax returns, fi-
nancial statements, affidavits, declarations, and any
other document or written or oral statement—to
the IRS or to any court handling a tax case, in
connection with any matter pending or likely to
be pending before them.
In addition, under Circular 230, tax professionals
are prohibited from taking a tax position that lacks a
‘reasonable basis’ or is an ‘unreasonable position’
under Code section 6694(a)(2) (ie lacks substantial
authority). The degree of reasonableness of a tax re-
porting position may be evaluated by estimating the
likelihood that the reporting position at issue will
prevail if challenged by the IRS:
a. More likely than not: greater than 50 per cent
probability of success if challenged by IRS.
Trusts & Trustees, Vol. 25, No. 1, February 2019 Articles 71

b. Substantial authority: weight of authorities in
support of a position is substantial in relation
to the weight of authorities in opposition to the
position (40 per cent chance of success).
c. Reasonable basis: significantly higher than not
frivolous and lower than realistic possibility of
success (25 per cent chance of success).
d. Not frivolous: not patently improper; some merit
Under the aforementioned rules, tax advisers must
be careful in recommending a particular tax reporting
position to a taxpayer by evaluating the strength of
each available position and ensuring that the chosen
position has at least a reasonable basis to be in ac-
cordance with Circular 230.
IRS and judicial weapons to police

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to position.
In addition, under Circular 230, tax profes-
sionals are prohibited fromtakinga taxposition
that lacksa‘reasonable basis’orisan‘unreason-
able position’ under Code section 6694(a)(2)
(ie lacks substantial authority)
As noted above, under Circular 230, a tax adviser
may recommend, and a taxpayer may proceed with,
a transaction if it meets at a minimum the ‘reasonable
basis’ standard. There is, of course, always a risk that
the IRS will disagree with and challenge the tax results
of the transaction, giving rise to a tax deficiency and an
underpayment penalty.3 That penalty does not apply,
however, to any underpayment due to a legal position
with at least a ‘reasonable basis’ if the taxpayer discloses
such position on the relevant return, or any position
for which there is ‘substantial authority’, even if such
position is not disclosed to the IRS. Substantial author-
ity can be found in the Internal Revenue Code and
other statutory provisions; proposed, temporary, and
final regulations construing such statutes; revenue rul-
ings and procedures; tax treaties and regulations there-
under; court cases; congressional intent reflected in
various committee reports; the Bluebook;4 private
letter rulings and technical advice memoranda; general
counsel memoranda, and other administrative pro-
nouncements by the IRS; IRS press release in the
Internal Revenue Bulletin, etc.5
unethical practice
Judicial doctrines
Tax practitioners and the courts alike frequently face
the task of drawing a line between legitimate tax
minimization strategies and overly aggressive, illegal
tax planning.6 As taxpayers and tax practitioners
continue to develop and implement new tax plan-
ning structures that are increasingly complex,
sophisticated, and technically legal, the courts and
the IRS have more frequently been utilizing norma-
tive legal principles to evaluate whether certain tax
planning techniques are ethically and legally toler-
able. The emerging view is that tax planners should
not engage in tax minimization strategies solely for
that purpose, even if the structure is legally sound.
In other words, a strategy should have a broader
business or personal purpose and should not be
pursued solely for tax minimization purposes.
Below are some judicial doctrines that are frequently
employed by the courts and the IRS to find that a
transaction constitutes overly aggressive, illegal tax
avoidance.
 ‘Substance over Form’: The substance-over-form
doctrine is a judicially created rule used by the
courts and the IRS to recast or re-characterize a
transaction when the form of that transaction is
inconsistent with its underlying economic

3. Specifically, the IRS may impose an underpayment penalty pursuant to Code s 6662 if it determines that the taxpayer has underreported its tax due by $5000
or more, or by 10% of the total tax due.
4. The Bluebook is an explanation of newly enacted tax legislation that is prepared and published at the end of each Congress by the Joint Committee on
Taxation (with input from the House Committee on Ways and Means and the Senate Committee on Finance). For each provision, the document includes a
description of present law, explanation of the provision, and effective date. 5https://www.jct.gov/publications.html?func¼select&id¼94accessed 12 October 2018.
5. See Treas Reg § 1.6662-4(d).
6. The illegal tax planning discussed in this section refers to tax planning that is illegal in a civil sense but does not rise to the level of criminal tax evasion (which
usually involves an element of willfulness and intentional disregard of the law).
72 Articles
substance. The doctrine is frequently employed to
re-characterize purported debt instruments as
equity, or leases as sales, turning otherwise deduct-
ible interest or lease payments (ie revenue-based
transactions) into equity contributions or gross
proceeds (ie capital transactions that generally do
not have immediate revenue consequences). See eg
Mixon’s Est v United States, 464 F 2d 394, 402 (5th
Cir 1972) (listing various factors that tend to sup-
port the re-characterization of a formal debt ar-
rangement as equity on the basis of the
substance-over-form doctrine; relevant factors in-
clude thin capitalization in the debtor, highly
speculative possibility of principal repayment, and
debtor’s inability to obtain financing from conven-
tional sources).
 ‘Step Transaction’: The step transaction doctrine is
a variant of the substance-over-form doctrine that
permits courts and the IRS to collapse, combine, or
ignore certain steps in a series of business transac-
tions if various tests are satisfied—for example, if
the ‘end result’ of a series of transactions would
have been the same even without some transitory
intermediate steps, or if certain intermediate steps
are ‘interdependent’ with other steps (ie antecedent
steps would not take place but for the later steps).
The real question is whether certain of the steps
have independent, non-tax significance (ie legal or
economic consequences which do not depend on
the tax consequences). See eg Andantech LLC v
Comm’r, 83 TCM (CCH) 1476 (2002), aff’d on
this issue, 331 F 3d 972 (DC Cir 2003) (disregarding
LLC created as part of lease-stripping transaction;
LLC purchased computers and leased them back to
user, sold rights to future rents, and allocated re-
sulting income to nonresident alien members, who
claimed exemption under income tax treaty and
quickly disposed of their interests pursuant to
pre-arranged plan).
 ‘Economic Substance’: The common law economic
substance doctrine gives the courts and the IRS the
ability to disregard a transaction or part of a trans-
action that either: (i) fails to meaningfully change
the taxpayer’s non-tax economic position; or
Trusts & Trustees, Vol. 25, No. 1, February 2019
(ii) lacks a subjective, bona fide business or non-
tax purpose. It is now buttressed by a statutory
gloss (IRC § 7701(o)), which provides that a trans-
action is treated as having economic substance only
if the transaction changes a taxpayer’s economic
position in a meaningful way (apart from tax con-
sequences), and the taxpayer has a substantial non-
tax purpose for entering into the transaction. In the
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case of individual taxpayers, the doctrine applies
only to transactions entered into in connection
with a trade or business or in connection with an
activity engaged in for the production of income.
See Gregory v Helvering (1935) 293 US 465 (court
disregarded taxpayer’s plan under which he formed
a new corporation and effected a corporate re-
organization to transform what would have been
a sale of stock followed by a dividend to a tax-
free reorganization followed by a sale of stock at
the preferred capital gains rate based on the reason-
ing that the transaction lacked substance).
 ‘Alter Ego’/’Nominee’: When an agent or nominee
(hereinafter an ‘agent’) sells property on behalf of
his or her principal, the courts and the IRS will
generally attribute the income or loss to the prin-
cipal (the real party in interest) rather than
the agent. See Brittingham v Comm’r, 57 TC
91 (1971), acq, 1971-2 CB 2. The agent’s actual
authority (an express or implied agreement be-
tween agent and principal), see King World Prod,
Inc v Fin News Network, Inc, 660 F Supp 1381
(SDNY 1987), or apparent authority, see Coopers
& Lybrand v Arol Dev Corp, 621 NYS2d 24 (NY
App Div 1994) to act for the principal generally
defines and limits the scope of the agency relation-
ship. A principal–agent relationship can also be
inferred if, among other things, the principal con-
tinues to treat property as if she owns it even after
transferring physical custody of the property to the
agent.
 ‘Sham Transaction’: A transaction that is entered
into to hide or at least blur the outlines of what
is really going on may be disregarded as a sham
transaction. Such transactions generally raise the
specter of civil fraud, which, if proven, carries a
Trusts & Trustees, Vol. 25, No. 1, February 2019
75 per cent tax penalty.7 See Rice’s Toyota World,
Inc v Commissioner, 752 F 2d 89 (4th Cir 1985)
(IRS disallowed interest and depreciation deduc-
tions that Rice took on income tax returns filed
for 1976, 1977, and 1978 on the basis that under-
lying sale and leaseback transactions for used com-
puters were, for tax purposes, a sham).
 ‘Reciprocal Trust’: When two individuals (usually
husband and wife) enter into a ‘reciprocal’ trust
arrangement, whereby each person creates and
funds a trust for the benefit of the other without
retaining any life interest in the transferred trust
assets (such that those assets are not includible in
the transferor’s estate under a literal application of
the law), the IRS may ‘uncross’ the trusts and treat
each person as having created and funded a trust
for the benefit of him/herself. The doctrine is trig-
gered where the:
trusts [are] interrelated, and [the] arrangement, to the
extent of mutual value, leaves the settlors in approxi-
mately the same economic position as they would
have been had they created trusts naming themselves
as life beneficiaries;
the subjective intent of the parties in creating the
trusts is irrelevant. United States v Estate of Grace
(1969) 395 US 316.
As taxpayers and tax practitioners continue to
develop andimplement new taxplanning struc-
tures that are increasingly complex, sophisti-
cated, and technically legal, the courts and the
IRS have more frequentlybeen utilizing norma-
tive legal principles to evaluate whether certain
taxplanning techniques are ethicallyandlegally
tolerable
Although there is no bright line rule as to when the
IRS may invoke one of these judicial doctrines to limit
or bar a taxpayer’s planned tax consequences, they are
7. Interestingly, in connection with the recent Offshore Voluntary Disclosure Program, taxpayers were allowed to ‘sham’ the existence of offshore companies
used to hide assets or income in order to simplify the tax consequences of the transactions to avoid income accounting and reporting obligations under the anti-
deferral tax regimes applicable to ‘‘Controlled Foreign Corporations’’ and ‘‘Passive Foreign Investment Companies’’.
Articles 73
generally used where a taxpayer is seen to be obtain-
ing significant tax benefits (which might result from
structuring a transaction giving rise to low taxed cap-
ital gains or equally from structuring a transaction
which generates significant ordinary deductions and
losses that can be used to offset high taxed income)
that are out-of-line with a taxpayer’s economic in-
vestment or risk in the transaction. As can be seen
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from the variety of judicial doctrines that are avail-
able, the IRS and the courts are increasingly scrutiniz-
ing taxpayers who appear to reap disproportionately
great tax benefits, focusing on what the substance and
true purpose of a transaction is to determine its le-
gality. In this environment, Judge Learned Hand’s en-
dorsement of taxpayers’ freedom to minimize their
income tax liability through the use of any legal
means may no longer hold true if the tax minimiza-
tion strategy, completely legal from its inception to
completion, has no purpose other than a reduction in
the taxpayer’s tax bill.
Although there is no bright line rule as to when
the IRS may invoke one of these judicial doc-
trines to limit or bar a taxpayer’s planned tax
consequences, they are generally used where a
taxpayer is seen to be obtaining significant tax
benefits (which might result from structuring a
transaction giving rise to low taxed capital
gains or equally from structuring a transaction
whichgenerates significant ordinarydeductions
and losses that can be used to offset high
taxed income) that are out-of-line with a tax-
payer’s economic investment or risk in the
transaction
Policing tax shelters: listed transactions
Besides the above-mentioned judicial doctrines,
which the IRS uses to limit or reconfigure tax conse-
quences to reach a proper tax result, there are also so-
74 Articles Trusts & Trustees, Vol. 25, No. 1, February 2019

called ‘listed transactions’—transactions that are the
same as, or substantially similar to, the ones that the
IRS has determined to be a tax avoidance transaction
and identified by IRS notice or other form of pub-
lished guidance—which are a category of artificial
and generally prohibited transactions that are asso-
ciated with frequently publicly marketed schemes con-
sidered to be tax shelters. These generally involve
the transaction as planned. In addition, tax practi-
tioners must also diligently monitor and review the
status of their compliance with the standards of prac-
tice applicable to tax planning. Even with such meas-
ures, there will inevitably be new scenarios where the
line between legality and illegality is murky. For ex-
ample, a taxpayer may, at the inception of a transac-
tion, innocently and in good faith obtain legal advice

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complex transactions giving rise to significant tax con-
sequences that have little or wholly artificial economic
consequences for the participants. Listed transactions
entail burdensome information reporting obligations
and potential civil penalties under IRC section 6700.
Ethical tax planning strategies
The multiple layers of ethics rules and enforcement
practices that have become applicable to tax practi-
tioners in recent years have generally increased the
risks arising from aggressive tax planning and resulted
in a decrease in the scope of what is considered per-
missible. In light of this increasingly restrictive tax
planning environment, tax practitioners and tax-
payers should take caution to carefully plan the
method and extent of their tax strategies so as to
not overstep the shrinking boundaries of legality.
At a minimum, taxpayers should ensure that their
tax planning is procedurally and ethically sound by
seeking professional tax advice from experts, making
full disclosure of all facts relevant and material to the
tax plan, and making sure that the tax minimization
plan as actually implemented is in conformity with
from a tax professional that is, unbeknownst to
such taxpayer, incorrect, and abusive, but which the
taxpayer relies upon in good faith. If such a taxpayer
realizes at some subsequent point in time the likely
invalidity of her tax position, but does not take af-
firmative steps to remedy it, what tax exposure should
such taxpayer have? Moreover, depending upon the
nature and magnitude of tax benefits improperly rea-
lized and the zest with which the taxpayer embraces
the tax position, might such a taxpayer even be trea-
ted as having crossed the line from illegal, but civil,
tax avoidance to criminal tax evasion? The answers
are far from clear.
The primary goal of most taxpayers is to reduce their
tax liability as much as possible through lawful, stra-
tegic planning. They must also recognize, however, that
the determination of whether the strategies they
employ are ‘lawful’ is subject to multi-layered, con-
stantly evolving standards of legality, influenced by
considerations of morality, ethics, and government ob-
jectives. What is acceptable, if aggressive, today might
tomorrow be considered overly aggressive and subject
to re-characterization and penalty, absent grounds for
a ‘reasonable cause’ exception.

Michael G. Pfeifer is a Member in the Washington DC office of Caplin & Drysdale, Chartered, a boutique law
firm known for its broad tax, private client, exempt organization, complex litigation, and political law expertise.
He holds a JD from Cornell Law School and an LLM in Tax from New York University. He was formerly a
Special Counsel at IRS Chief Counsel (International). E-mail: MPfeifer@Capdale.com

Sae Jin Yoon is an Associate in the Washington DC office of Caplin & Drysdale, Chartered, a boutique law firm
known for its broad tax, private client, exempt organization, complex litigation and political law expertise. She
holds a JD from Georgetown University Law Center. E-mail: SJYoon@Capdale.com