Attorneys Suggest Changes to Circular 230 Regs Relating to Employee Benefits, Compensation

The undersigned are attorneys with major law firms. The discussions contained in this letter are reflections of the personal views of the signatories to this letter and do not necessarily represent the views of the signatories' respective law firms. The issues discussed herein, however, are not correlated with the size of the law firm, and in some cases will impact smaller firms more acutely because of insufficient personnel to cope with the uncertainties, ambiguities and other interpretive difficulties inherent in the new regulations.

We and other members of our firms have spent an extraordinary amount of time and effort in recent weeks attempting to understand the impact of Section 10.35 of the Circular 230 regulations on employee benefit and compensation issues. We strongly urge the U.S Department of the Treasury ("Treasury") and the Internal Revenue Service (the "Service") to take the appropriate steps to create certainty and to alleviate the potential burden on the employee benefits and compensation practice which the regulations were not intended to cause. We believe that all of our suggestions are reasonable, narrowly and appropriately tailored and fully consistent with the purpose of the regulations. Of course, we do not intend our suggestions to be read to exclude from the scope of the Circular 230 regulations any listed employee benefits transactions or other similar abusive transactions marketed by third parties for the primary purpose of tax avoidance. Abusive transactions can and should be explicitly excluded in making interpretations under current authority and from further authority in this area.

A. Advice concerning tax-qualified plans.

For the reasons noted below, we respectfully request that you confirm that it is reasonable to interpret the exception in Section 10.35(b)(2)(ii)(B)(1) of Circular 230 for advice that "concerns the qualification of a qualified plan" (the "Qualified Plan Exception") to encompass (i) all plans that provide retirement benefits on a tax-favored basis and (ii) all advice provided to entities and individuals (such as plan sponsors, plan fiduciaries, third party recordkeepers, actuaries and other persons acting in their capacities as third party service providers to a particular plan, plan participants, and individual retirement account ("IRA") depositors and their advisors) relating to the selection, implementation, administration, design and proper operation of such plans. To the extent the language of the regulations does not permit such an interpretation, we respectfully request that the regulations be amended to provide for such an interpretation.

All of these plans are subject to similar strict Code limitations on contributions and benefits and, with the exception of IRAs, to similar antidiscrimination and anti-abuse requirements. For purposes of the Qualified Plan Exception and the purposes of Section 10.35 of Circular 230, it should not matter whether the plan sponsor receiving advice is a tax exempt or taxable entity, or whether it has chosen to take advantage of a simplified type of retirement plan that has been made available by Congress, such as a SEP or SIMPLE plan.

Accordingly, we request confirmation that, for purposes of the Qualified Plan Exception, the term "qualified plan" includes: (i) tax-qualified plans under Code Section 401(a) or 403(a); (ii) tax- deferred annuities under Code Section 403(b); (iii) IRAs or annuities established under Code Sections 408 or 408A, including traditional IRAs, Roth IRAs, SEP-IRAs and grandfathered SAR-SEPs; (iv) SIMPLE Plans; and (v) Code Section 457(b) plans of governmental and nongovernmental organizations. All of these plans, as tax-favored retirement vehicles, have a common underlying objective and increasingly similar applicable legal requirements and attendant tax treatment.¹

Explanations that are within the Qualified Plan Exception should include communications to participants, and no less to plan sponsors, which, in turn, should include, inter alia: (i) descriptions of the tax consequences and benefits of participation, such as the deferral of tax on contributions or trust earnings until distribution (including Code Section 4974); (ii) descriptions of the tax treatment of participant loans from a qualified plan, including defaults of such loans; (iii) the availability of a rollover option and further tax deferral on lump sum and similar distributions; (iv) the special tax treatment for unrealized appreciation in employer securities; (v) other rules described in the Code Section 402(f) safe harbor notice (such as the mandatory 20% withholding and penalties under Code Section 72(t)); and (vi) the description of the tax consequences to employers of establishing and maintaining qualified plans (such as tax deductions) and to trusts of qualified plans (such as unrelated business taxable income).

For example, as we interpret it, the Qualified Plan Exception would cover: descriptions of the tax treatment of such plans in summary plan descriptions; brochures seeking to encourage participation in Code Section 401(k) plans (again, an objective not only consistent with but in furtherance of government policy), or describing automatic enrollment; prospectuses required to be distributed when such plans offer company stock as an employee investment option;² PowerPoint slide presentations; and explanations of benefit options given to participants to explain their choices as to form of benefit (including explanations complying with the "relative value" regulations upon termination of employment or to explain an in-service withdrawal or the consequences of a default on plan loans).

The Qualified Plan Exception should also cover all related advice to plan participants, plan sponsors, plan administrators, recordkeepers, or other third party service providers regarding required tax reports, such as advice regarding the correct reporting of participant distributions on Forms 1099.

Stated differently, the Service's recognition that matters relating to plan qualification are outside of Circular 230 should encompass not only the implementation of plans, but also activities that are the natural outgrowth of having achieved tax-qualified status, and should also extend to all vehicles sharing the essential characteristics of tax-qualified plans (i.e., all vehicles providing for immediate deductions to fund deferred retirement benefits subject to maximum contribution and benefit limits) regardless of the section of the Code that authorizes them.

We note that, wholly without regard to the interpretation we have explained above, we believe that these communications (especially to employees) do not typically involve a "reliance opinion," since the description of the tax consequences of participation does not involve any "significant Federal tax issue." Similarly, an employer's description of the consequences and benefits of plan participation to its own employees, and counsel's legal review of such descriptions, in furtherance of government policy promoting employee understanding of such matters, or facilitating a plan sponsor's adoption of a particular tax-favored retirement arrangement, does not appear to fall within the intended meaning of the term "marketed opinion." The propriety of an exception for the type of "in-house" advice represented by preparation or review of communications to the plan sponsor's own employees is further confirmed by the fact that it is not readily distinguishable from the exception in Section 10.35(b)(2)(ii)(D) of Circular 230 for in-house advice provided to an employer by a practitioner who is an employee of that employer. We agree with the comment made by Michael C. Desmond at the ABA Teleconference on August 16, 2005 (the "ABA Teleconference") that Circular 230 should be interpreted in a way that will not discourage the dissemination of information to employees.

The term "marketed opinion" seems, in light of the basic purpose of curbing abusive tax shelters, directed at opinions intended to serve commercial marketing purposes, rather than advice given to plan sponsors or participants regarding the tax benefits that Congress intentionally provided in order to encourage the creation of such plans and participation therein.

Thus, while the Qualified Plan Exception should be interpreted as suggested above, we believe the same result should follow independently of the Qualified Plan Exception for the reason that the tax-related communications discussed above do not involve either reliance opinions or marketed opinions within the intent of Circular 230. Nevertheless, the matters are too important to be left to possible divergent interpretations of the critical terms of the regulations and we repeat our request for confirmation that our interpretation discussed above is correct.

Employers and plan administrators are obliged to communicate to employees (including eligible retirees) and their dependents or beneficiaries regarding the tax treatment of plan participation and benefits, including, for example, the requirements for making contributions on a pre-tax basis under the "cafeteria plan" rules of Code Section 125 and the different treatment depending on whether contributions for long-term disability benefits are made on a pre-tax or after-tax basis. Similar explanations are also required for more recently created welfare benefit arrangements such as medical and health savings accounts. The same principle should apply to advice intended to ensure COBRA compliance, since advice given for the purpose of avoiding excise tax and similar tax penalties is intended to ensure compliance with the underlying requirements of statute and policy, and not for the purpose of tax avoidance, as is discussed further in Section B below.

For the same reasons noted above in connection with qualified plans, summary plan descriptions, enrollment brochures, explanations on election forms, PowerPoint and similar presentations, and the like seek to encourage participation by employees in welfare plans by making them aware of the opportunities available and describing the tax benefits of the various Code provisions governing such plans. Whether or not such explanations come from inside counsel or outside counsel, or a combination thereof, making them subject to Circular 230 is counterproductive to the furtherance of the policies that give rise to the preferred tax benefits.

Similar considerations apply to tax-favored benefits provided to further other public policies. Thus, employers and plan administrators and their counsel should not have to include disclaimers or incur the expense of covered opinions when offering salary reduction plans for qualified transportation fringe benefits under Code Section 132(f)(4). A broader interpretation of the Qualified Plan Exception seems clearly needed to avoid impeding the establishment of plans that were deliberately encouraged in furtherance of Congressional policy, as in the case, for example, of the qualified transportation fringe benefit.

B. Advice concerning avoidance of excise and similar taxes on benefit plans.

We agree with the informal statements made by Treasury officials at the ABA Teleconference that "written advice" concerning one or more Federal tax issues for purposes of Circular 230 should not include advice regarding excise taxes or other similar tax penalties. We believe that this conclusion follows from the definition of a "Federal tax issue" under Circular 230, since an excise tax or similar tax penalty is not an item of income, gain, loss, etc. Therefore, we request that the interpretation made by Treasury officials in the ABA Teleconference, and with which we concur, be formalized, and that it be made clear that this interpretation covers all advice related to the avoidance of excise taxes and similar tax penalties associated with the improper operation of tax-favored retirement plans and welfare plans, as well as to all advice regarding the tax penalties associated with plan distributions.

We submit that advice should be viewed as fitting within this special category of penalty avoidance only if the failure to incur (i.e., avoidance of the payment of) the tax is a permissible and otherwise proper course of action under both tax law and policy. Advice regarding penalties, or excise or other taxes that essentially constitute penalties, is unrelated to any tax avoidance motive. In fact, the policy goals behind such taxes and penalties (i.e., the fostering of compliance) would be satisfied if the excise taxes and similar tax penalties were never incurred.

We also believe it reasonable to conclude that tax advice should not include any advice regarding tax-favored retirement plan and welfare plan penalties that are substantially similar to excise taxes. Given that penalties functionally equivalent to "excise taxes" are given different names under the Code, and that important penalties for non-compliance with provisions such as COBRA and Section 204(h) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") are not under sections headed "excise taxes," consideration should be given to formally interpreting "written advice" concerning a Federal tax issue to include neither advice regarding excise taxes nor advice regarding defined retirement plan and welfare plan tax penalties which are substantially similar to excise taxes, regardless of their label. As set forth in Section A.3 above, this advice is intended to ensure compliance with the underlying requirements of statute and policy and not for the purpose of tax avoidance.

Advice that is outside of the scope of tax advice should therefore include, at a minimum, advice regarding taxes and penalties for failure to satisfy minimum funding requirements under Code Section 4971, for making excess and nondeductible contributions under Code Sections 4972, 4973 and 4979, for failure to send out a "204(h)" notice under Code Section 4980F, for failure to satisfy continuing health coverage requirements under Code Section 4980B, and for advice relating to the "prohibited transaction" excise taxes under Code Section 4975.

With respect to the exclusion of Code Section 4975 in particular, we would like to make certain specific points regarding the appropriateness of the proposed interpretation of tax advice in light of the special pervasive compliance-related nature of the rules under Code Section 4975. Code Section 4975 imposes excise taxes on non-exempt prohibited transactions between an employee benefit plan (and certain other plans) and a disqualified person, as well as certain other prohibited transactions. Code Section 4975 is essentially a companion provision to the rules under Sections 406 through 408 of ERISA, which generally prohibit such transactions as a matter of substantive law. As indicated below, we believe that the type of advice typically rendered regarding Code Section 4975 was never intended to, and should not be, within the ambit of Circular 230.

Similar considerations apply where an excise tax or similar tax penalty exists not in connection with an ERISA prohibition (e.g., with respect to "Keogh" plans covering only business owners or in certain cases involving an IRA) but in furtherance of a Congressional policy, the disregard of which is not considered an appropriate alternative. (We note that excise taxes and similar tax penalties such as those for a failure by a plan participant to take the minimum required distribution from a qualified plan or the making of a nondeductible contribution to a qualified plan, as discussed above, also arguably fall into this latter category because the tax or penalty is avoided by engaging in compliant behavior that Congress sought to encourage.)

Thus, advice regarding the excise tax provisions of Code Section 4975 is in the nature of substantive legal compliance and not tax avoidance. Seeking to avoid prohibited transactions and the punitive excise taxes that result therefrom (e.g., through establishing funds which qualify as venture capital operating companies or which do not have significant participation by benefit plan investors pursuant to Department of Labor regulations) should not be considered an avoidance of taxation for purposes of Circular 230 but, rather, an effort to comply with applicable requirements of ERISA and tax law in particular and substantive law in general. With respect to Code Section 4975, a taxpayer only incurs an excise tax if the taxpayer has done something improper (i.e., a taxpayer seeking to avoid the payment of an excise tax is attempting to comply with the law, generally, and not simply reduce otherwise payable taxes). We submit that compliance advice is not what Circular 230 is designed to address.

In addition, without confirmation that tax advice does not include prohibited transactions, we note that Circular 230 could potentially have an even more expansive impact. Disclosure in securities and other offerings, and disclosure and advice in transactions generally, commonly discuss ERISA compliance in the context of investment by plans subject to Code Section 4975. The disclosure and advice will implicate Circular 230 in a broad set of circumstances, even if taxation is not expressly addressed by the disclosure or other advice in question. We do not believe that the Service intends Circular 230 to have such a wide-ranging impact on corporate offering and other documentation in the marketplace merely because the effect of actual compliance with law is that an excise tax or similar tax penalty is not incurred.

In light of the foregoing, we read the current language of Circular 230 not to apply to excise taxes and similar tax penalties. Thus, we respectfully submit that advice on the avoidance of excise taxes and similar tax penalties should not be discouraged by a narrow reading of the Circular 230 rules, and that the inapplicability of Circular 230 to excise taxes and similar tax penalties should be expressly confirmed.

C. Tax disclosures relating to equity compensation

In addition to the tax disclosures related to qualified plans discussed above, companies often prepare and disseminate tax disclosures to service providers³ who receive equity compensation awards. Sometimes these disclosures are required under the securities laws (usually together with other disclosures). For example, a prospectus delivered pursuant to Form S-8 promulgated under the Securities Act of 1933, as amended (the "Securities Act") requires, among other things, that a public company disclose the Federal tax consequences of equity awards.⁴ Even when not required, companies often provide participants with tax disclosures so that participants are aware of the timing of income associated with the award, the tax character of the award (i.e., compensatory or capital in nature) and applicable tax rates.

These equity compensation awards are often awards made in the ordinary course, the tax treatment of which is well-established under the Code. We believe that tax advice⁵ relating to the following forms of equity compensation does not present any interpretive difficulty and therefore should not be covered by Circular 230:

• The grant and exercise of a non-qualified stock option with an exercise price at or above the fair market value of the underlying shares, granted by a corporation to a service provider, including the sale of the underlying shares (without any additional gain deferral features);

• the grant and exercise of an incentive stock option that complies with Code Sections 421-422 and sale of the underlying shares (including a disqualifying disposition) without any additional gain deferral features;

• stock-for-stock dispositions to which Revenue Ruling 80-244 applies;

• participation in an employee stock purchase plan to which Code Section 423 applies;

• an equity award that specifically does not constitute a deferral of compensation under Code Section 409A (e.g., an option or stock appreciation right meeting applicable regulatory requirements or a restricted stock unit or other award which must be settled after vesting); and

• the grant, vesting and payout of restricted stock (or other property) without additional deferral features, and the tax consequences of any Section 83(b) election relating to transferred property.

For Federal tax advice to constitute a reliance opinion or a marketed opinion, a "significant purpose" of the advice must be to evade or avoid a tax imposed by the Code. There is no definition of "significant purpose" in Section 10.35(b)(10) of Circular 230, or in Code Section 6662 or the regulations issued thereunder.⁶ Rather, the phrase has meaning by reference to a "principal purpose" of avoidance or evasion (also set forth in Section 10.35(b)(10) of Circular 230). Avoidance or evasion is the principal purpose of a plan or arrangement "if that purpose exceeds any other purpose." However, a principal purpose of avoidance or evasion does not exist if a plan or arrangement "has as its purpose the claiming of tax benefits in a manner consistent with the statute and Congressional purpose."

It would appear, then, that a significant purpose of avoidance or evasion exists when (i) avoidance or evasion is at least one purpose among other purposes and (ii) that purpose is significant. It also appears to be possible under the language of Section 10.35(b)(10) of Circular 230 for a significant purpose of tax avoidance or evasion to be present notwithstanding that the purpose of a plan or arrangement is to claim tax benefits in a manner consistent with the Code and Congressional purpose.

Ordinary-course equity compensation arrangements typically present no efforts to avoid Federal income tax.⁷ A company does not "avoid" the tax treatment associated with stock options when it settles on granting its service providers restricted stock (or vice versa), or when it attaches a particular vesting schedule associated with these awards, or when it determines the other terms and conditions that may attach to these awards. Similarly, a holder of a stock option does not avoid taxes when he or she does not exercise his or her option on any given day. Rather, decisions relating to these ordinary-course forms of equity compensation reflect choices among different Federal tax regimes permitted by Congress and the Service.⁸

Even if a significant purpose of tax avoidance could be present notwithstanding that tax benefits are being claimed in a manner consistent with the Code and Congressional purpose, we believe that the Federal tax issues associated with ordinary-course equity compensation are not sufficiently significant to constitute a "significant purpose" of a company's grant of equity compensation and therefore to bring tax disclosures to service providers within Circular 230's definition of a "covered opinion." See Section 10.35(b)(2)(i)(C) of Circular 230. Companies grant equity compensation to their service providers in order to (among other reasons) reward them for past service; encourage them to devote their best efforts to the businesses of the company in the future; align their interests with the interests of shareholders; and encourage them to continue to provide their services to the company. In connection with the decision to award equity compensation to their service providers, companies must resolve a host of important and related ancillary issues, such as: the type of equity compensation to be granted; the vesting schedule; the effect of a termination of employment; the terms of the award, including transfer restrictions, call rights or rights of first refusal; and the inclusion of noncompetition clauses or other restrictive covenants. Generally, issues related to the Federal tax principles associated with equity compensation, though important, are secondary to the foregoing. The Federal tax issues associated with equity compensation generally involve only the timing of the recognition of income and deductions.⁹

As to these issues, the vast majority of companies (especially companies that make grants to large numbers of its service providers) tend to grant equity compensation as to which the Federal tax consequences are reasonably clear to ensure that service providers will understand (and therefore appreciate) the awards they receive. In addition, if the Federal tax treatment as disclosed to service providers were unclear and later resolved in a manner different from the disclosure, it is possible that companies could have exposure under the Federal securities laws and that their service providers would make claims against them to be made whole for the erroneous disclosure.

We recognize that there are a number of more sophisticated forms of equity compensation, such as those involving the use of leverage. The Federal tax principles associated with the structure of these forms of equity compensation may be uncertain or otherwise subject to various interpretations. We acknowledge that Federal tax advice related to these forms of equity compensation may require a different analysis under Circular 230. Since practitioners would bear the risk associated with a failure to comply with Circular 230, we expect that, in any reasonably close case, the legend will be added to a disclosure (or a covered opinion will be obtained). However, where the Federal tax principles are clear, we see no reason why companies should be obligated to legend disclosures or obtain the requisite opinions under Circular 230.

For purposes of Circular 230, a Federal tax issue is "significant" if the Service has a reasonable basis for a successful challenge to the advice. See Section 10.35(b)(3) of Circular 230. Where there is no reasonable basis for a successful challenge, tax advice should not constitute a reliance opinion. As described above, for most ordinary-course equity compensation, there will no reasonable basis for the Service to challenge advice provided by a company to its service providers, as the Federal tax treatment of the equity compensation will be clear and well-established. If a practitioner concludes that tax advice in respect of equity compensation is not reasonably subject to challenge, then that advice should not constitute a reliance opinion, and we request that Treasury confirm this interpretation.

In fact, however, equity awards do not result in "marketing" to service providers in the manner contemplated by Circular 230. In a typical arrangement to which Circular 230 is intended to apply, a practitioner would draft an opinion for use by a third party in promoting the tax characteristics of an arrangement to a person that would then directly or indirectly purchase the arrangement. In contrast, compensatory equity is typically awarded to service providers for no consideration other than the continued performance of services, and service providers are given little or no opportunity to evaluate the award or its tax attributes prior to grant. More fundamentally, to the extent that the employer promotes the equity compensation to any degree, it promotes not the tax treatment of the awards but rather the underlying purpose of the award (for example, the opportunity to participate in the appreciation of the value of the company's stock). We believe that these tax disclosures have been unnecessarily considered to be within the ambit of Circular 230 because of an overly broad reading of the regulation by tax practitioners, and we request confirmation of our interpretation that Circular 230 is not intended to cover these disclosures.

We and our law firms have spent significant amounts of time in analyzing the effects of Circular 230 on our employee benefits and compensation practices. This letter has been an attempt to point out the aspects of the regulations that we believe should be interpreted in a manner completely consistent with the language and the purposes of Section 10.35 of Circular 230 for the purposes of alleviating the unintentional burdens that would be placed upon practitioners in the employee benefits and compensation area if the interpretations described above were not confirmed.

Thank you for your consideration of these matters. We are happy to discuss this matter further with you if you would like an opportunity to do so. In such event, please call Laraine Rothenberg at (212) 859-8745, Jonathan Lewis at (212) 859-8044 or Andrew Oringer at (212) 878-8171 and she or he will have the group of signatories available to discuss the issues reflected in this letter with you.

² Although a prospectus is required to describe the tax consequences of participation, since only a Form S-8 itself is required to be filed with the Securities and Exchange Commission ("SEC"), a prospectus is not clearly covered by the exception for documents filed with the SEC under Section 10.35(b)(ii)(B)(3) of Circular 230. See SEC Release 33-6867, "Information Required in the Section 10(a) Prospectus," Requirement f-Tax Effects of Plan Participation, requiring that a prospectus include a discussion of the tax effects to employees and the registrant.

³ As used in this memorandum, the term "service providers" means employees and independent contractors (such as consultants and non-employee directors) who are individuals and who receive equity compensation from the entity to which they provide services or a parent of that entity.

⁴See supra note 2.

⁵ For purposes of this discussion, we have assumed that Treasury and the Service would view these disclosures as a form of tax advice. Nevertheless, we concur with the statement of W. Thomas Reeder at the ABA Teleconference that generalized disclosures not given in relation to a particular set of facts should not be considered tax advice, and encourage official confirmation of that view.

⁶See Chief Counsel Advice 200513022 (April 1, 2005) ("The term 'significant purpose' is not defined in Code Section 6662. In addition, the regulations pursuant to Code Section 6662 do not address the meaning of 'significant purpose' because they have not been updated since the test was changed from 'principal purpose' to 'significant purpose' for transactions entered into after August 5, 1997").

⁷ Incentive stock options can be viewed as an exception to this general rule, since a company could choose between non- qualified stock options and incentive stock options primarily to obtain for its employees the tax benefits associated with incentive stock options. However, as discussed below, we do not believe that the Federal tax issues associated with incentive stock options are sufficiently significant to cause disclosures relating to incentive stock options to become a covered opinion.

⁸Cf. Sargent v. Comm'r, 929 F.2d 1252, 1260 (8th Cir., 1991) ("The Code provisions relating to qualified retirement plans are a deliberate congressional bestowal of benefits upon employers and employees; efforts to obtain the advantages of these benefits . . . are not to be deemed to render the taxpayer culpable of illegal tax avoidance or evasion"), citing Keller v. Comm'r, 77 T.C. 1014, 1030 (1981).

⁹ For example, one company might choose options over restricted stock because options provide a recipient with control over the timing of income, whereas restricted stock does not, while another company might choose restricted stock over options because restricted stock grants generally provide the company with greater certainty as to the timing of its deductions. Also, because a service provider would usually prefer not to have to pay taxes out of other assets, companies might also consider structuring awards so that the taxable event occurs at a time when the holder can liquidate all or part of the award for cash.