What Is a Tax Opinion and When Do You Need One?

A tax opinion is a formal, written piece of advice from a qualified tax professional, such as a tax attorney or a Certified Public Accountant (CPA). This document analyzes a specific transaction or set of facts under applicable tax laws to conclude on the likely tax treatment. It is distinct from informal tax advice.

Prepared by an independent professional, the opinion provides a carefully reasoned explanation of a taxpayer’s position. This formal advice helps individuals and businesses navigate complex financial decisions, like mergers or significant deductions, by providing a clear understanding of the associated tax risks and compliance requirements.

Purpose of a Tax Opinion

The primary function of securing a tax opinion is to establish a defense against potential IRS penalties, particularly the substantial understatement penalty. This penalty, governed by Internal Revenue Code Section 6662, can be imposed if a taxpayer understates their tax liability by a significant amount. A “substantial” understatement is defined as an amount exceeding the greater of 10% of the tax required to be shown on the return or $5,000.

A well-reasoned tax opinion is a tool for demonstrating that the taxpayer acted with “reasonable cause and good faith,” a defense outlined in Internal Revenue Code Section 6664. To be effective, the opinion must be obtained before filing the tax return, as this shows the taxpayer relied on professional advice. The opinion documents the taxpayer’s effort to assess their proper tax liability, which can persuade the IRS to waive penalties even if the underlying tax position is ultimately disallowed.

Beyond penalty protection, a tax opinion serves to provide assurance to parties involved in a financial transaction. For example, in a merger or acquisition, investors, lenders, and the company’s board of directors need confidence that the planned tax outcomes are sound before committing capital. The opinion provides this comfort by confirming that the transaction has been structured to align with established tax laws, allowing the deal to proceed with reduced uncertainty.

The opinion also helps document that a taxpayer’s position meets a certain legal threshold, such as having “substantial authority.” A tax opinion analyzes statutes, court cases, and IRS rulings to determine if this standard is met. This documentation is not submitted to the IRS with the tax return but is kept as evidence in the event of an audit.

Levels of Assurance in Tax Opinions

Tax opinions convey different levels of confidence regarding the likely success of a tax position if challenged by the IRS. These levels of assurance are guided by professional standards, most notably Treasury Department Circular 230, which regulates practitioners who practice before the IRS. The language used by the practitioner has a precise meaning.

• Will: This is the highest level of assurance, indicating an extremely high degree of certainty, approaching 95% or more, that the tax position will be upheld. This level is reserved for conclusions based on straightforward applications of well-established law where there is little to no ambiguity.
• Should: This opinion represents a very high level of confidence, generally considered to be a 70% or greater probability of success. While a strong endorsement, it acknowledges a slight possibility of an alternative interpretation by tax authorities.
• More Likely Than Not (MLTN): This standard means there is a greater than 50% chance that the tax position would be sustained on its merits if challenged. An MLTN opinion is a specific requirement for avoiding penalties on certain reportable transactions and tax shelters.
• Substantial Authority: This is a qualitative assessment rather than a numerical probability. A position has substantial authority if the weight of legal sources supporting the position is substantial compared to opposing sources. An opinion concluding substantial authority exists can help a taxpayer avoid understatement penalties for many transactions, provided the position does not involve a tax shelter.
• Reasonable Basis: This is the lowest level of assurance and is significantly higher than a frivolous position but does not require that the position is likely to prevail. It is often interpreted as having roughly a one-in-three chance of success and is insufficient on its own to protect against penalties unless the taxpayer formally discloses the position to the IRS on Form 8275.

Information Required for a Tax Opinion

The credibility of a tax opinion is dependent on the accuracy and completeness of the information provided by the client. The practitioner’s analysis is built upon a specific set of facts, and any omission or misstatement can invalidate the opinion’s conclusions. The client must gather and disclose all pertinent details before the opinion can be drafted.

• A complete description of the proposed or completed transaction. This narrative should explain the business purpose and economic substance behind the transaction, as the IRS may disregard transactions lacking a legitimate business purpose.
• All relevant legal documents, including draft or executed contracts, purchase and sale agreements, loan documents, and corporate resolutions. These documents contain the specific terms and conditions that dictate the legal rights and obligations of the parties.
• Financial records and correspondence related to the transaction. Financial statements, appraisals, projections, and emails can provide context and verify the economic details of the deal and reveal intent that may not be in formal legal documents.

Anatomy of a Tax Opinion Letter

A formal tax opinion letter is a highly structured document, with each section serving a distinct function. While the exact format can vary, most letters follow a logical progression from the factual basis to the final opinion.

• Statement of Facts: This section summarizes all the relevant facts, representations, and assumptions upon which the opinion is based. It will state that the analysis is contingent on the accuracy of these facts, as the legal conclusions are only valid for the specific factual scenario described.
• Legal Analysis: This forms the core of the letter, where the practitioner discusses the applicable tax laws, citing authorities such as the Internal Revenue Code, Treasury Regulations, and relevant court cases. This section provides a balanced discussion of the authorities, including those that may be unfavorable to the client’s position.
• Application and Reasoning: This is where the practitioner connects the legal authorities to the specific facts of the client’s transaction. It lays out the logical steps and reasoning used to arrive at the conclusion, explaining how the law applies to the client’s unique circumstances.
• Conclusion: This is the definitive statement of the practitioner’s opinion on the likely tax outcome, using one of the specific levels of assurance. The letter will also contain disclosures and limitations that clarify the scope of the opinion and state that it is not a guarantee of success with the IRS.