If you were told something in the tax
code is a gray area, there's a very high
chance the person telling you that
doesn't actually understand the law.
Okay, because it's a gray area is not a
tax plan, it's a lottery ticket, and a
real tax expert who has researched the
actual tax law does not explain the law
that way. They don't say, "Eh, it's a
gray area." That's how cousin Bob
explains his shitty tax position. Okay,
a true tax expert says things like, "We
have substantial authority for this
position, right? There's reasonable
basis. So, we need to disclose this on
the return. The regulations are silent
here, but we have persuasive authority
from tax court." Those are completely
different conversations. All technically
gray areas, but some with legal
requirements to meet to avoid massive
penalties, and others that come with
calculated risk that you should
understand if you're going to take that
position. And here's the problem. The
moment you accept gray area as an
explanation, you have completely lost
any understanding of the risk that
you're taking, and you've lost control
of the outcome. Okay, so in this video,
I'm going to break this down into three
parts. The problem, what people usually
mean when they say gray area, the levels
of authority, right? The tax research
that should happen before anyone says
that, and the strategy. What you should
do when the law truly isn't black and
white. And I'm Jasmine Dilichi, I'm a
practicing tax attorney, CPA, and
enrolled agent. I work in audits, tax
controversy, and real tax planning, and
I see this issue constantly, okay?
People taking positions they were told
were gray that are actually just illegal
because no one researched the actual tax
law. Let's start with the problem. What
people are actually saying when they
call something a gray area. Because most
of the time, they're not describing the
law, right? They're describing
uncertainty in their own understanding.
Okay, when someone says, "It's kind of a
gray area," what they usually mean is
they didn't look at the statute, they
didn't read the Treasury regulations,
they didn't check the court cases, and
they don't know how strong the tax
position actually is. So, instead of
saying, "I don't know," they say, "It's
gray." Because that is a gray area in
their mind, not a gray area in the tax
law. So, here's how it works. Tax law
operates on levels of authority. Okay,
there is a massive difference between
clear statutory authority, right, the
law itself from Congress, then Treasury
regulations, how the US Treasury
interprets the law, court cases, which
is how disputes have been resolved, and
then of course IRS guidance, which is
how the IRS interprets the law. And even
within all of those categories, not all
authority carries the same weight. A
Supreme Court case is not the same as
court memo opinion. Okay, a Treasury
regulation is not the same as an IRS
notice, revenue ruling, or private
letter ruling. So, when you're building
a tax position, you do not just ask, is
there support? You ask, what kind of
support and how much can I rely on this?
A real tax advisor is thinking, where
does this fall on the authority scale?
Not, eh, it feels gray. Okay, because
once the IRS shows up, they're not
asking, did you feel that this was
reasonable? They're asking, what legal
authority supports this position and do
we need to follow it? Now, let's talk
about the levels of authority and what
tax research should actually be
happening before anyone labels something
uncertain. Okay, because most tax
questions are not nearly as ambiguous as
people think. A real analysis usually
includes this following structure. Step
one, the statute, right, the Internal
Revenue Code. This is always the
starting point. Okay, what does the law
actually say?
But here's the problem. The statute is
often broad. It gives you the rule, but
not always the full road map. So, take
section 162A for example, the main
business deduction statute. It says that
you can deduct ordinary necessary
expenses paid or incurred in carrying on
a trade or business.
That sounds simple until you actually
try to apply it. What does ordinary
mean? Ordinary for whom, right? Your
industry, your specific business,
businesses at your stage? And what does
necessary mean? Does it mean actually
required or just helpful? So, step two,
Treasury regulations. Treasury
regulations interpret the statute. Okay,
we care about Treasury's interpretation,
not your interpretation, right? They add
the detail that the code leaves out.
Definitions, examples, exceptions, and
the mechanics of how a rule actually
works. And sometimes the answer everyone
talks about is not in the statute at
all. It's in the regulations, right? And
a good example of that is the short-term
rental exception from the passive
activity rules. A lot of people talk
about short-term rentals, right? As if
Congress wrote this special Airbnb
loophole into the code. But that's not
what happened. The rule comes from
Treasury regulations, which define when
an activity is not treated as a rental
activity for passive loss purposes. Then
step three, my favorite,
>> [laughter]
>> court cases. If there's still ambiguity,
we look at how courts have ruled, and
this is why there's so few gray areas
unless you're truly in a complex or new
area of the tax law. Because if there
was a gray area when the law came out,
it stops being gray after we have
decades of court cases ruling in one
direction. The courts interpret the
statute and Treasury regulations and
tell us what they mean. Okay, so when
your accountant, or more likely your
unlicensed tax strategist, thinks
they're a creative genius, you should
wonder is this person truly thinking of
something innovative? Probably not,
okay? [laughter]
Or are they so clueless that they don't
know how to look up the fact that it's
completely illegal. So court cases are
where a lot of those gray areas are
resolved. And finally, we have step
four, which is IRS guidance. Things like
revenue rulings, notices, publications,
chief counsel advice. They tell you how
the IRS is likely to treat this
position. If you ever find a higher
level of IRS guidance, usually like a
revenue ruling or revenue procedure,
which is the IRS's official published
position, then the IRS is bound to it,
and courts give it real weight. Notices
and chief counsel advice sit below that.
They're useful, but they're weaker
support. And then things like IRS
publications, FAQs, and instructions may
feel official, but they're actually just
plain language summaries that you can't
legally rely on for authority. And
here's the key point, okay? Most issues
get resolved somewhere in that process.
Not perfectly, not always absolute
certainty, but enough to say way more
than it's gray. Now, let's talk about
the strategy. Because are there
situations where the law is not
perfectly black and white? Yes. Okay,
but even then, we do not just shrug and
call it gray, okay? We analyze it. Tax
law has actual named thresholds for how
much legal support a position has, and
the rung you land on determines what you
can do, whether you need to disclose it,
and what penalty protection you may need
to have if the IRS disagrees. From
weakest to strongest, okay? First, there
is frivolous. There's no real support.
There's no strategy here. You do not
take this tax position. Then we have a
reasonable basis, okay? Which is roughly
a 20% chance of being sustained on the
merits. This is the lowest level that is
legitimately arguable, okay? On its own,
reasonable basis usually is a not enough
to take a position quietly, but if you
properly disclose it, it can help you
protect from the accuracy-related
penalty. Then we have substantial
authority, okay? This is roughly a 40%
chance of being sustained on the merits.
This is the one people love to throw
around without understanding it.
Substantial authority doesn't mean
guaranteed. It does not even mean more
likely than not. It means the weight of
the real legal authority supporting your
position is substantial compared to the
weight of the real legal authority
against it. In other words, you're not
asking, "Can I find one thing that
sounds helpful?" You're asking, "When I
put the code, the regulations, court
cases, and IRS guidance on both sides of
the scale, is the support for my
position substantial?" And if you meet
that standard, you may be able to take
the position without disclosure and
still have penalty protection. Then we
have more likely than not,
[clears throat] right? Which is greater
than 50%, and this is at the top of the
everyday ladder and is generally what
you want for the riskiest positions,
right? Especially tax shelters,
reportable transactions, and anything
that is likely to be heavily
scrutinized, and authority does not mean
whatever your strategist feels strongly
about. So, say you do research and you
are now below substantial authority. Now
it becomes a strategy decision and you
have more than one move. First,
strengthen it. Okay, find better
authority if you can or restructure the
transaction so it actually qualifies.
Second, disclose it. Okay, a position
with reasonable basis can often be
disclosed to the IRS on form 8275.
Disclosure tells the IRS exactly what
you did and it helps knock out the
substantial understatement penalty.
You're not hiding the ball, right? You
are putting it on the table. Third,
paper with a real opinion. Okay, a
genuine written analysis from a
competent advisor based on actual facts
and relied on in good faith can support
a reasonable cause defense if the
position is challenged later, but that
is a defense to penalties, right? Not a
license to take a bad tax position and
it won't save you from the tax itself.
And finally, walk away. Okay, sometimes
the answer is the support is not there.
So, we do not do it. Okay, that is not a
weakness, that is the advisor doing
their job. And here's the whole point.
Every one of those is a controlled risk.
You know where you stand, what protects
you, and what happens if it's wrong.
Gray area is uncontrolled exposure.
Okay, you took a position without
knowing what authority supports it, what
authority cuts against it, or what
penalty standard you should be relying
on. Because remember, the IRS does not
react to your intentions. They react to
the position that you took, the
authority behind it, whether you
disclosed it when required, and whether
you can defend it. The goal is not
pretending tax law is always certain.
The goal is knowing exactly which wrong
you are standing on and choosing it on
purpose. So, the next time you hear
someone say, "It's kind of a gray area."
you should immediately translate that to
this person needs [laughter] to go do
more research because the real framework
is what type of authority supports it,
how likely would I be to win if it's
challenged. By the way, how expensive
would it be to win if challenged? Do we
need to legally disclose it on the
return to protect me from penalties.
That's how the tax law works. If you
want more real tax law explained by tax
attorney who actually deals with the
IRS, then subscribe.
