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Larry Jacobson

Tax Preparers Beware

The IRS may be gunning for you.

July 17, 2008
by Larry Jacobson, CPA/JD

The Treasury Department just promulgated Proposed Regulations that would expand tax preparer liability.

On June 17, 2008, the Treasury Department issued Proposed Regulations regarding the standard of conduct that must be met to avoid imposition of the tax return penalty under IRC 6694. The Small Business and Work Opportunity Act of 2007, Public Law 110-28 (the "2007 Act") completely revised IRC 6694 and greatly expanded the potential penalties to be imposed on tax preparers for failure to act in a professionally prescribed manner. Under IRC 6694(a), a preparer who prepares any return with respect to which any part of an understatement is due to an unreasonable position shall pay a penalty equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return. IRC 6694(b) defines an "unreasonable position" (a) as one where the preparer knew (or reasonably should have known) of the position, (b) there was not a reasonable belief that the position would more likely than not be sustained on its merits and (c) either the position was not adequately disclosed on the taxpayer's tax return or (disclosure notwithstanding) there was no reasonable basis for the position taken on the tax return.

The clear intent of the 2007 Act changes was to increase the duty of tax preparers to be confident of positions taken on tax returns. The 2007 Act not only increased the penalty imposed on preparers, but created a new legal standard under which preparers must operate. The Proposed Regulations, which are not binding until finalized (which is expected by the end of 2008), provide specific guidance on the responsibilities of preparers under revised IRC 6694.

The good news, if any, is that preparers are still generally allowed to rely in good faith, WITHOUT VERIFICATION, upon information provided by the taxpayer in preparing the tax return. The Proposed Regulations make it explicit that the preparer is not required to audit or examine the books and records or documents or other evidence of the taxpayer in preparing a tax return. However, the Proposed Regulations state the preparer may not ignore the implications of the information provided and must make "reasonable inquiries" of the taxpayer if the information as furnished appears incorrect or incomplete. Thus, under the Proposed Regulations, in order to avoid preparer penalties, a preparer can trust the information given to him or her as long as it seems reasonable on its face.

The Proposed Regulations go to great lengths in describing the steps a preparer must take in applying the law to the underlying facts in an effort to avoid preparer penalties. If a position taken on a tax return is not disclosed, in order to avoid penalties, the preparer must reasonably believe that a position would more likely than not be sustained on its merits (in lay terms this means that the preparer believes the position has a greater than 50 percent likelihood of being sustained if challenged by the IRS). The Proposed Regulations state that the preparer must analyze the pertinent facts and authorities in order to reach the greater than 50 percent likelihood comfort level and cannot take into account the probability that the return will be audited by the IRS. This standard is applied on a facts and circumstances basis and takes into account the preparer's diligence, experience in the area of the tax law in question, the familiarity with the taxpayer's activities and the complexity of the issue. Finally, the more likely than not standard is generally to be applied as of the date the return is signed by the preparer.

The preparer penalties are not designed to be applied where the law in a particular situation is unclear or ambiguous. The Proposed Regulations make it quite clear that a preparer will not be subject to penalties even if there is no legal authority dealing with the issue if the position taken by the preparer is supported by a "well-reasoned construction of the applicable statutory provision". Nevertheless, if the weight of legal authorities is against the taxpayer claiming a favorable tax position, the preparer will be required to take a position on the return that is adverse to the taxpayer, unless the preparer makes adequate disclosure of the type described in the next paragraph.

Avoiding Preparer Penalties

The preparer can also avoid penalties, even in situations where he or she believes that the position on the tax return is not likely to be sustained on its merits. To avoid preparer penalties in situations where the preparer believes the position has a reasonable basis, but not a more-likely-than-not basis, one of the following must occur:

  1. The position must be disclosed on a filed tax return that includes an IRS Form 8275 or IRS Form 8275-R or the preparer must give the taxpayer a return to be filed with the IRS Form 8275 or IRS Form 8275-R attached;
  2. If the taxpayer refuses to disclose the position on his or her return, the preparer must advise the taxpayer of the penalty standards under IRC 6662 that might be applied if the disclosure is not made on the return and the preparer must also contemporaneously document the advice given to the taxpayer in his or her files; or
  3. If, regardless of disclosure on the tax return, the position involves certain tax shelters, reportable transactions or listed transactions, the preparer advises the taxpayer that (a) the taxpayer must possess a reasonable belief that the tax treatment was more likely than not the proper treatment in order to avoid a penalty under IRC 6662(d) and (b) disclosure will not protect the taxpayer from the assessment of the IRC 6662(d) penalty. Moreover, the preparer must also contemporaneously document the advice given to the taxpayer in his or her files.

The Proposed Regulations also introduce the concept of a "non-signing tax return preparer" into the new penalty regime. Although a broad discussion of the concept of a "non-signing tax return preparer" is outside the scope of this article, such a person is not the person who signs the return as preparer, but one who either prepares a substantial portion of the return or gives advice (as a lawyer or accountant) with respect to events that have occurred at the time the advice is given on a matter that involves a substantial portion of the return. The Proposed Regulations make it clear that the advice can be in oral or written form and can be to the taxpayer directly or the taxpayer's preparer and further elaborate with examples that the non-signing preparer can include advice given by an attorney or accountant after a transaction if the advice is given after the transaction is completed and it involves a substantial portion of the return. In these instances, the non-signing preparer is subject to the penalties on the same basis as the signing preparers and is entitled to the same defenses as a signing preparer under the Proposed Regulations.

Assuming the Proposed Regulations are adopted in final form, tax preparers, whether designated as signing or non-signing taxpayers, must take steps to protect themselves from potential preparer penalties. First, if the position to be taken on a return is at all subject to doubt, the preparer should research the point and prepare a file memorandum analyzing the facts, law and the reason why the position either meets the more-likely-than-not standard or, in the case of most disclosed positions, the reasonable basis standard. Failure to do so puts the preparer squarely at risk for penalties if the position is not ultimately sustained. Second, tax advisors who are not signing preparers should determine whether the tax advice given after a transaction is completed is substantial enough to qualify them as tax preparers. If so, the advisor should follow the procedures described earlier in this paragraph about written a file memorandum regarding his or his analysis as to why taking the position is defensible under the IRC 6694 standards.

The 2007 Act was designed squarely to improve the quality of the work done by tax preparers. Preparers who do not conform to the higher standard of conduct should expect the IRS to assess the IRC 6694 penalties against them with increasing frequency.

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Larry Jacobson, CPA/JD, is a senior partner in the Chicago office of the law firm Schiff Hardin LLP. He holds a BA from Washington University, an MBA from the University of Chicago, an MSOD from the University of Pennsylvania and a JD from the Georgetown University Law Center.