The Small Business and Work Opportunity Tax Act signed into law on May 25, 2007 (Pub. L. No. 110-28) (the “2007 Act”) amended section 6694 of the Internal Revenue Code (the “Code”) by raising the standard of conduct for tax return preparers to avoid the imposition of penalties, expanding the scope of tax return preparers to which the penalties apply, and increasing the penalties on tax return preparers. At the same time the 2007 Act amended section 7701(a)(36) of the Code to remove the definition of income tax return preparer and replace it with a definition for tax return preparer.
Prior Law. Prior to its amendment Code section 6694 imposed a $250 penalty on any income tax return preparer with respect to an understatement of liability on a return or a claim for refund where the income tax return preparer knew, or reasonably should have known, was due to a position for which there was not a realistic possibility of being sustained on its merits and such position was not disclosed or was frivolous. The penalty could be avoided if the income tax return preparer acted in good faith and showed that there was reasonable cause for the understatement (the “Good Faith Reasonable Cause Exception”). If the understatement of liability was due to a willful attempt in any manner to understate the tax liability by the income tax return preparer on a return or claim for refund, or to a reckless or intentional disregard of rules or regulations by the income tax return preparer, then the penalty imposed was $1,000 reduced by the $250 penalty paid by the income tax return preparer by reason of taking a position for which there was not a realistic possibility of being sustained on its merits.
Prior to its amendment Code section 7701(a)(36) provided that an income tax return preparer was any person who prepared for compensation, or who employed other people to prepare for compensation, all or a substantial portion of an income tax return or refund claim.
Changes Made by the 2007 Act. For returns prepared after May 25, 2007 Code section 6694(a) imposes a penalty on any tax return preparer who prepares any return or claim for refund with respect to which any part of the understatement of liability is due to an unreasonable position (the “Section 6694 Penalty”). A tax return position is unreasonable if (i) the tax return preparer knew, or reasonably should have known, of the position, (ii) the tax return preparer did not have a reasonable belief that the position would more likely than not be sustained on its merits, and (iii) the position was not properly disclosed on the return, or there was no reasonable basis for the position. The penalty for taking an unreasonable position is the greater of $1,000 or one-half of the income derived, or to be derived, by the tax return preparer with respect to the return or claim. The Good Faith Reasonable Cause Exception continues to apply. The standard of conduct for a willful attempt in any manner to understate the tax liability by the tax return preparer for a return or claim for refund, or for a reckless or intentional disregard of rules or regulations have remained the same. However, the penalties for this type of conduct have been increased to the greater of $5,000 or one-half of the income derived, or to be derived, by the tax return preparer with respect to the claim or refund.
At the same time as raising the standard to an unreasonable position, the amended Code section 6694 expands the scope of those persons subject to penalties from income tax return preparers with respect to income tax returns or claims for refunds to tax return preparers with respect to any returns or claims for refund. The amended Code section 7701(a)(36) now defines tax return preparer as any person that for compensation prepares, or employs other people to prepare, any tax return or any claim for refund of tax, or a substantial portion of a tax return or claim for refund. Accordingly, these penalties are no longer limited to persons who prepare income tax returns or claims of refunds of income tax. The Section 6694 Penalty may now apply to, but not be limited to, persons who prepare estate, gift, or employment tax returns.
The existing regulations under Code section 6694 make it clear that the Section 6694 Penalty applies not only to signing tax return preparers but to non-signing tax return preparers as well. Under Treasury Regulation section 1.6694-1(b)(2), a non-signing preparer is any preparer who is not a preparer who signs a return or a claim for refund as preparer (“signing preparer”). A non-signing preparer is someone who provides written or oral advice to a taxpayer or to a preparer who is not associated with the same firm as the preparer who provides the advice. For example, attorney provides advise to a client concerning the proper treatment of a significant item on the client’s income tax return, which advice constitutes a substantial portion of the client’s income tax return, the attorney is a non-signing tax return preparer to which the Section 6694 Penalty would apply.
Proposed Changes to Circular 230. In order to conform the professional standards for practice before the Internal Revenue Service (“IRS”) with the civil penalties for tax return preparers, the Department of Treasury issued proposed regulations to Circular 230 on September 24, 2007. Under the proposed regulations, section 10.34(a) of Circular 230 has been amended to provide that a tax practitioner may not sign a tax return as a preparer, or provide advise a client to take a position on a tax return, unless the practitioner has a reasonable belief that the tax treatment of each position on the return would more likely than not be sustained on its merits, or there is a reasonable basis for each position on the return and such positions are adequately disclosed to the IRS.
The changes made by the 2007 Act increase the standard for tax return preparers from a realistic possibility of being sustained on the merits, which under Treasury Regulation section 1.6694-2(b)(1) requires that the income tax return preparer conclude that a position is likely to be sustained by at least one and three, to a standard which requires a more than 50% likelihood of being sustained on its merits. Not only is this an increase in the tax return preparer standard, but it also imposes a higher standard on tax return preparers than for the imposition of penalties on taxpayers. Under Code section 6662(d) a taxpayer is subject to penalty for a substantial understatement of tax liability unless the taxpayer had substantial authority for the tax position, or the facts regarding the tax position are adequately disclosed and there is a reasonable basis for such position (the “Section 6662(d) Standards”). Under Treasury Regulation section 1.6662-4(d)(3), the substantial authority standard is less stringent then the more likely than not standard, which requires a 50% likelihood of being sustained on its merits, but more stringent than the reasonable basis standard. The substantial authority standard requires approximately a 40% likelihood that the tax position will be sustained on its merits. This creates a conflict of interest for tax return preparers and could create a situation where a taxpayer is required to report a position on a return that he may not have otherwise reported solely to allow the tax return preparer to avoid penalties.
These changes have raised many questions among practitioners. Who is a tax return preparer? How does Code section 7701(a)(36) apply to signing and non-signing tax return preparers? What constitutes the preparation of a return or claim for refund? What if the tax position has substantial authority but it is not more likely than not to be sustained on its merits, how does the tax return preparer advise the taxpayer? Are taxpayers better off preparing and filing there own returns? While some of these questions are not new and the regulations under Code section 6694 deal with the definition of income tax return preparer, given the increase in the penalties on tax return preparers and the broadening of the type of tax return preparers subject to penalties the questions have become more significant.
IRS Relief and Guidance. In light of the questions that have arisen due to the change in the standards of conduct for tax return preparers to avoid penalties, the Treasury Department and the IRS have issued guidance on this matter first in the form of transitional relief with the issuance of Notice 2007-54, 2007-27 I.R.B. 12, on June 11, 2007, and then with the issuance of Notices 2008-11, 2008-3 I.R.B. 279, and 2008-13, 2008-3 I.R.B. 282 on December 31, 2007. The Treasury Department and the IRS issued its transitional relief so that they can prepare for the effective tax administration of the new law, which they indicated will require changes to relevant forms and publications as well as altering existing procedures in order to process disclosures with certain forms and in electronic formats.
Notice 2007-54 and Notice 2008-11
The transitional relief under Notice 2007-54 applied to all returns, amended returns and refund claims due before January 1, 2008, to 2007 estimated returns due before January 16, 2008, and to 2007 employment and excise tax returns due before February 1, 2008. Under Notice 2007-54, the IRS will apply the law prior to the change to Code section 6694 and the current section 6694 regulations in determining whether to impose a Section 6694(a) Penalty for income tax returns, amended returns and refunded claims. For all other returns and claims for refund, the IRS will apply the reasonable basis standard in the Section 6662 regulations in determining whether to impose a Section 6694(a) Penalty. No transitional relief was provided under this Notice with respect to penalties relating to a willful attempt in any manner by a tax return preparer to understate tax liability or to any reckless or intentional disregard of rules or regulations by a tax return preparer. Notice 2008-11 was issued to clarify Notice 2007-54.
Notice 2008-11 clarified Notice 2007-54 in three ways. First, by providing that the transitional relief described in Notice 2007-54 applies to timely amended returns or claims for refunds, other than 2007 employment and excise tax returns, filed on or before December 31, 2007, and timely amended employment and excise tax returns or claims for refund filed on or before January 31, 2008. Second, Notice 2008-11 clarified that the transitional relief applies to original returns, other than 2007 employment and excise tax returns, filed on before December 31, 2007, and to original employment and excise tax returns filed on or before January 31, 2008 regardless of the extension due date. And, finally, the transitional relief was clarified by providing that it applies to non-signing preparers for advice provided on or before December 31, 2007.
Notice 2008-13
With the issuance of Notice 2008-13, the Treasury Department and the IRS provided interim guidance regarding the application of the new tax return preparer penalties under Code section 6694.
The Notice sets forth in exhibits which tax returns or claims for refunds are covered by Code section 6694. The Notice provides that a claim for refund of tax also includes a claim for credit against any tax. Exhibit 1 of Notice 2008-13 sets forth the returns or claims for refund to which Code section 6694 will apply to and a tax return preparer will include a tax return preparer who prepares any returns set forth in Exhibit 1. Exhibit 1 includes, but is not limited to, Form 990-PF, Return of Private Foundation, Form 990T, Exempt Organization Business Income Tax Return; Form 1040, U.S. Individual Income Tax Return; Form 1040-A, U.S. Individual Income Tax Return; Form 1040-EZ, Income Tax Return for Single Filers and Joint Filers with No Dependents; Form 1041, U.S. Income Tax Return for Estates and Trusts; Form 1120, U.S. Corporations Income Tax Return; Form 1120S∗, Income Tax Return for an S Corporation; Form 706, U.S. Estate Tax Return; Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return; and certain employment tax returns - Form 940, Form 940-PR, Form 941, Form 943, and Form 944.
Exhibit 2 sets forth information returns which will be subject to Code section 6694 if such information return includes information that is or may be reported on the taxpayer’s return or claim for refund to which Code section 6694 could apply if the information reported constitutes a substantial portion of the taxpayer’s tax return or claim for refund. Exhibit 2 includes, but is not limited to, Form 1065, U.S. Return of Partnership Income; Form 1120S*, U.S. Income Tax Return for an S Corporation; Form 8038, Information Return for a Tax-Exempt Private Activity Bond Issue; and Form 8038-G, Information Return for a Government Purpose Tax-Exempt Bond Issues.
Exhibit 3 sets forth documents that would not subject a tax return preparer to the Code section 6694 penalties unless such document was prepared so as to willfully in any manner understate the tax liability or was prepared in reckless or intentional disregard of the rules or regulations. Exhibit 3 documents include, but are not limited to, Form 1099; Form W-2; Form SS-8; Form 990; Return of Organization Exempt from Income Tax, Form 1040-ES, Estimated Tax for Individuals; Form 1120-W, Estimated Tax for Corporations; Form 2350, Application for Extension of Time to File U.S. Income Tax Return; Form 4768, Application for Extension of Time to File Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes; Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Returns; Form 8868, Application for Extension of Time to File an Exempt Organization Return; Form 8892, Application for Automatic Extension of Time to File Form 709 and/or Payment of Gift/Generation-Skipping Transfer Tax. Practitioners should refer to Notice 2008-13 for a complete listing of returns and/or other documents to determine whether and how any return which a practitioner may be preparing or providing advice on is affected by the amendments to Code section 6694.
The Notice then goes on to address inconsistencies between the new law and the existing regulations. Pursuant to the Notice, the definition of income tax return preparer under Treasury Regulations sections 1.6694-1, 1.6694-3 and 301.7701-15 is modified to eliminate the word income so that the regulations conform to the current amendments made under the 2007 Act. In addition, the definition of returns and claims for refunds under these regulations have been expanded to returns of the tax and claims for refunds with respect to income taxes, estate and gift taxes, employment taxes and excise taxes. The Notice also provides guidance as to the interpretation of substantial portion in determining what constitutes a substantial portion of a return for purposes of the definition of tax return preparer under Treasury Regulations Section 301.7701-15(b)(1). The Notice provides that substantial portion means a schedule, entry, or other portion of a tax return or claim for refund that, if adjusted or disallowed could result in a deficiency determination, or disallowance of refund claim, that the preparer knows or reasonably should know is a significant portion of the tax liability reported on the return (or, in the case of a claim for refund, a significant portion of the tax originally reported or previously adjusted). A practitioner preparing a substantial portion of a return or claim for refund is a tax return preparer for purposes of Code sections 6694 and 7701(a)(36).
Under Notice 2008-13, for purposes of Code section 6694, a tax return preparer is considered reasonably to believe that the tax treatment of an item is more likely than not the proper tax treatment if the tax return preparer analyzes the pertinent facts and authorities in a manner provided in Treasury Regulations section 1.6662-4(d)(3)(ii) for determining whether substantial authority is present and, based upon that analysis, reasonably concludes in good faith that there is a greater than 50% likelihood that the tax treatment of the item will be upheld on a challenge by the IRS. In making such a determination a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, by another advisor, tax return preparer or other third-party. A tax return preparer is not required to independently verify or review the items reported on the tax returns, schedules or other third-party documents to determine if the items meet the standard requiring a reasonable belief that the tax position would more likely than not be sustained on the merits. However, the tax return preparer may not ignore the implications of information furnished to the tax return preparer or actually known to the tax return preparer. If the tax return preparer receives information that appears to be incorrect or incomplete, the tax return preparer must make reasonable inquiries to the provider of such information in order for the standard to apply.
The guidance further provides that the reasonable basis standard under the Section 6662(d) Standards will apply for purposes of Code section 6694. The same rules regarding good faith reliance on information furnished by a third party for the reasonable belief standard as described in the prior paragraph apply to the reasonable basis standard.
Generally, the rules applicable to the Good Faith Reasonable Cause Exception continue to apply, except that Notice changes the regulations such that a tax return preparer is considered to have acted in good faith if the tax return preparer relied on the advice of a third party who is not in the same firm as the tax return preparer, which replaces “another preparer’ under the existing regulations, and who the tax return preparer had reason to believe was competent to render such advice.
The interim penalty compliance rules set forth in Notice 2008-13 provides that, for the purposes of Code section 6694, a signing tax return preparer shall be deemed to meet the requirements of Code section 6694 with respect to a tax position for which there is a reasonable basis but for which a tax return preparer does not have a reasonable belief the position would more likely than not be sustained on its merits, if a tax return preparer meets any of the following requirements:
1. The position is properly disclosed.
2. The tax return preparer provides the taxpayer with a prepared tax return that includes the proper disclosure, if the position would not otherwise meet the Section 6662(d) Standards without disclosure.
3. If there is substantial authority for the tax, the tax return preparer advises the taxpayer of the difference between the Section 6662(d) Standards applicable to the taxpayer and the penalty provisions applicable to the tax return preparer under Code section 6694, and contemporaneously documents in the tax return preparer’s files that this advice was provided.
4. If the Section 6662(d) Standards does not apply because the position is attributable to a tax shelter, the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under Code section 6662(d)(2)(C) and the difference, if any, between these standards and the standards under Code section 6694, and contemporaneously documents in the tax return preparer’s files that this advice was provided.
For purposes of Code section 6694, a non-signing tax return preparer shall be deemed to meet the requirements of the amended Code section 6694 with respect to a tax position for which there is a reasonable basis but for which the non-signing tax return preparer does not have a reasonable basis that the tax position would be more likely than not sustained on its merits, if the advice to the taxpayer includes a statement informing the taxpayer of any opportunity to avoid penalties under Code section 6662 that could apply to the position as a result of disclosure, if relevant, and of the requirements of disclosure. If the non-signing tax return preparer provides advice to another tax return preparer, a non-signing tax return preparer shall be deemed to meet the requirements of the amended Code section 6694 with respect to a position for which there is a reasonable basis but for which there is not a reasonable belief that the position would more likely than not be sustained on its merits, if the advice to the tax return preparer includes a statement that disclosure under Code section 6694 may be required. If the advice with respect to the position is in writing, then the statement must be in writing. If the advice was oral, then the statement can be oral. Contemporaneously prepared documentation in the non-signing tax return preparer’s files is sufficient to establish that the statement was given to the taxpayer or other tax return preparer.
The Notice makes clear that it is only interim guidance and the Treasury Department and the IRS intend to revise the regulatory scheme governing tax return preparer penalties in 2008, which they expect to be finalized by the end of 2008. Tax return preparers can rely on the interim guidance in Notice 2008-13 until the further guidance is issued. Practitioners offering tax advice on any transaction or tax planning to which a position may be taken on a tax return should be aware and familiar with these rules.
Many commentators are weighing in on this subject and the Treasury Department and the IRS are requesting comments. The Bush administration has even weighed in on the issue, by proposing that tax return preparers should be confident that they have substantial authority when taking a tax position that is not disclosed on a return, thereby aligning the penalty standards for tax return preparers with taxpayer penalty standards. Of course, this type of change will require legislative action. In the meantime the IRS is working on guidance for tax return preparer standards. Practitioners should remain alert to upcoming changes, which absent legislative relief will come in the form of revised regulatory scheme. The Treasury Department and the IRS cautions in Notice 2008-13, that the revised regulatory schedule could be substantially different from the rules provided in Notice 2008-13 and in some cases may be much more stringent.
Lisa M. Rico is a partner at McCarter & English, LLP in Boston. She concentrates her practice on estate, gift, generation-skipping transfer and income tax planning for high net worth individuals, estate and trust administration, and the representation of nonprofit organizations and charitable trusts.