Analysis: 2007 Tax Preparer Penalty Statutory Revisions

By Kip Dellinger, CPA
Notice 2008-13, issued by the IRS Dec. 31, establishes temporary rules for the application of the revised IRC Sec. 6694 preparer penalty provisions that were enacted by the Small Business and Work Opportunity Tax Act of 2007.
   Accompanying Notice 2008-13 were Notice 2008-11 and Notice 2008-12. Notice 2008-11 clarifies Notice 2007-54, which provided “transitional relief” for application of the penalty provisions after their May 25, 2007 effective date for 2006 federal tax returns filed through Dec. 31, 2007 (and with regard to some returns, through Jan. 31, 2008). Notice 2008-12 provides an interim exception to the requirement, under IRC Sec. 6695, that a preparer “sign” a federal tax return with regard to those federal returns that, prior to the new rules, did not provide for signature.
   What does all this mean for tax practitioners?

Signing Preparers and Adequate Disclosure
A signing preparer may satisfy the “disclosure” of a tax position for which there is a reasonable basis, but not a more likely than not level of confidence, by advising the taxpayer of the differences between the taxpayer’s substantial authority requirements under IRC Sec. 6662(d)(2)(B)(i) and the preparer’s requirements under IRC Sec. 6694 and contemporaneously document in the preparer’s files that the advice was provided. The same process may also be used regarding “tax shelter” issues for the taxpayer and preparer under IRC Sec. 6662(d)(2)(C).
   This very liberal position essentially says if the taxpayer and the preparer are “in conflict,” the taxpayer may make the disclosure decision for the preparer as long as the preparer has advised the taxpayer of the conflict between the preparer and taxpayer disclosure standards.

Non-signing Preparers and Adequate Disclosure
Non-signing preparers are only required to advise a taxpayer of any possibility of avoiding penalties under IRC Sec. 6662 by disclosure for lack of substantial authority, provided that there is reasonable basis for the advice. In other words, non-signing preparers have no duty to require—or even request—disclosure for their own protection under IRC Sec. 6694.
   When providing advice to a signing preparer, a non-signing preparer must, however, advise the signing preparer of the opportunity to avoid penalties under IRC Sec. 6694 by disclosure. Signing preparers may, until further notice, discharge their responsibility with regard to a position that meets substantial authority, but not more likely than not, by informing the taxpayer and contemporaneously documenting the file.
   Nonetheless, non-signing preparers generally provide advice in writing and, despite the guidance, may not be able to provide “penalty protection” if they cannot reach a more likely than not confidence threshold due to restrictions imposed by the “covered opinion” provisions of Circular 230 (IRC Sec. 10.35), for example, where the advice is “reliance” advice under Circular 230.

Signing Preparers and Taxpayers Relying on Non-signing Preparers
The regs also make clear that a “signing preparer may rely on representations of the taxpayer or from third-parties and is not required to independently verify information. The preparer should make inquiries with regard to information that appears incorrect and cannot ignore the implications of information that may not be correct if known to the preparer.

Reliance on Another (Non-signing) Preparer
A preparer may rely on another adviser. The current regs are superseded by reliance requirements that:
• the advice is not unreasonable on its face;
• the preparer knows or should know that the third-party did not have all relevant facts; and
• the preparer knows or should know that no changes in the law have occurred since the advice was given.

Pass-through Entity Returns
The rules retain the concept that preparation of a K-1 constitutes preparation of the recipient’s tax return if the K-1 preparer should reasonably know that the amounts on that form will be significant with regard to the recipient’s return.

Non-signing Preparer Advice: When is it Preparer Advice?
The temporary guidance retains the long-standing position in the regs that only post-transaction type advice qualifies as “non-signing preparer” advice. That is, planning advice or pre-transaction advice does not make the adviser a “tax preparer” for purposes of the imposition of the penalty. Advisers who provide both pre- and post- transaction advice will be considered non-signing preparers. Similarly, if the adviser is asked to and confirms the pre-transaction advice, it will become post-transaction advice and rise to non-signing preparer advice subject to the penalty provisions.

Additional Non-signing Preparer Issues and Advice
The notices also make clear that a person who prepares—for compensation—documents such as depreciation schedules or cost, expense or allocation studies that constitute a substantial portion of a return is subject to the preparer penalties. In this arena, think cost segregation studies, valuations, IRC Sec. 382 net operating loss studies and transfer pricing studies.
   Non-signing preparers who perform these types of studies have an obligation to inform a signing preparer of the duty of disclosure. In turn, for now, signing preparers may discharge their responsibility with regard to a position that meets substantial authority, but not more likely than not, by informing the taxpayer and documenting the file contemporaneously. I believe the IRS is serious about the "contemporaneous" requirement.

Advice on Insubstantial or Insignificant Amounts
The notices provide that a substantial portion of a return or claim (the preparation of which is a requirement for imposing the preparer penalty), including the preparation of a schedule, entry or other portion of a return that the preparer knows or should know is substantial if, adjusted or disallowed, it would result in a significant tax deficiency determination. This provision is intended to clarify that whether or not a person is a tax return preparer is dependent on the relative magitude of the deficiency attributable to the schedule, entry or other portion.

Observation

It seems the U.S. Treasury was intent on assisting the practitioner community in controlling costs with regard to (particularly for non-signing preparers) providing advice on routine and minor matters with regard to tax reporting issues, as well as not making every depreciation schedule or similar item (for example, IRC Sec. 199 allocations) subject to extensive review under the preparer penalty rules.

Signing Preparers and Engagement Understandings
Under the law as enacted prior to this guidance, the “signing preparer” community had to consider obtaining a “waiver” from clients acknowledging that the tax preparer might require disclosure in a return of an item (because the preparer did not believe the tax position did not meet a more likely than not confidence threshold) that the taxpayer may not otherwise be required to disclose (because the taxpayer had “substantial authority” for a non-tax shelter item).
   The way the rules now operate—documenting the file with regard to the more likely than not/substantial authority issue—they may render engagement letter references to more likely than not unnecessary. As long as the tax practitioner is diligent about the documentation that is probably a correct statement because while disclosure might be a preferred avenue, it really isn’t required under these temporary operating rules.
   Similarly non-signing preparers must only provide advice to the client based on the client’s filing requirements. However, many preparers may choose to include language in their engagements that the client will advise the signing preparer of any tax positions of which the client is aware that do not meet the substantial authority threshold.

Exhibits and Examples
Notice 2008-13 contains three exhibits:
• Exhibit 1 is a list of returns the preparation of which may lead to a preparer penalty.
• Exhibit 2 is a list of pass-through entity forms that, although there is no tax calculated on the particular forms, may result in imposition of a preparer penalty with regard to the entity or person on which the pass-through amounts are reported for purposes of determining a federal tax liability, for example, partnership and S corp returns.
• Exhibit 3 provides a list of information returns for which the preparer penalty will only be imposed if the preparer “willfully” understated a liability of tax on a return (or claim for refund) in any manner or demonstrated reckless of intentional disregard for the rules and regulations.
   Notice 2008-13 also contains 12 examples of the application of the guidance it sets forth. In summary, the examples illustrate:

1. Filing out Form 8886 for a Reportable Transaction is not subject to the preparer penalty because it is not a substantial portion of a tax return and is not relevant to the actual determination or calculation of any federal tax.
2. Preparation of a partnership return by an accountant constitutes preparation of the individual partner’s returns.
3. An attorney who gives only pre-transaction “tax planning” advice on a corporate transaction is not a “tax return preparer.”
4. An attorney who gives advice on a single entry on a large, complex corporate return meets the “insignificant” exception and is not a “tax return preparer.”
5. An attorney who provides “tax planning” advice and then follows that advice with post-transaction advice to a group of affected parties (with knowledge that the items to be reported by those parties is “significant”) is a tax return preparer for the tax returns of each affected taxpayer.
6. The exception to the preparer penalty for a “signing preparer” accountant who relies on a schedule prepared by someone else in the accountant’s office (where the schedule is not obviously erroneous on its face). It states that the signing preparer is not required to audit, examine or review the schedule to reach a more likely than not reasonable belief standard. This is noteworthy because it appears to be far more liberal than the preparer rules that existed prior to the guidance.
7. The ability of an accountant to rely on an actuary with regard to the deduction of qualified plan contribution to avoid the preparer penalty.
8. When an accountant fails to make obvious inquiries with regard to a $50,000 charitable contribution of property, such as inquiring about the existence of a qualified appraisal and Form 8283, the accountant cannot rely on client representations and the accountant is therefore subject to a preparer penalty.
9. A situation involving a missing 1099, which the accountant obtains after inquiry based on a comparison with prior years. However, despite a general inquiry about any other 1099s, the client does not disclose yet another 1099 and income is significantly underreported. The accountant is not subject to a preparer penalty because the accountant may rely upon the taxpayer’s representation and the accountant did make inquiry with respect to an item that was obvious.
10. A situation where the accountant encounters an issue involving various small asset expenditures and is unable reach a more likely than not conclusion concerning the tax treatment of these items. The return is filed without disclosure. The example concludes that no tax preparer penalty is assessable, apparently because the amounts in question are not a substantial portion of the return.
11. How an accountant informs the client that the accountant cannot reach a more likely than not confidence threshold, but that the client has substantial authority for the tax treatment of item and explains to the client the differences between the preparer and taxpayer penalty standards and contemporaneously the accountant creates documentation for their files. The taxpayer files the return without disclosure and no penalty is assessed against the preparer.
12. A situation where an attorney gives advice to a client that there is not “substantial authority” for the tax treatment of an item and advises the client that without disclosure the client will be subject to an accuracy-related penalty. The attorney contemporaneously documents the advice in the attorney’s files. The example concludes that the attorney is not subject to a preparer penalty. This treatment is consistent with IRC Sec. 10.34 of Circular 230 “best practices” prior to the revised preparer penalty provisions.

Concluding Thoughts

The guidance provides a workable solution, if only temporary, for the unreasonable conflict in the taxpayer and tax preparer disclosure statutes, such as not forcing taxpayer disclosure merely to protect the preparer from penalties. In addition, the guidance provides that incidental or insignificant advice within an entire return will not render the adviser a “tax preparer,” and the guidance also recognizes that a non-signing preparer has no real control over whether or not the recipient of the advice makes a disclosure.
   Still, there are a multitude of unanswered questions. For example, the guidance is focused on income tax preparation and does not address the other common area of concern for attorneys and some CPAs: estate and gift tax returns. And the guidance does not address  potential areas of overlap between those returns and income tax returns, such as family limited partnerships that have both income and estate and gift tax implications where the advice given may involve non-signing preparers (and that may involve pre- and post- transaction advice).
   Identifying and addressing these, and other, issues will be an important element for tax professionals and their professional organizations to address in the process of developing a new regulatory structure for the expanded preparer penalty regime.

Kip Dellinger, CPA is senior tax partner at Kallman & Co. LLP CPAs in Los Angeles. You can reach him at kip@kallmanandco.com.

Posted Jan. 4, 2008