Putting Tax Return Preparer Penalties in Perspective

California CPA magazine: January/February 2009

By Kip Dellinger, CPA

Tax preparers have endured an interesting roller coaster ride over the past 17 months regarding their responsibilities for recommending tax positions when preparing tax returns, or advising clients in the preparation of tax returns.

When the ride coasted to a rather gentle stop with passage of the Emergency Economic Stabilization Act of 2008, tax practitioners were back in familiar territory. In addition, the revised preparer standards for recommending tax positions are generally retroactive and thus replace the initial changes that were effective May 25, 2007, contained in the Small Business and Work Opportunity Tax Act of 2007.

Before the May 2007 legislation, a preparer was subject to a penalty for recommending or taking a nondisclosed income tax return tax position, of which the preparer had, or should have, knowledge where there was not a realistic possibility of success that the position would be sustained on the merits if challenged by the IRS. If a position was disclosed in the return, either as set forth in an annual revenue procedure or on a Form 8275 or 8275-R, the preparer was not subject to penalty if the position was not frivolous.

The taxpayer’s standard was a little higher: for a nondisclosed income tax return position—to avoid an accuracy-related penalty—the taxpayer was required to have substantial authority for the tax treatment of the item; if a position was disclosed, the taxpayer was required to have a reasonable basis for the treatment. Authorities to support tax positions are set forth in Treas. Reg. Sec. 1.6662-4 and have remained unchanged for nearly 20 years.

The initial May 2007 change required that a tax preparer have a reasonable belief that a nondisclosed tax position would more likely than not be sustained on the merits if challenged—a higher standard than the taxpayer’s substantial authority standard. For disclosed the positions, the tax preparer was required to have a reasonable basis for the position—essentially the same as for the taxpayer.

The higher tax preparer standard for nondisclosed positions placed the tax preparer in basically untenable conflict with the taxpayer as the preparer might be required to disclose a tax position that the taxpayer would not otherwise have to disclose. Temporary rules in Notice 2008-13 permitted the preparer to make required disclosure for income tax positions to the taxpayer rather than in the tax return (see “A Closer Look”, California CPA, March/April 2008).

Proposed regulations under Code Sec. 6694 released in June 2008 continued to permit the disclosure to the client, and not in the return, for income tax positions for which substantial authority existed but where the tax preparer did not believe the more likely than not threshold was met.

The penalty for a violation of the penalty provision was increased from $250 to $1,000 or, if greater, 50 percent of the income derived with respect to the return (or amended return). Also, the penalty for a willful understatement of tax or reckless conduct under the revised provision increased from $1,000 to $5,000 or, if greater, 50 percent of the income derived with respect to the return (or amended return).

The more likely than not confidence threshold requirement for nondisclosed positions, and reasonable basis for disclosed positions, have been the required standard in California for both preparers and taxpayers since 2002, The penalty is $1,000 for violation of the tax position standard and $5,000 for willful or reckless conduct.

After several attempts to enact remedial legislation, Congress finally revised the preparer penalty standard in the Emergency Economic Stabilization Act (EESA) to remove the preparer-taxpayer conflict.

In general, the confidence threshold for the tax preparer for recommending or taking nondisclosed positions was lowered to substantial authority (identical to the taxpayer’s required standard for avoiding the accuracy-related income tax penalty).

The reasonable basis threshold for disclosed positions was retained; this is also the same as the taxpayer’s standard for avoiding an accuracy-related penalty. The revision applies retroactively to tax return positions after May 25, 2007.

But the revisions in the EESA do contain an additional requirement with regard to evaluating tax positions that tax preparers may find troublesome. Essentially, the revised code section continue to require a more likely than not confidence threshold for nondisclosed tax positions described as a “tax shelter” in the taxpayer accuracy-related penalty section.

Many practitioners will simply ignore that standard “because my clients don’t use tax shelters”; however, that section’s language generally describes a tax shelter as any partnership or other entity, any investment plan or arrangement or any other plan or arrangement that has as a “significant purpose” of the undertaking the avoidance of federal income tax.

This is the identical language that caused much hand wringing in June 2005 when Circular 230 revisions pertaining to certain “written tax advice” became effective and continues to cause many tax professionals to “brand” their e-mails and similar communications with language to the effect that the communication may not be relied upon to protect the recipient against penalties imposed under the IRC.

Practitioners who believe that a “significant purpose” is found in most client tax advice situations will be faced with evaluating a range of tax positions under the significant purpose standard when taking tax positions on returns.

Alternatively, practitioners may now argue that “significant purpose” should be narrowly defined - limited to transactions that lack a business or personal financial purpose other than tax savings or to which there is no economic substance. That is probably what was intended the offending language was transported to Circular 230. Tax professionals may be well served in addressing the revised prepare penalty standard by removing the “branding” from their e-mail and similar communications.

The higher confidence threshold for preparer nondisclosed income tax return positions pertaining to tax shelter significant purpose applies to returns prepared for years ending after Oct. 3, 2008. For those types of tax positions taken on returns after May 25, 2007, and for years ending before Oct. 3, 2008, the proposed regulations are likely to be revised to consider “disclosure made” for “significant purpose” transactions if the taxpayer was informed by the tax preparer of any penalties that might apply to the taxpayer.

Since May 25, 2007, the preparer penalty provisions have applied to all federal returns. Generally, this means the common returns CPAs prepare: income tax returns for individuals and all types of business entities, as well as estate, gift and employment tax returns.

The taxpayer has different disclosure standards for other than income tax returns, so the tax preparer will likely be able to comply with disclosure requirements by advising the taxpayer of the taxpayer’s reporting standards and penalties that may apply and documenting the discussion.

Also, the IRS intends to publish lists of returns for which the substantial authority and reasonable basis confidence thresholds do not apply, but where the standard for taking positions will ordinarily be not willfully misleading or incorrect (e.g., W2s and 1099 forms are included and are likely to remain in this group).

Proposed regulations issued in June 2008 under IRC Sec. 6694 are very practitioner favorable. The following includes key elements of those regulations.

Who is a Preparer?
Tax return preparer regulations have long provided that the penalty for tax return positions that do not meet certain requirements may be imposed on tax practitioners that physically prepare and sign income tax returns. In addition, tax practitioners who “advise” on income tax return positions—when the advice is given with regard to tax return positions that are based on facts and circumstances and with an exception for specific amount—may be subject to the penalty.

The proposed regulations change the approach with respect to who is a tax return preparer. Instead of retaining a “one preparer per firm” approach, the proposed regulations adopt a “one preparer per tax position” approach.

Signing Preparers
A preparer who signs a return is generally considered the person subject to the penalty. However, the signing preparer may provide information that another person within the signing preparer’s firm was primarily responsible for, such as the tax positions on the return or claim for refund that gives rise to an understatement, which can generate a preparer penalty.

This change addresses the reality of today’s tax practice: multiple “experts” within a given signing preparer’s firm may advise on different aspects of a tax return within their areas of expertise.

Non-signing preparers
Signing preparers often rely on tax professionals not associated with their firm for advice rendered with respect to tax positions to be taken on a return. For example, a CPA firm prepares a return which a partner of the firm signs, but the CPA firm relies on an opinion from tax legal counsel (a “non-signing preparer”) with respect to the tax treatment of certain items within the return. The rules for non-signing preparers are made the same for all such preparers, whether or not the non-signing preparer is associated with the signing preparer (including the signing preparer’s firm).

The penalty may be imposed on any non-signing preparer with respect to a tax position for which the non-signing preparer is responsible. In the case of multiple non-signing preparers, the person with the overall supervisory authority is the responsible person, unless that person provides evidence to the contrary.

A non-signing preparer is responsible with respect to advising on a tax position if it is attributable to a “substantial portion of a return,” which may be a single entry on a return. That determination remains a facts-and-circumstances-test based on the size and complexity of the item relative to the taxpayer’s gross income. There is also de minimis exception solely for non-signing preparers.

Preparers of Pass-through Entity Returns
The proposed regulations retain the concept that the preparer of a pass-through entity tax return may also be the considered the preparer of the recipient’s pass-through items from the entity. Thus, the preparer of a pass-through entity may be the preparer of the returns of the principal owners in situations even when the preparer does not prepare the principal owners’ returns.

Liability of a Firm for the Preparer Penalty
A firm that employs a tax return preparer may also be subject to the preparer penalty when one or more members of the principal management of the firm, or particular office, participated in or knew of the conduct giving rise to a preparer penalty; the firm failed to provide reasonable and appropriate procedures for review of the tax position giving rise to the penalty; or the procedures were knowingly disregarded by the firm through willfulness, recklessness, or gross indifference.

No Automatic ‘Referral’ and No Penalty ‘Stacking’
The preamble to the proposed regulations contains two comments likely to be of great comfort to tax practitioners.

First, the IRS intends to modify its internal guidance to provide that a referral to the Office of Professional Responsibility by a revenue agent will not be automatic when a tax return position preparer penalty is assessed against a tax return preparer.

Second, the Treasury Department is empowered to impose monetary penalties on Circular 230 practitioners for violations of the provisions of the Circular’s rules and requirements. However, the Treasury and IRS anticipate that Circular 230 will be revised to state that the IRS “generally” will not stack the Code Sec. 6694 penalties and the monetary penalties.

Penalty Calculation
In a very generous interpretation of the penalty calculations, rather than using 50 percent of the income derived from the return as the upper measure of the preparer penalty, if adequate records exist, the 50 percent amount will be measured by the engagement income attributable to taking the tax position.

Relying on Client and Third-Party Representations
Finally, the proposed regulations provide that the tax preparer may rely upon client representations and information and third-party information (e.g., K-1 information) subject only to the caveat that the prepare may not ignore the implications of information furnished to or known by the practitioner, and the practitioner should make appropriate inquiry if the information provided appears to be incomplete, incorrect, or inconsistent with a know fact or factual assumption.

Kip Dellinger, CPA is senior tax partner at Kallman & Co. LLP, Los Angeles, and is chair of the Tax Practice Responsibilities Committee of the AICPA Tax Division. You can reach him at kip@kallmanandco.com.