Introduction

Section 6694 and the related definitional provisions under section 7701(a)(36) of the Internal Revenue Code (Code) were amended by the Small Business and Work Opportunity Tax Act of 2007 (the Act), Pub. L. No. 110-28, 121 Stat. 190.

Section 8246 of the Act amended several provisions of the Code to extend the application of the income tax return preparer penalties to all tax return preparers, alter the standards of conduct that must be met to avoid imposition of the section 6694(a) penalty for preparing a return which reflects an understatement of liability, and increase applicable penalties under section 6694(a) and (b). The amendments made by the Act to section 6694 are effective for tax returns and claims for refund prepared after May 25, 2007. The Treasury Department and the IRS issued Notice 2007-54, 2007-27 I.R.B. 12, on June 11, 2007, which provided transitional relief under section 6694(a).

Prior to amendment by the Act, section 7701(a)(36) defined income tax return preparer as any person who prepared for compensation an income tax return or claim for refund, or a substantial portion of an income tax return or claim for refund. As amended by the Act, section 7701(a)(36) now defines tax return preparer as any person that prepares for compensation a tax return or claim for refund, or a substantial portion of a tax return or claim for refund, and is no longer limited to persons who prepare income tax returns.

Section 301.7701-15 of the current Procedure and Administration Regulations defines the term income tax return preparer to include any person who prepares for compensation all or a substantial portion of a tax return or claim for refund under Subtitle A of the Code. Operation of the current regulations brings into the preparer penalty regime a wide range of activities performed by persons who do not sign the tax return or claim for refund, who may have no knowledge of how their work is ultimately reported on the tax return or claim for refund, or who may have no knowledge of the size or complexity of the schedule, entry, or other portion of a tax return or claim for refund relative to the entire tax return. For example, current regulations broadly define the term substantial portion using a facts and circumstances test that compares the relative length, complexity, and tax liability of a particular schedule, entry, or other portion of a tax return or claim for refund to the length, complexity, and tax liability of the tax return or claim for refund as a whole. Case law, including Goulding v. United States, 717 F. Supp. 545 (N.D. Ill. 1989), aff'd, 957 F.2d 1420 (7th Cir. 1992), supports the current regulations which deem the preparer of a Schedule K-1 for a partnership to be the preparer of a partner's income tax return on which the partnership items were reported, if the Schedule K-1 constitutes a substantial portion of the partner's tax return.

The Act also amended section 6694(a) by raising the standards of conduct for tax return preparers. For undisclosed positions, the Act replaced the realistic possibility standard with a requirement that there be a reasonable belief that the tax treatment of the position would more likely than not be sustained on its merits. For disclosed positions, the Act replaced the nonfrivolous standard with the requirement that there be a reasonable basis for the tax treatment of the position.

The amendments made by the Act did not modify the exception to liability under section 6694 that is applicable when it is shown, considering all the facts and circumstances, that the tax return preparer has acted in good faith and there is reasonable cause for the understatement.

The following article discusses the IRS standards necessary to avoid the section 6694 penalty for both disclosed and undisclosed positionsSection 6694,  Section 7701(a)(36), Small Business and Work Opportunity Act of 2007