IRS Issues Proposed Regulations on Tax Return Preparer Penalties (NPRM REG-129243-07)


The IRS has released proposed return preparer penalty regulations. The proposed regulations. The proposed regulations provide guidance on the new Code Sec. 6694(a) more-likely-than-not preparer standard, and contain a comprehensive overhaul of all preparer penalties. The IRS predicted that final regulations will be in place for the 2009 filing season. A hearing on the proposed regulations is scheduled for August 18, 2008, at the IRS National Office in Washington, D.C.



The IRS stated that it will not stack penalties under Code Sec. 6694 and Circular 230. The IRS stated that penalties under Code Sec. 6694 are not automatic (TAXDAY, 2008/03/07, I.9). Additionally, the IRS included many examples of various provisions in the proposed regulations.



The House-passed Renewable Energy and Job Creation Bill of 2008 (HR 6049) would equalize the preparer and taxpayer penalty standards at substantial authority. Although Senate Democrats were unable to bring HR 6049 before the full Senate for debate during the week of June 9, they are expected to try again the week of June 16.


Passage of the Small Business and Work Opportunity Tax Act of 2007 (2007 Small Business Tax Act) (P.L. 110-28), sparked the drafting of the proposed regulations. The new law replaced the "realistic possibility of success standard" in Code Sec. 6694(a) with the heightened "more likely than not standard" for nonabusive undisclosed positions. The preparer must have a reasonable belief that the tax treatment of the position would more likely than not be sustained on its merits.



The 2007 Small Business Tax Act also extended Code Sec. 6694 to preparers of all returns and not just preparers of income tax returns. Additionally, the new law significantly increased the penalties for noncompliance. The old, first-tier $250 penalty in Code Sec. 6694(a) jumped to the greater of $1,000 or 50 percent of the income derived, or to be derived, by the preparer. The penalty for willful or reckless conduct in Code Sec. 6694(b) increased from $1,000 to the greater of $5,000 or 50 percent of the income derived or to be derived by the preparer.


Preparer Within Firm


The proposed regulations eliminate the current "one preparer per firm" rule used in determining who in a particular firm is responsible for penalties in favor of a framework that focuses on returns on a position-by-position basis. If a preparer is primarily responsible for a position on a return giving rise to an understatement, that person will be subject to Code Sec. 6694. Only one person within a firm will be considered primarily responsible for each position; however, multiple individuals may be responsible for a position if employed by multiple firms.



The individual signing the return will continue to be held responsible for all of the positions on a return, but if another individual is determined (either via information received from the signing individual or from other sources) to have primary responsibility for a position giving rise to the understatement, that other individual will be responsible under Code Sec. 6694. If there are one or more nonsigning tax return preparers at the same firm and no signing preparer at the firm, the individual within the firm with supervisory responsibility for the position will be responsible for the Code Sec. 6694 penalty.



These new rules allow the IRS more flexibility in assessing responsibility for positions giving rise to understatements than the IRS has under the current "one preparer per firm" system.


Income Derived


The proposed regulations also provide new guidance for determining the amount of income derived by a firm or an individual in preparing a return containing a position giving rise to an understatement, upon which the maximum penalty under Code Sec. 6694 is calculated. Income derived includes all compensation the preparer receives or expects to receive in preparing the return or providing tax advice. If the preparer is paid by a firm for work done for a client of the firm, income derived is all compensation that can be reasonably allocated to work done in preparing the return or advising the client on a position giving rise to an understatement.



If the firm is subject to penalty under Code Sec. 6694, then all compensation received by the firm will be included as income derived from the transaction. If both the firm and the preparer are subject to liability, the income derived from the transaction will only count once, meaning that income received by the firm from the client and paid to the preparer will not both be used in determining the maximum penalty.


"More Likely Than Not Standard"


The proposed regulations provide additional guidance on satisfaction of the "more likely than not" standard. The standard would be satisfied if the preparer analyzes the facts and authorities and reasonably concludes in good faith that the position has a greater than 50-percent likelihood of being sustained. The IRS will take into account the preparer's experience in tax law, familiarity with the taxpayer's affairs and the complexity of the facts. The standard may also be satisfied through a well-reasoned construction of statutory authority where no other authority exists or if the preparer relies upon the advice of another preparer or the taxpayer. However, the preparer may not rely upon information provided by taxpayers with respect to legal conclusions on tax issues.


Adequate Disclosure, Reasonable Basis


Preparers must provide disclosure of a return position where the position has a reasonable basis, but the "more likely than not" standard cannot be satisfied. The proposed regulations provide that the reasonable basis standard for these purposes is the same as is used for the accuracy-related penalty under Code Sec. 6662 (significantly higher than not frivolous or patently improper and not satisfied by a position that is merely arguable or a merely colorable claim). However, in meeting the "reasonable basis" standard, preparers can rely in good faith upon the advice furnished by a taxpayer, advisor or another preparer without verification.



The proposed regulations also provide guidance on what constitutes adequate disclosure, building upon guidance provided in Notice 2008-13. For a signing return preparer, disclosure can be accomplished in one of five ways:



- through the use of Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, or on the return in accordance with the annual procedure (see Rev. Proc. 2008-14, I.R.B. 2008-7, 435);



- if the position does not satisfy the substantial authority standard of Reg. §1.6662-4(d), provision of a disclosure to the taxpayer with the prepared tax return;



- if the position does satisfy the substantial authority standard of Reg. §1.6662-4(d), by advising the taxpayer of all the penalty standards applicable under Code Sec. 6662;



- if the position can be described as a tax shelter or reportable transaction, the preparer must advise the taxpayer of the requirements of minimum substantial authority and possession, on the part of the taxpayer, of a reasonable belief that the "more likely than not standard" is met and that the disclosure does not preclude the assessment of an accuracy-related penalty; or



- for returns or refund claims subject to penalties other than the accuracy-related penalty for substantial understatements, the preparer must advise the taxpayer of the applicable penalty standards under Code Sec. 6662.


For a nonsigning return preparer, adequate disclosure may be met in one of three ways:


- through the use of Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, or on the return in accordance with the annual procedure (see Rev. Proc. 2008-14, I.R.B. 2008-7, 435);



- the preparer may advise the taxpayer of opportunities to avoid potentially applicable Code Sec. 6662 accuracy-related penalties and of applicable standards of disclosure; and



- the nonsigning preparer advises another preparer that disclosure may be required and notes this advice in the other preparer's files.


Each of these methods of disclosure with regard to advice given to a taxpayer must be tailored to the taxpayer's facts and circumstances. Boilerplate language is not sufficient.

Reasonable Cause


Under current Reg. §1.6694-2(d), an exception to the imposition of the penalty is provided where the understatement is due to reasonable cause where the preparer acted in good faith. The regulation includes factors to be considered in determining if the exception applies. The proposed regulations provide that whether the position is supported by generally accepted administrative or industry practices is to be added as an additional factor to be taken into consideration.


Tax Return Preparer


The proposed regulations provide definitions of both a signing tax return preparer and a nonsigning tax return preparer. A signing tax return preparer is any tax return preparer who signs or is required to sign a return or claim for refund. A nonsigning tax return preparer is any tax return preparer who is not a signing tax return preparer but prepares all or a substantial portion of a return.


Electronically Filed and Signed Returns


The proposed regulations provide two changes that will better facilitate the use of electronically signed returns. First, Reg. § 1.6107-1(a), which requires signing return preparers to provide a copy of the filed return to the taxpayer is proposed to be amended to allow preparers electronically filing Form 1040EZ or Form 1040-A to provide the copy to the taxpayer by reproducing the information on Form 1040. Also, a preparer need not sign an electronically signed return prior to providing the taxpayer with a copy of the return but must provide all of the information to that taxpayer at the same time the preparer provides the taxpayer with Form 8879, IRS e-file Signature Authorization.


Additional Proposed Changes


The proposed regulations also provide the following changes:



- the rules under Reg. §§1.6694-2 and -3 are proposed to be changed to allow for a firm to be subject to penalty where the firm's review procedures are not followed through willfulness, recklessness or gross indifference;



- a reasonableness standard is provided for signing return preparer's due diligence requirements in determining eligibility for the earned income credit; and



- for purposes of the penalties under Code Sec. 6694, the date that a return is determined to be prepared is the date the return is signed by the preparer or, if the preparer fails to sign the return, the date the return is filed.



The IRS stated in the preamble to the proposed regulations that the Service intends to modify its internal guidance so that a referral by revenue agents to the IRS Office of Professional Responsibility (OPR) will not be per se mandatory when the IRS assesses a tax return preparer penalty under Code Sec. 6694(a) against a tax return preparer who is also a practitioner within the meaning of Circular 230.


Hearing and Comments


A public hearing has been scheduled for August 18, 2008, beginning at 10:00 a.m. Written or electronic comments must be received by the IRS by August 16, 2008. Outlines of topics to be discussed at the public hearing must be received by August 4, 2008.