Section 6694 adequate disclosure exception

Penalties for understatement due to unreasonable positions will not be imposed even there is no reasonable belief that the position would more likely than not be sustained on its merits if the position is adequately disclosed and there is a reasonable basis for the tax treatment of such item (Code Sec. 6694(a)(2), as amended by Small Business Tax Act of 2007 (P.L. 110-28)). For returns prepared on or before May 25, 2007, penalties will not be imposed even though a position does not have a realistic possibility of being sustained, provided that the position is not frivolous and is adequately disclosed (Reg. §1.6694-2(c)(1)). A frivolous position is one that is patently improper (Reg. §1.6694-2(c)(2)).

Generally, disclosure is adequate if made on Form 8275 (Disclosure Statement) or Form 8275-R (Regulation Disclosure Statement), attached to the return, amended return or refund claim. For certain items, proper representation on the return is sufficient disclosure for purposes of Code Sec. 6694(a) (Rev. Proc. 2001-11).

Transitional Relief. For income tax returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), the standards set forth under the previous law and current regulations under Code Sec. 6694 will be applied in determining whether the IRS will impose a penalty under Code Sec. 6694(a). Generally, in applying transitional relief for income tax returns, amended returns or refund claims, disclosure would be adequate if made on a Form 8275 Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, attached to the return, amended return, or refund claim, or pursuant to the annual revenue procedure authorized in Reg. §1.6694-2(c)(3) and Reg. §1.6662-4(f)(2). For all other returns, amended returns, and claims for refund, including estate, gift, and generation-skipping transfer tax returns due on or before December 31, 2007 (determined with regard to any extension of time for filing), 2007 employment and excise tax returns due on or before January 31, 2008, and 2007 estimated tax returns due on or before January 15, 2008, the reasonable basis standard set forth in the regulations issued under Code Sec. 6662, without regard to the disclosure requirements contained therein, will be applied in determining whether a penalty under Code Sec. 6694(a) will be imposed (Notice 2007-54, I.R.B. 2007-27, June 11, 2007).

Under interim guidance for all tax returns, amended tax returns, and claims for refund (other than 2007 employment and excise tax returns) filed on or after January 1, 2008 with respect to advice provided on or after that date, and for employment and excise tax returns filed on or after February 1, 2008 with respect to advice provided on or after that date, reasonable basis will be interpreted in accordance with Reg. §1.6694-3(b)(3). In determining whether the tax return preparer has a reasonable basis for a position, the tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, another tax preparer, or other third party, but may not ignore the implications of information furnished to, or actually known to, the tax return preparer. The tax return preparer must also make reasonable inquiries if the information furnished by another tax return preparer or a third party appears to be incorrect or incomplete (Notice 2008-13, I.R.B. 2008-3, December 31, 2007).

Example (1):

Hannah, a tax preparer, interviews her client, Paul, .in the process of preparing Paul's 2008 income tax return. Paul stated that he made a $75,000 charitable contribution of real estate in 2007, but such statement is false. Hannah did not inquire about whether Paul had a qualified appraisal for the contribution or otherwise satisfy the reporting and substantiation requirements for the donation. Hannah reports a charitable contribution deduction on Paul's 2008 tax return, resulting in an understatement of liability for tax. Hannah is subject to a penalty under Code Sec. 6694.


Signing and nonsigning return preparers. Different disclosure rules are prescribed for signing and nonsigning preparers (see ¶39,956A.02). For a signing preparer, disclosure is adequate if it complies with the adequate disclosure standards of the substantial understatement penalty (Reg. §1.6694-2(c)(3)(i)). These standards permit disclosure on Form 8275 (Disclosure Statement), on Form 8275-R (Regulation Disclosure Statement), or by proper representation on a return in accordance with Rev. Proc. 2001-11. (Reg. §1.6662-4(f)).

A nonsigning preparer adequately discloses advice to a taxpayer concerning a position not meeting the realistic possibility standard if the advice includes a statement that the position lacks substantial authority and, therefore, may subject the taxpayer to the substantial understatement penalty unless adequate disclosure is made. For a tax shelter item, the statement must note that the taxpayer may be subject to the substantial understatement penalty regardless of whether adequate disclosure is made. If the advice is in writing, the statement must also be in writing. If the advice is oral, the statement may be oral. The determination as to whether an oral statement was given is based on all the facts and circumstances. Contemporaneously prepared documentation of the oral statement usually is sufficient to establish that the statement was made to the taxpayer (Reg. §1.6694-2(c)(3)(ii)(A)).

Transitional relief for signing and nonsigning return preparers. Interim guidance has been provided to signing and nonsigning tax return preparers with respect to a position for which there is a reasonable basis, but for which the tax return preparer does not have a reasonable belief that the position would more likely than not be sustained on the merits (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,997). The Code Sec. 6694(a) penalty will not be imposed if there is disclosure in accordance with Reg. §1.6662-4(f) (which permits disclosure on a properly completed and filed Form 8275 or Form 8275-R, or on the return in accordance with the annual revenue procedure described in Reg. §1.6662-4(f)(2)). If the taxpayer does not have substantial authority for the position, and therefore would be required to make disclosure in order to avoid the accuracy related penalty under Code Sec. 6662(d)(2)(B), the tax return preparer will also not incur the Code Sec. 6694 penalty by providing the taxpayer with the prepared return which includes the disclosure in accordance with Reg. §1.6662-4(f). If the taxpayer does not file the return with such disclosure, the tax return preparer can avoid the Code Sec. 6694 penalty by establishing that the return as provided to the taxpayer included the required disclosure.

The interim guidance also addresses the situation in which the taxpayer is not required to make disclosure because the taxpayer has substantial authority for the position, but the signing tax return preparer cannot avoid the Code Sec. 6694 penalty because the tax return preparer cannot satisfy the more likely than not standard. This creates a potential conflict between the taxpayer and the tax return preparer, the former perhaps wanting to avoid disclosure because the substantial authority threshold is met, and the signing tax return preparer needing the taxpayer to make such disclosure in order for the tax return preparer to be protected against the Code Sec. 6694 penalty. While this potential conflict might be addressed in the tax return preparer's engagement letter with the taxpayer, the interim guidance offers an alternative approach. The tax return preparer can advise the taxpayer of the difference between the penalty standards applicable to the taxpayer under Code Sec. 6662 and the penalty standards applicable to the tax return preparer under Code Sec. 6694, and contemporaneously document that such advice was given in the tax return preparer's files.

Similarly, if the taxpayer is involved in a tax shelter as described in Code Sec. 6662(d)(2)(C), and therefore disclosure will not protect the taxpayer from the Code Sec. 6662 penalty even if there is a reasonable basis for the position, the signing tax return preparer can avoid the penalty by advising the taxpayer of the penalty standards applicable to the taxpayer under Code Sec. 6662(d)(2)(C) and the difference, if any, between such standards and the standards under Code Sec. 6694, and by contemporaneously documenting in the tax return preparer's files that this advice was provided (Notice 2008-13, I.R.B. 2008-3, December 31, 2007 at ¶46,229).

Example (2):

Kerry, an accountant, is hired by Meca, Inc. to prepare its 2008 corporate income tax return. Kerry does not reasonably believe that a position on the return would more likely than not be sustained on the merits, although there is substantial authority for the position. Kerry prepares and signs a 2008 tax return for Meca which does not disclose the position, but advises Meca about the difference between the penalty standards applicable to Meca under Code Sec. 6662, and the penalty standards applicable to Kerry under Code Sec. 6694. Kerry also contemporaneously documents in his file for Meca that this advice was provided. Meca signs and files its 2008 tax return without disclosing the position. The IRS later audits the Meca return and determines that there is an understatement of liability reported on the tax return. Kerry should not be subject to the penalty under Code Sec. 6694.


For a nonsigning tax preparer, if the position on the return would satisfy the reasonable basis standard, but neither the substantial authority or more likely than not standard, the taxpayer can avoid the Code Sec. 6662 penalty, and the tax return preparer can avoid the Code Sec. 6694 penalty, by making disclosure on the return. However, if the taxpayer does not include the disclosure statement with the return, the nonsigning tax return preparer will still avoid the penalty if the advice to the taxpayer includes a statement informing the taxpayer of the opportunity to avoid the Code Sec. 6662 penalty by making disclosure, and explaining the requirements for such disclosure. The statement must be made in the same manner, oral or written, as the advice given to the taxpayer. Contemporaneously documenting the advice in the nonsigning tax return preparer's files is sufficient to document that the statement was given to the taxpayer (Notice 2008-13, I.R.B. 2008-3, December 31, 2007.

Example (3):

Attorney Laura advises Bigco, Inc. in writing about the proper treatment of certain complex entries on Bigco's 2008 corporate tax return. Laura knows that if such treatment is disallowed the resulting tax liability would be a significant portion of Bigco's 2008 tax return liability. At the time the advice is rendered, Laura concludes that one position with respect to the entries satisfies the reasonable basis standard, but neither the substantial authority nor the more likely than not standards. Laura advises Bigco in writing that the position lacks substantial authority, and may subject Bigco to the Code Sec. 6662 penalty unless disclosed on its return. Laura contemporaneously documents in her files that she gave such written advice to Bigco. Bigco files its 2008 return without including the disclosure statement. Although Laura does not sign the return, she is still considered a tax return preparer because her advice constitutes preparation of a substantial part of Bigco's return. However, because she gave Bigco written advice about the accuracy-related penalty, and contemporaneously documented giving such written advice to Bigco, Laura will not be subject to the Code Sec. 6694 preparer penalty.


Advice to another preparer. A nonsigning preparer who provides advice to another preparer can adequately disclose a position that does not have a realistic possibility of being sustained by including a statement in the advice that disclosure under Code Sec. 6694(a) is required. The statement must be made in the same manner, oral or written, as the advice given to the other preparer (Reg. §1.6694-2(c)(3)(ii)(B)).

Transitional relief for advice to another preparer. If the reasonable basis standard, but not the more likely than not standard, is satisfied with respect to an item for which a nonsigning tax return preparer provides advice to another tax return preparer, the nonsigning tax return preparer will be deemed to meet the requirements of Code Sec. 6694 by including a statement in the advice to the tax return preparer that disclosure under Code Sec. 6694(a) may be required. The statement must be made in the same manner, oral or written, as the advice given to the other preparer. Contemporaneously documenting the advice in the nonsigning tax return preparer's files is sufficient to document that the statement was given to the other tax return preparer. (Notice 2008-13, I.R.B. 2008-3, December 31, 2007). This interim guidance rule will apply instead of Reg. §1.6694-2(c)(3)(ii) until further guidance is issued.