Taxpayer Advocate comment on section 6694

National Taxpayer Advocate's 2007 Annual Report to Congress, January 10, 2008

I
Definition of Problem

Without a current national system to regulate unenrolled tax return preparers, the IRS needs to effectively use the tools at hand to address incompetent or unscrupulous tax return preparers. However, through the following inactions, the IRS is sending a message to preparers that it tolerates noncompliance:
 The IRS does not consistently assess and collect preparer penalties, and

 The IRS has taken no enforcement action on either criminal or civil penalties for unauthorized use and disclosure of tax return information under Internal Revenue Code (IRC) §§ 7216 and 6713; and

The National Taxpayer Advocate will continue to evaluate IRS oversight of Electronic Return Originators (EROs), which are "Authorized IRS e-file Providers" (Providers). The IRS needs to continually check to determine whether all individuals identified on the ERO application as Principals, Responsible Officials, and Delegated Users have unpaid preparer penalties assessed against them. Furthermore, the IRS needs to determine whether ERO applicants claiming not-for-profit status are actually not-for-profits.

While the IRS inadequately enforces preparer penalty provisions, it is also failing to abide by existing power of attorney bypass procedures. More importantly, the IRS is considering amending procedural rules to allow IRS employees to work directly with represented tax-payers who initiate contact with the IRS. The existing bypass procedures were designed to protect against over-reaching by the government, and by failing to follow them, or by amending them, the IRS is depriving taxpayers of their right to representation.

Finally, the National Taxpayer Advocate is concerned about the recent changes to IRC § 6694 The higher standards of conduct put in place by the changes may affect the way tax preparers dispense advice and, in some cases, create conflicts of interest between pre-parers and their clients.



Analysis of Problem



Assessment and Collection of Preparer Penalties

As illustrated in the table below, the IRS has collected only slightly more than 20 percent of net assessed return preparer penalties under IRC §§ 6694 and 66952 in the last six fiscal years. The IRS collected approximately 25 percent of the assessed amount in fiscal year (FY) 2007.


Table 1.9.1, IRS assessment and Collection of IRC §§ 6694 and 6695 Return Preparer
Penalties for FY 2002-20073

_____________________________________________________________________________________
Fiscal Year Penalty Penalty Dollars Applied Percentage of
Assessment Amt Abatement Amt to Penalties** Net Assessed
Return Penalties
Collected

_____________________________________________________________________________________
2002 $1,095,033 $80,493 $268,767 24.54%

2003 $2,427,198 $247,000 $267,324 11.01%

2004 $1,052,550 $52,725 $303,845 28.87%

2005 $910,752 $89,850 $337,832 37.09%

2006 $1,856,461 $48,450 $212,733 11.46%

2007 $2,736,725 $63,250 $681,974 24.92%

_____________________________________________________________________________________
Total $10,078,719 $581,768 $2,072,475 20.56%

_____________________________________________________________________________________
3 IRS ERIS Data; IRC §§ 6694 and 6695 Penalty Data (through Sept. 2007). These
numbers exclude penalty reference 622, understatement of taxpayer liability by
income tax preparer.



However small the assessed penalties may have been relative to the IRS's other enforce-ment efforts, these penalties may effectively deter noncompliance by preparers and, more importantly, have a cascading effect to increase compliance by their clients. In addition, by assessing but not collecting these penalties, the IRS is sending a mixed message about whether it will tolerate poor performance by preparers.4

It is important to note that the authorized amount of preparer penalties imposed under IRC § 66694 was significantly increased effective May 25, 2007.5 The National Taxpayer Advocate will continue to monitor the IRS's assessment and collection efforts in light of the new legislative changes. Her concerns about the changes to IRC § 6694 are detailed below.



Enforcement of IRC §§ 7216 and 6713 6

The IRS does not currently enforce the penalties imposed under IRC §§ 6713 and 7216. IRC § 7216 imposes criminal penalties on preparers who knowingly or recklessly make unauthorized disclosures or uses of information furnished to them in connection with the preparation of an income tax return. IRC § 6713 imposes civil penalties on preparers for disclosure or use of this information unless an exception under the rules of IRC § 7216(b) applies. Because safeguarding taxpayer data is crucial to the integrity of the tax system, the IRS should give utmost priority to the enforcement of these penalties. However, the IRS has not assessed or collected any penalties under either section during the period reviewed by our office (2002 through 2007).



Authorized IRS e-file Providers

In the 2005 and 2006 Annual Reports to Congress, the National Taxpayer Advocate raised concerns about inadequacies in the IRS's performance of initial suitability checks and subsequent monitoring of electronic return originators (EROs).7 The Treasury Inspector General for Tax Administration (TIGTA) recently audited the e-file program and raised simi-lar concerns.8 While the National Taxpayer Advocate still maintains that the IRS needs to improve suitability checks and e-file monitoring, we will pay close attention to the process utilized by the IRS to periodically monitor all individuals identified on the ERO application as Principals, Responsible Officials, and Delegated Users to determine whether they have outstanding preparer penalties assessed against them. By awarding an ERO designation to a business organization, the IRS is providing that organization with the privilege of participation in IRS e-file as an "Authorized IRS e-file Provider." The IRS should not grant entry into the e-file program or allow an existing ERO to continue participating if any of the indi-viduals listed on the ERO application owe uncollected preparer penalties. The IRS needs a comprehensive and permanent program to systematically check for outstanding preparer penalties on those individuals given the privilege of participating in the e-file program. It is insufficient to perform tax compliance checks solely during the application process and e-file monitoring visits. The IRS should perform periodic tax compliance checks on the individuals identified on the ERO application as Principals, Responsible Officials and Delegated Users.9

Moreover, in its recent audit of the IRS e-file program, TIGTA found the IRS does not verify whether ERO applicants claiming not-for-profit status are actually not-for-profits. Once an applicant checks the box on the application indicating such status, the applicant is excluded from all e-file program requirements and suitability checks. Thus, the IRS provides a broad exclusion to these entities without even checking to ensure that they qualify for the exclusion. TIGTA recommended that the IRS perform such verification procedures in the application process, and the IRS agreed.10 The National Taxpayer Advocate will monitor the IRS's progress on this initiative.






Recent Changes to Standard of Conduct in § 6694 Preparer Penalties



Background

Section 8246 of the Small Business and Work Opportunity Act of 200721 recently amended IRC § 6694 as follows.
 Increased Penalties. The legislation raised the penalties imposed on return preparers for understatements due to unreasonable positions from $250 to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or claim. In addition, the legislation increased penalties for understatements due to willful or reckless conduct from $1,000 to the greater of $5,000 or 50 percent of the income derived by the preparer with respect to the return or claim in question.

 Expanded Application of Penalties to Taxes Other Than Income. Before the amendment, IRC § 6694 applied to only income taxes. The new legislation applies the penalties to all types of tax returns, including estate and gift tax, employment tax, and excise tax returns.

 Higher Standard of Conduct on Undisclosed Positions. The amendment established a higher standard of conduct for preparers to avoid imposition of penalties when the IRS alleges that the preparer knew or reasonably should have known of an unreasonable position. The old standard required the position taken on the return to have a "realistic possibility of being sustained on its merits." The new standard requires "a reasonable belief that the position would more likely than not be sustained on its merits." Regulation § 1.6694-2(b) translates the previous realistic possibility standard to equate to a one in three (approximately 33 percent) or greater likelihood of being sustained on its merits. The new standard translates to approximately 51 percent or greater likelihood, which is significantly higher than the substantial authority standard that applies to taxpayers.22

 Higher Standard of Conduct on Disclosed Positions. The legislation also establishes a higher standard of conduct for disclosed unreasonable positions as well. Previously, the preparer could avoid penalties on disclosed unreasonable positions if the position was not frivolous. Now the preparer must have a reasonable basis for the disclosed position. This change actually makes the standard for disclosed positions the same for taxpayers and preparers.23

 Effective Date of Legislation. The legislation was effective upon enactment. Thus, the new rules apply to positions on returns prepared after May 25, 2007. However, as described below, the IRS issued guidance providing transitional relief.

In the interest of effective tax administration and in response to practitioner concerns about the effective date of the new legislation,24 the IRS issued Notice 2007-5425 to provide transitional relief. The transitional relief provides the following:
 Returns, Amended Returns and Claims for Refund for Income Taxes. With respect to understatements due to an unreasonable position, the standards included in the previous law and current regulations apply to income tax returns, amended returns, or claims due on or before December 31, 2007.

 Returns, Amended Returns, and Claims for Refund for Taxes Other Than Income Taxes. For all other returns, amended returns, and claims due on or before December 31, 2007 that include an understatement due to an unreasonable position, the reasonable basis standard defined in Treas. Reg. §1.6662-3(b)(3) will apply.26 The relief also applies to 2007 estimated tax returns due on or before January 15, 2008 and 2007 employment and excise tax returns due on or before January 31, 2008.

 Understatement Due to Willful or Reckless Conduct. There is no transitional relief provided for return preparers who exhibit willful or reckless conduct.

 The Department of Treasury and the IRS Office of Chief Counsel have committed to release detailed guidance on the new IRC § language.27



Ethical Concerns

Subsequent to the enactment of the legislation, the practitioner community voiced concerns over the change in the standard of conduct required to avoid the imposition of IRC §6694 penalties.28 The National Taxpayer Advocate is particularly concerned that the legislation created a significant disparity between the standard applicable to preparers and the standard applicable to taxpayers. This disparity can potentially lead to ethical problems for preparers which in turn will affect how they advise their clients.

The practitioner standard requiring that the position would more likely than not be sustained on its merits is now considerably stricter than the taxpayer standard. Undisclosed positions on returns prepared by taxpayers are subject to the substantial authority standard.29 Treas. Reg. § 1.6662-4(d)(2) specifically states that the "substantial authority" standard is less stringent than the "more likely than not" standard.30

Recent changes to the standard of conduct may cause preparers to recommend that their clients include numerous disclosures in their tax returns. This development has the potential to place the preparer in an ethical dilemma, because the preparer needs to recommend a course of action to protect the preparer's interest even though it may not be in the client's best interest. Form 8725, Disclosure Statement, was designed for taxpayers to disclose information to avoid IRC § 6662 penalties.31 In cases where there is substantial authority for a certain position taken on a return and the client is confident that the IRS will not impose IRC § 6662 penalties, the client has no incentive to sign a disclosure statement to protect the preparer. Thus, the preparer is placed in a very difficult position if he or she hopes to avoid preparer penalties.32

The "more likely than not" standard may also discourage preparers from interpreting ambiguous tax rules in a taxpayer-friendly manner. Specifically, preparers can avoid significant penalties only if they disclose a reasonably based position or ensure there is at least a 51 percent possibility that any undisclosed position would be sustained on its merits. In situations where the applicable tax law is ambiguous or not well developed, preparers may shy away from undisclosed positions that are aggressive yet reasonable interpretations of the law if they face the threat of sizeable penalties.33 Further, preparers may have ethical reasons to avoid disclosing certain tax return positions to the IRS if the taxpayers' substantial authority standard of conduct has been met, but the preparers' more likely than not standard has not.



Conclusion

To increase preparer compliance, the IRS needs to effectively assess and collect preparer penalties. Collecting only slightly more than 20 percent of assessed preparer penalties under IRC §§ 6694 and 6695 during the past six years is inadequate. The IRS is also putting taxpayers at risk by failing to enforce the criminal and civil penalties under IRC §§ 6713 and 7213. In addition, the IRS should develop a comprehensive and permanent program to systematically check whether all individuals identified on the ERO application as Principals, Responsible Officials, and Delegated Users have unpaid preparer penalties assessed against them.

The National Taxpayer Advocate will monitor the IRS's implementation of its authority to bypass taxpayer representatives. While the tool exists to protect clients against incompetent or unethical practitioners, the IRS should only employ this tool when absolutely necessary. By not providing proper guidance to IRS employees and by not following its own procedures, the agency risks depriving taxpayers of their fundamental right to representation.

Finally, the Office of the Taxpayer Advocate will continue to monitor the recent changes to IRC § 6694 specifically the effect the new increased standards of conduct have on preparer behavior and how the IRS plans to enforce the provisions.



IRS Comments

A majority of taxpayers rely on return preparers to help them navigate, understand, and comply with their tax obligations. The IRS agrees that return preparers are a critical component of the IRS's goal of increasing voluntary compliance, and is developing a comprehensive and Servicewide Return Preparer Strategy that effectively balances services with consistent enforcement of the tax laws. The goal of the Strategy is to enhance tax administration through collaboration with return preparers by providing clear guidance and effective service support, while ensuring overall compliance with the tax laws.

A majority of tax returns received by the IRS are prepared by paid tax return preparers. There are increasing complexities for the tax filing population due, in part, to frequent law changes and the existence of a more global environment. These complexities affect the demands on the IRS to provide more resources to assist taxpayers and their return preparers so they can meet their tax responsibilities. The IRS must be able to fulfill its obligations in an ever-changing environment, and our mission is to ensure that all points of return preparer contacts with the IRS are a part of its strategy - education, e-services and e-applications, compliance guidelines, enforcement, and modernization efforts.

The framework for the Strategy will focus on several guiding principles:
 Develop a better understanding of the important role of return preparers and how they affect voluntary compliance;

 Identify opportunities to provide service resources that mitigate errors, reduce taxpayer and preparer burden, and increase IRS efficiencies; and

 Ensure a consistent IRS enforcement presence in the return preparer community.



Assessment and Collection of Preparer Penalties

The IRS agrees that return preparer penalties may decrease noncompliance by preparers and quite possibly increase compliance by their clients. In addition to protecting taxpayers from being harmed by unscrupulous return preparers, the larger compliance impact is certainly a goal of the program. The IRS agrees that improvements can be made in collection of these penalties; however, there are other aspects to measuring the success of the program beyond dollars collected. All preparers who are assessed penalties receive collection notices, with some also being contacted by collection personnel. Based on the preparer's individual financial condition, collection alternatives are considered to resolve the case. These alternatives do not always result in full payment or installment agreements.

The IRS utilizes business rules in the collection case assignment process. Business rules are also used to identify areas of special emphasis, and return preparer cases are identified as "Special Emphasis" because of the compliance nature of the assessment. Current risk-based case assignment practices do not always provide sufficient emphasis on these cases. Therefore, the IRS is implementing programming changes targeted for November 2008 that should allow more preparer penalty cases to be assigned to revenue officers in the collection field function.



Enforcement of IRC §§ 7216 and 6713

Over the past several years, the IRS has, on occasion, asserted the penalty under IRC § 6713, Disclosure or Use of Information by Preparers of Returns. But, given the nature of the penalty, examiners will rarely uncover situations where this penalty would be warranted, which is one factor why the penalty is not more frequently utilized. We agree, however, that additional emphasis on this penalty is needed and have several actions planned to increase awareness including:
 Discussing the penalty during future conference calls with Area Return Preparer Program (RPP) Coordinators and ERO Coordinators;

 Updating the ERO training material to include that if examiners identify a potential violation, a referral should be made to the RPP Coordinator; and

 Updating the IRM pertaining to the RPP to include procedures for applying this penalty.

IRC § 7216 provides for a misdemeanor charge imposing a sentence of not more than one year in jail and fine not more than $1,000 for the improper disclosure or use of taxpayer information by preparers. This statute can be used to address criminal violations of return preparers typically involved in refund crimes or crimes related to identity theft. The IRS Criminal Investigation Division (CI) generally does not recommend charges under § 7216 because the violation is only a misdemeanor. CI instead recommends felony charges for return preparers who improperly disclose or use taxpayer information while involved in abusive criminal behavior related to the preparation of false tax returns or use of taxpayer information to file fictitious returns in the attempt to obtain fraudulent refunds.

In lieu of IRC § 7216, CI (with the approval of Department of Justice Tax Division) will recommend to the U.S. Attorney's Office that abusive return preparers should be charged under (1) IRC § 7206(2) Aiding or Assisting the Preparation of a False or Fraudulent False Tax Return or Fraudulent Document; (2) 18 U.S.C. § 287 Making False, Fictitious, or Fraudulent Claims for Refund; (3) 18 U.S.C. § 286 Conspiracy to Defraud the Government with Respect to Claims of Tax Refunds; and/or (4) 18 U.S.C. § 1028A Aggravated Identity Theft. These charges are felony charges that impose sentencing of from two years to ten years along with fines of up to $250,000.



Authorized IRS e-file Providers

The IRS reviews preparer penalties during its Tax Compliance Checks as part of the Suitability Check completed on firms, principals, and responsible officials. Preparer penalties assessed in the last three years over a specified amount, and occurring in more than one tax period, are considered in determining suitability. The IRS uses the Automated Suitability Analysis Program (ASAP) to identify preparer penalty assessments and unpaid balances that are more than a specific amount. Assessments and unpaid balances are identified by ASAP during processing of e-file applications and on a continual basis after acceptance as an authorized IRS e-file provider. When criteria are met during the Suitability Check, a transcript is generated to e-Help. Transcripts are generated on a weekly basis. e-Help reviews the information, investigates as needed, and takes the appropriate action, which may include denial, suspension, or expulsion. The suitability process is described in IRM 3.42.10.18.

The Automated e-file Application Processing system has been in use for a number of years and automates the process of checking and monitoring tax compliance and ensures that applicants and approved e-file providers are current with their tax return filings and tax payments. In addition, this process ensures that individuals and businesses have not been assessed fraud and/or preparer penalties. In a recent TIGTA audit report, a review of 98 applications found that tax compliance checks were correctly performed for the 137 principal and responsible officials and the 94 businesses listed on these applications.




Recent Changes to Standard of Conduct in § 6694 Preparer Penalties

As noted by the National Taxpayer Advocate, the recent changes made to IRC § 6694 increase the standards for paid preparers. The IRS will work with the National Taxpayer Advocate in implementing the statutory changes and any related Treasury guidance. The IRS will also provide additional procedural guidance and technical training materials to ensure our employees properly apply the new law.



Summary of Planned Actions

In summary, and in response, the IRS plans to take the following actions:
 Changes to the risked-based case assignment programming are targeted for November 2008 to allow more preparer penalty cases to be assigned to revenue officers in the collection field function;

 Discuss the IRC § 6713 penalty during future conference calls with RPP Coordinators and ERO Coordinators;

 ERO training material will be updated to indicate that if examiners identify a potential violation of IRC § 6713, a referral should be made to the RPP Coordinator;

 The IRM pertaining to RPP will be updated to include examiner procedures for IRC § 6713; and

 Training materials will be developed to educate Service employees on the appropriate application of the new IRC § 6694 standards.