Economic Stabilization Act of 2008 (P.L. 110-343)

The amendment to section 6694(a) revised the definition of "unreasonable position" and modified the standards for imposition of the tax return preparer penalty.

THE BACKGROUND

The Small Business and Work Opportunity Tax Act of 2007 (P.L. 110-28) expanded the scope of return preparer penalties to include all tax return preparers for returns prepared after May 25, 2007 (Code Sec. 6694). The phrase "tax return preparer" covers preparers of not only income tax returns but also estate and gift tax, employment tax, excise tax, and exempt organization returns.

Under the Small Business Tax Act an "unreasonable position" penalty applies to tax return preparers if the preparer knew (or reasonably should have known) of the position, did not have a reasonable belief that the position would more likely than not be sustained on its merits, and either did not disclose the position as provided in Code Sec. 6662(d)(2)(B)(ii) or did not have a reasonable basis for the position. The more likely than not standard adopted by the Small Business Tax Act replaced the previous realistic possibility standard.

Interim guidance concerning application of the more likely than not standard was subsequently provided (Notice 2008-13, IRB 2008-3, 282). The interim guidance explains that a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, as well as information furnished by another advisor, tax return preparer or other third party. Thus, a tax return preparer is not required to independently verify or review the items reported on tax returns, schedules or other third party documents to determine if the items meet the standard, but the preparer may not ignore the implications of information furnished to or actually known to the preparer. The tax return preparer must make reasonable inquiries if the information furnished by another tax return preparer or a third party appears to be incorrect or incomplete.

For disclosed positions, Code Sec. 6694(a) requires that there be a reasonable basis for the tax treatment of the position. One way to disclose a position is to use Form 8275, Disclosure Statement, which is attached to the taxpayer's return. The interim guidance also permits a tax return preparer to advise the taxpayer of the difference between the penalty standards applicable to the taxpayer and the penalty standards applicable to the preparer along with contemporaneously documenting that the advice was provided (Notice 2008-13, IRB 2008-3, 282).

Proposed regulations were subsequently issued addressing the return preparer penalty standards, and providing that a tax return preparer may reasonably believe that a position would more likely than not be sustained on its merits if, after analyzing the pertinent facts and authorities and, in reliance upon that analysis, the tax return preparer reasonably concludes in good faith that the position has a greater than 50-percent likelihood of being sustained on its merits (Prop. Reg. §1.6694-2(b)(1), NPRM REG-129243-07).

The amount of the return preparer penalty for the understatement of a tax liability is 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 refund claim (Code Sec. 6694(a)(1)). The return preparer penalty for an understatement of a tax liability due to willful or reckless conduct is the greater of $5,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or refund claim (Code Sec. 6694(b)(1)).

NEW LAW EXPLAINED

Penalty on understatement of taxpayer's liability by tax return preparer modified. --

For tax returns prepared after May 25, 2007, the definition of "unreasonable position" is revised, and the standards for imposition of the tax return preparer penalty are modified. The definition of unreasonable position is divided into three categories --a general category, a disclosed positions category, and a tax shelters and reportable transactions category --each with its own standard to determine whether such position is an unreasonable position (Code Sec. 6694(a)(2), as amended by the Emergency Economic Stabilization Act of 2008 (P.L. 110-343)).


"Substantial authority" is the nondisclosure standard retroactive to May 26, 2007 replacing the requirement that a preparer was required to have a reasonable belief that a tax position would "more likely than not"(MLTN) be sustained on its merits if challenged by the IRS. Substantial authority for a tax position is analogous to the exception to the accuracy-related penalty for taxpayers under Code Sec. 6662.

Division C, Act Sec. 506 of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) requires that the MLTN remain applicable in determining the tax preparer penalty to a reportable transaction under Code Sec. 6662A, or if a significant purpose of an entity, plan or arrangement is the avoidance of income tax described as a tax shelter in Code Sec. 6662(d)(2)(C)(ii).Tax return preparers need to evaluate tax positions for "significant purpose" potential. This is a very subsjective standard that may be a trap for the unwary tax return preparer. Obviously, all transactions that appear to are motivated by tax savings should be examined as "tax shelters." Tax reduction is not "tax avoidance" but it may appear to be "tax avoidance."

For undisclosed positions, which fall into the general category, the penalty applies unless there is or was substantial authority for the position (Code Sec. 6694(a)(2)(A), as amended by the Emergency Economic Act of 2008).

Sec. 6694(a)(3), as amended, retains the good faith reasonable cause exception to imposition of the penalty. A preparer is not considered to have relied in good faith if: (i) the advice is unreasonable on its face; (ii) the preparer knew or should have known that the third party advisor was not aware of all relevant facts; or (iii) the preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the tax return or claim for refund was prepared, that the advice was no longer reliable due to developments in the law since the time the advice was given (Proposed Reg. §1.6694-2(d)(5)).

The reasonable cause exception to the Code Sec. 6694(a)penalty requires a review of all applicable facts and circumstances with reference to the nature of the error, the frequency and materiality of the errors, the preparer's normal office practice, reliance on another preparer's advice, and reliance on generally accepted administrative or industry practice. The most relevant Code Sec. 6694(a) penalty issue remains the reasonableness of the preparers belief in the reported position, not the likelihood it will prevail.

It is almost difficult to to distinguish between "more likely than not" and "substantial authority" when facing an aggressive IRS examiner. For that reason it is my opinion that the lobbying efforts of the ABA, the ABA, and other professional organizations was mostly a waste of time and effort. The lobbying effor should have been focused on the draconian lare size of the penalties. Without question, IRS examiners and IRS software will raise 6694(a) and (b) penalty issues whenever there is an underpayment of tax that triggers the negligence penalty under section 6662. Amended 6694(a)conforms the tax return preparer penalty standard for positions falling within the general category to the Code Sec. 6662(d)(2)(B)(i) taxpayer standard for imposition of the accuracy-related penalty (Joint Committee on Taxation, Technical Explanation of H.R. 7060, the "Renewable Energy and Job Creation Tax Act of 2008" (JCX-75-08)). By reducing the standard from more likely than not to substantial authority, and conforming the tax return preparer standard to the taxpayer standard, not much has been accomplished because the Final Regulations are expected to retain the most critical requirements for tax return preparers: the need to provide an "analysis" of the relevant tax "authorities" to negate penalties for either disclosed on nondisclosed positions. In short, the 6694 regulations require tax return preparers to be experts on the tax law and provide technical support for "unreasonable positions" which are negated by "substantial authority" for undisclosed positions and "reasonable basis" for disclosed positions. I find it quite strange that the return preparation industry is slow to realize the high standards preseantly required to support any complex factual or legal tax issue.

Although the preparer does not have to examine or verify supporting information, they should make sure that the support data meets the substantiation requirements of the tax regulations.

As a tax attorney, I document controversial positions with a legal memorandum. Disclosed positions are best supported with a legal memorandum to support the positions taken in order to prevent the return from being selected for examination and also to negate a possible section 6662 negligence penalty for your client.

Retained positions equire documentation of any tax related research (including authorities both for and against the tax position), the reasoning behind the conclusion, and relevant authorities supporting the conclusion. Reality check: return prepared can only avoid the 6694(a)and (b) penalties with an analysis of the relevant authorities when the nondisclosed positions are examined by the IRS. The section 6694(b) penalty will apply if the return preparer is perceived as "reckless" - the same term used in section 6662(c). I have little doubt that aggressive IRS examiners will term any lack of knowledge of a technical position as "reckless" where the issues are clearly covered by tax regulations (e.g., substantiation requirements), revenue rulings, IRS notices, reportable transactions, applicable case law and other authority that should have been known by the tax return preparer.

-- Division C, Act Sec. 506(a) of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), amending Code Sec. 6694(a);



-- Division C, Act Sec. 506(b), providing the effective date.