1.6694-2 of the proposed regullations

Section 1.6694-2(b) provides, as follows:

(b) Reasonable belief that the position would more likely than not be sustained on its merits—

(1) In general. A tax return preparer may “reasonably believe that a position would more likely than not be sustained on its merits” if the tax return preparer analyzes the pertinent facts and authorities, and in reliance upon that analysis, reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits. In reaching this conclusion, the possibility that the position will not be challenged by the Internal Revenue Service (IRS) (for example, because the taxpayer’s return may not be audited or because the issue may not be raised on audit) is not to be taken into account. The analysis prescribed by §1.6662-4(d)(3)(ii) (or any successor provision) for purposes of determining whether substantial authority is present applies for purposes of determining whether the more likely than not standard is satisfied. Whether a tax return preparer meets this standard will be determined based upon all facts and circumstances, including the tax return preparer’s diligence. In determining the level of diligence in a particular situation, the tax return preparer’s experience with the area of Federal tax law and familiarity with the taxpayer’s affairs, as well as the complexity of the issues and facts, will be taken into account. A tax return preparer may reasonably believe that a position more likely than not would be sustained on its merits despite the absence of other types of authority if the position is supported by a well-reasoned construction of the applicable statutory provision. For purposes of determining whether the tax return preparer has a reasonable belief that the position would more likely than not be sustained on the merits, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer’s firm), as provided in §1.6694-1(e).

(2) No unreasonable assumptions. A position must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person. For example, a position must not be based on a representation or assumption that the tax return preparer knows, or has reason to know, is inaccurate.

Under section 6694(a)(2)(A) as amended, the "more likely than not standard" was replaced by the "substantial authority" standard of conduct.

For that reason, the final regulations will amend section 1.6694-2(b) to provide that the return preparer must have a reasonable belief that the position will be sutained on its merits with "substantial authority."

The quantitavie analysis required will be reduced from "greater than 50 percent" to most likely "greater than 40%. It is hard to see what difference that will make because the "more likely than not" sandard and the "substantial authority" standard are each subjective standards.

If a return preparer is "negligent" then the penalty will apply automatically because the "substantial authority" standard will apply even if the return preparer is not negligent. If a return preparer is "negligent" then the $5,000
reckless" penalty will likely apply. Why? Because the position taken in the return MUST NOT be based on a representation or assumption that the tax return preparer knows, or has reason to know, is inaccurate.

How can any return preparer have a client that is negligent and then be able to take the position that he "had no reason to know" that his client was negligent?

Suppose the 6662 20% penalty applies to a client because the client did not did not have the records required under section 6001. How can a return preparer claim that he or she had no reason to know that the client kept inadequate records to substantiate expenses and deductions? A few questions to a client should surface the quality of client's records. Reliance on taxpayer data does not mean that the return preparer can get away with asking basic questions about the quality of the data.

In short, every time the section 6662 penalty applies to a client, the return preparer will have to defend against an IRS accusation that the return preparer had reason to know that the taxpayer/client was negligent. The IRS is an aggressive organization on examination issues. You can fairly assume that the IRS will always argue "you had reason to know" and then cite the regulations as their authority for that qestion. Now that the "reckless" penalty is $5,000, what will stop the IRS from determining that the return preparer is "reckless" when the taxpayer client is negligent? Also, the IRS assessment of the return preparer on the 6694(b) $5,000 penalty will be presumed to be correct.

The solution is simple. Even though the proposed regulations say you can rely on information provided by your client, do not fall for that "trap." Return preparers will need to make sure that the taxpayer can support all of the data submitted to the return preparer. After that threshold is passed, the return preparer will have to make sure the positions taken meet the "substantial authority" standard.

Given the large size of the penalties, it would be foolish for return preparers to think that they can rely on statements furnished by their clients without verification. More work is involved, but then you can charge for that additional time needed to prepare tax returns. Schedule C data should always be closely verified.

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