6694 Article - Taxes Magazine
I like seeing another article on 6694. It has a good discussion of the legislative history. I regret that it did not provide a "bread and butter" set of guidance how how the "substantial authority" standard will be met.
Shifting Sands Under Preparers’
Feet: Waiting for the Last Word on
Tax Return Preparer Penalties
By Michael J. Desmond and Christopher P. Murphy*
Michael J. Desmond and Christopher P. Murphy examine the
evolution of the preparer penalty regime and conclude with a
discussion of open issues and concerns with the current preparer
penalty standards.
In recent years, Congress has focused increased attention on improving compliance with the tax law. This heightened interest stems from a confl uence of events, including updated Internal Revenue Service (IRS) estimates of the “tax gap” re¬leased in 2 005,1 skyrocketing federal budget defi cits2 and the political appeal of fi nding ways to raise tax revenue without increasing taxes or cutting spend¬ing. The pressure on compliance only increased when Democrats regained control of Congress after the 2006 elections and refocused attention on the Congressional “pay-go” rules that require (at least in theory) every new tax expenditure to be offset with a revenue raiser.3 The heightened emphasis on compliance has generated a number of legislative, regulatory and administrative proposals.4 Until re¬cently, political constraints on legislation that might improve compliance, but could be viewed as a tax increase, focused the discussion on improved in¬formation reporting and tax penalty provisions. This focus helps to explain and put in context a number of recent changes to the return preparer penalty regime in Code Sec. 6694 of the Internal Revenue Code (“the Code”).
In the 20 years since Congress last overhauled the taxpayer accuracy-related and preparer penalty rules, there have been a number of proposals to modify those provisions to better target noncompliance. As the tax law has grown more complicated and paid preparers play an increasing role in our “voluntary” tax system,5 there has been a growing concern that preparers are falling short in their obligations to the tax system and, in some cases, even facilitating non¬compliance.6 In response, legislative proposals have been introduced to subject paid return preparers to regulation,7 the Treasury Department and the IRS have tightened the practitioner ethics rules under Circular 230,8 and increased government resources have been focused on pursuing problematic preparers.9
Against this backdrop, when debating revenue raisers to offset tax expenditures in the Small Busi¬ness and Work Opportunity Tax Act of 2007 (“the 2007 Act”),10 Congress again considered amending the return preparer penalty rules, an idea that had been circulating in various forms for a number of years. With little substantive debate on the amend¬ment, the fi nal version of the 2007 Act included the fi rst major changes to Code Sec. 6694 since 1989. These changes expanded the statute beyond prepar¬ers of income tax returns to include paid preparers of all returns, raised the confi dence standards pre¬parers are required to meet to avoid penalties and substantially increased the amount of the preparer penalty. The 2007 changes generated an immedi¬ate outcry from preparers, who argued that the new statute could actually hurt compliance by driving preparers out of business, forcing taxpayers to prepare their own returns or retain unscrupulous preparers who were not deterred by the increased penalty exposure.11
This article provides a general overview of the preparer penalty standards in place prior to the 2007 Act, a summary of the changes made in 2007, the interim guidance and proposed regulations that followed the 2007 changes, and a discussion of the statutory retraction from the 2007 Act made by the Tax Extenders and Alternative Minimum Relief Act of 2008 (“the 2008 Act”).12 Noteworthy provisions in fi nal preparer penalty regulations published in December 2008, shortly after passage of the 2008 Act, are also discussed. The article concludes with a summary of open issues under the new statute and the fi nal regulations and a discussion of some problematic aspects of the preparer penalty rules in their current form.
Evolution of the Preparer Penalty Regime
A. Preparer Penalty Regime Following the 1989 Act
In 1989, Congress amended the return preparer penalty rules in the Omnibus Budget Reconcilia¬tion Act of 1989 (“the 1989 Act”) to link them to the newly enacted accuracy-related penalty rules applicable to taxpayers under Code Sec. 6662.13 Under prior law, the preparer penalty was imposed only in the event of a “negligent or intentional dis¬regard of rules or regulations.”14 With the changes made by the 1989 Act, return preparers, like tax¬payers, were required to meet certain “confi dence” levels in order to avoid penalties with respect to reporting positions taken on returns they prepared. Importantly, under the 1989 Act, the confi dence levels that applied to preparers were lower than the confi dence levels that applied to taxpayers under Code Sec. 6662. Thus, as long as minimum stan¬dards were met, the taxpayer’s appetite for penalty exposure effectively controlled the reporting posi¬tion, and preparers generally were not subject to penalties on any position unless their clients would also have penalty exposure.
Under the 1989 Act, different confi dence require¬ments applied, depending on whether the return position was “disclosed” to the IRS.15 If disclosed, the position needed only to meet a low, “not frivolous” standard in order for a preparer to avoid penalties. If not disclosed, the return preparer had to meet a higher (but still relatively low) “realistic possibility of being sustained on the merits” stan¬dard.16 See Table 1.
Table 1.
Preparer Conf dence Standards Under the 1989 Act
“Tax Shelters” and Reportable No separate standard
Avoidance Transactions
Undisclosed Return Positions Realistic Possibility1
Disclosed Return Positions Not Frivolous2
Realistic possibility of success on the merits is the equivalent of a 1 in 3 chance of prevailing if the position is challenged. The standard is more fully defi ned in the prior version of Reg. §1.6694-2(b). See T.D. 8382, 1992-1 CB 392.
“Not frivolous” is the equivalent of a likelihood of success of at least 10 percent if the position is challenged. The standard is in the prior version of Reg. §1 .6694-2(c)(2) as being “not patently improper.” See T.D. 8382, 1992-1 CB 392; see also Staff of the Joint Comm. on Taxa¬tion, 106th Cong., 2d Sess., Comparison of Joint Committee Staff and Treasury Recommendations Relating to Penalty and Interest Provisions of the Internal Revenue Code, at 13, JCX-79-99 (1999), available at www.house.gov/jct/x-79-99.pdf.
Although the 1989 Act’s changes were not uni¬versally praised, they were generally accepted by taxpayers and preparers alike, essentially aligning the Code’s return preparer standards with other prevail¬ing ethical standards already in place.17 There is no evidence, however, that the 1989 Act’s changes had any measurable effect on compliance. As a result, new ideas to again modify the taxpayer and preparer penalty rules soon began to circulate.
In 1999, as part of a comprehensive review of the penalty and interest provisions of the Code, the Joint Committee on Taxation issued a report recommending that the minimum confi dence lev¬els for both taxpayers and paid income tax return preparers be raised to a “reasonable belief of more likely than not” standard.18 Over the ensuing years, proposals were introduced in Congress to raise the confi dence levels for both taxpayers and preparers, although they failed to generate broad popular or Congressional interest.19 With the release of the IRS’s updated tax gap estimate in February 2005, which showed that some $300 billion in taxes was owed but not paid each year, Congress refocused its attention on compliance measures and began to
consider a range of legislative compliance propos¬als in an effort to collect some of the $300 billion in lost annual “tax gap” revenue.
B. Changes to the Preparer Penalty Regime Made by the 2007 Act, Interim Guidance and Proposed Implementing Regulations
By early 2007, mounting political pressure to fi nd ways to improve compliance created an opportune environment for reconsideration of heightened preparer penalty standards. In May of that year, the 2007 Act was signed into law. The 2007 Act made a number of key changes to the preparer penalty regime, including the following:
Expansion beyond income tax returns. The preparer penalty was expanded to apply to preparers of all tax returns, rather than just income tax return preparers. While the stat¬ute remained linked to an “understatement of liability” (and thus seemingly limited to returns that actually report a tax liability) the long-standing defi nition of “return preparer”20 broadened application of the statute to include work done by any person that constituted a “substantial portion” of a return, thereby po¬tentially subjecting information returns and a wide range of other documents to the expanded preparer penalty rules, notwithstanding that these documents do not themselves refl ect an “understatement of liability.”
Increase in preparer confidence standards. For undisclosed positions, the “realistic pos¬sibility” confidence standard for avoiding preparer penalties was raised to require a “reasonable belief” that the position would “more likely than not be sustained on its merits.” The standard for disclosed positions was also raised, requiring a preparer to have a “reasonable basis” for the reporting position, replacing the prior “not frivolous” standard. See Table 2.
Table 2.
Preparer Confi dence Standards Under the 2007 Act
“Tax Shelters” and Reportable Avoidance Transactions
Undisclosed Return Positions
Disclosed Return Positions
Increase in penalty amount. The penalties ap¬plicable to “unreasonable” positions that did not meet the increased confi dence standards jumped from $250 per return to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer.21
By elevating the preparer confi dence standards above the standards generally applicable to taxpay¬ers under the accuracy-related penalty provisions of Code Sec. 6662, the 2007 Act created a troubling potential for confl icts of interest between preparers and their clients. When the substantial understate¬ment penalty under Code Sec. 6662(b)(2) and (d) is asserted against a taxpayer, that penalty can be avoided (so long as the adjustment is not attribut¬able to a “tax shelter”) if the taxpayer can show that it had “substantial authority” for its reporting posi¬tion.22 Similarly, the negligence penalty under Code Sec. 6662(b)(1) and (c) generally does not apply if there is at least a reasonable basis for the reporting position.23 Accordingly, after the 2007 Act, taxpayers could take an undisclosed reporting position that fell between the “substantial authority” and “more likely than not” confi dence standards, but paid preparers could not prepare the return taking that position without disclosure. This placed preparers in the uncomfortable position of requiring disclosure to protect themselves from penalties, while disclosure was not required from their clients, whose interests were actually against disclosure to the extent it would increase their audit risk. This confl ict was particularly troubling in the context of return positions that had no tax avoidance purpose, but fell short of the “more likely than not” standard as a result of ambiguities in the tax law and the absence of published guidance or other “authority.”24 Increasing the penalty to 50 percent of the preparer’s fee only compounded the potential for confl ict.
1. Interim Guidance Under the 2007 Act
Although changes to the preparer penalty rules had been under consideration by Congress for many years, inclusion of these changes in the 2007 Act came as a surprise to many preparers and to the IRS.25 This, combined with impending return fi ling deadlines and the need for more deliberate consid¬eration of transition rules, led the IRS to issue Notice 2007-54 on June 11, 2007.26 With the exception of understatements due to willful or reckless conduct by a preparer, Notice 2007-54 effectively delayed enforcement the 2007 Act changes to Code Sec.
6694 until 2008, with additional guidance promised by the end of 2007.
On December 31, 2007, the Treasury and the IRS issued Notice 2008-13, providing substantive, interim guidance on the 2007 Act changes to Code Sec. 6694.27 Among its more signifi cant provisions, Notice 2008-13 provided an expanded view of what consti¬tuted “adequate disclosure” of a position that would trigger the lower “reasonable basis” confi dence stan¬dard, provided a defi nition of the “reasonable belief of more likely than not” standard, and provided lists of the types of returns that would, could, and did not subject paid preparers to penalties.
Of particular signifi cance, Notice 2008-13 ad¬dressed the potential confl ict between preparers and their clients by relaxing the “disclosure” require¬ment that triggers a lower “reasonable basis” con¬fidence standard.28 For “nonsigning” preparers who may never see or re¬view the return that their work is ultimately report¬ed on, Notice 2008-13 provided a number of alternative mechanisms to meet the “adequate disclosure” test, thereby trigger¬ing the lower reasonable basis confi dence standard. In addition to actual disclosure on the return or on the return as prepared, under Notice 2008-1 3, the adequate disclosure test could be met by providing “a statement informing the taxpayer of any oppor¬tunity to avoid penalties under Code Sec. 6662 that could apply to the position as a result of disclosure, if relevant, and of the requirements for disclosure.” If the substantive advice was given in writing, this statement was required to be given in writing. If the advice was given orally, the statement could also be given orally, as long as the return preparer “[c] ontemporaneously prepared documentation ... suffi cient to establish that the statement was given to the taxpayer.” This disclosure mechanism (which has come to be known as the “speech rule”) effec¬tively allowed return preparers, through the simple expedient of a “statement,” to avoid the confl ict that would otherwise arise when the taxpayer was not required to disclose the position on its return in order to avoid accuracy-related penalties (i.e., when the confi dence level for the return position was somewhere between “substantial authority” and “more likely than not”).2. June 2008 Proposed Regulations
Although legislation was quickly introduced to modify the confi dence standards imposed by the 2007 Act,29 with no assurance of passage, the Treasury and the IRS proceeded with publication of proposed regulations in June 2008.30 Those regulations gener¬ally followed the template set out in Notice 2008-1 3, but also added a number of detailed new rules to relieve some of the pressure created by the 2007 Act. Noteworthy provisions in the proposed regulations included the following:
One preparer per firm rule. Modification of the prior “one preparer per firm” rule, which provided that when a person associ¬ated with a firm signed a return, that person alone was liable for the preparer penalty arising from any understatement on the return, regardless of actual culpability. Similarly, when several persons at a firm worked on a return but none of them signed the return, the “one preparer per firm” rule provided that only the person with “overall supervisory responsibility” for the firm’s work was liable for the penalty, again regardless of actual culpability. The proposed regulations use the prior rule as a starting point, assuming that the signing preparer or supervisor is liable for the penalty. However, the proposed regulations then add to that rule a “position-by-position” analysis. This analysis supports holding someone at the firm other than the signing preparer or supervisor liable for the position (or positions) giving rise to the understatement if information is available showing that another person should appropri¬ately be held liable. This modification to the “one preparer per firm” rule permits the penal¬ties to be targeted at the culpable individual (or individuals) within a firm, taking pressure off of signing and supervising preparers.
Reliance. The proposed regulations incorporate an expansion of the “reliance” rule set forth in Notice 2008-13, permitting preparers to reason¬ably rely on information provided by the taxpayer, other preparers, or third parties. Under prior regulations, the “reliance” concept was limited to reliance on taxpayer representations.
Penalty computation. The 2007 Act included a substantial increase in the amount of the preparer penalty, raising it to a maximum of 50 percent of the income derived from preparation of the return giving rise to an understatement. In the context of nonsigning preparers, the increased penalty amount gave rise to concerns over how broadly the IRS would interpret “income derived.” The proposed regulations address this by focusing on a specifi c return preparation engagement (if there is one) and allowing targeted allocation of the income derived from the engagement to the specifi c activity giving rise to the understatement, thereby reducing the base from which the penalty amount is computed.
Adequate disclosure. The proposed regulations follow the model of Notice 2008-13 by includ¬ing an expansive defi nition of “disclosure” to trigger the lower “reasonable basis” confi dence standard—the so-called speech rule.
Defi nition of “tax return preparer.” Some of the more troublesome issues that arose from the changes made by the 2007 Act stem from the long-standing, broad defi nition of “return preparer” (or, prior to 2007, “income tax return preparer”), which sweeps into the scope of the statute a wide range of persons who may not ever see, or have occasion to see, the return on which their work is reported. These “non-signing” preparers are nonetheless subject to penalties of up to 50 percent of their fees. Not¬withstanding the pressure brought to bear by this broad defi nition, the proposed regulations do not narrow the defi nition, although they do expand several de minimis safe harbors so that persons performing work on relatively nominal reporting positions are carved out (assuming they can somehow determine that the positions are in fact nominal). The proposed regulations also create an important new safe harbor. Pre¬viously, any advice given after a transaction closed subjected an individual to the return preparer penalty provisions. With the new safe harbor, individuals who spend less than fi ve percent of their aggregate time on advice given after the transaction has closed are not considered return preparers.
The June 2008 proposed regulations were, in part, overtaken by legislation enacted later in the year, although most of the provisions remained relevant notwithstanding changes made by the 2008 Act.
C. Congressional Retraction in the 2008 Act and Implementing Final Regulations
From 1989 through 2007, tax return preparers could take comfort in knowing the confi dence standards that applied to them were lower than the standards applicable to their clients. The change in confi dence standards included in the 2007 Act reversed this situation, subjecting preparers to more stringent stan¬dards than their clients and raising the prospect of signifi cant confl icts, particularly in situations where the “substantial authority” standard was met but the preparer could not reach a “more likely than not” conclusion with respect to the reporting position.
1. Bush Administration’s Budget Proposal
Recognizing the serious problems created by the 2007 Act, the Bush Administration’s Fiscal Year 2009 Bud¬get Bluebook, released in February 2008, included a proposal to change Code Sec. 6694 to “conform [the] penalty standards between preparers and taxpayers.”31 The proposal called for lowering the preparer standard for undisclosed positions to the substantial authority standard generally applicable to taxpayers, except in the case of “reportable avoidance transactions” covered by Code Sec. 6662A.32 Under this proposal, although taxpayers are generally subject to a “more likely than not standard” if the transaction involves a “tax shelter,” preparers would be held only to the lower substantial authority standard for tax shelter transactions. The disparate treatment of tax shelter transactions recognized the over-inclusive defi nition of that term under the accuracy-related penalty rules of Code Sec. 6662 (i.e., “a signifi cant purpose” of tax avoidance). The proposal also recognized the prob¬lems that the taxpayer-specifi c subjective defi nition of “tax shelter” could create if incorporated into a third party’s (i.e., a preparer’s) penalty standard. Under the Budget proposal, the standard for disclosed positions would remain at “reasonable basis,” as adopted by the 2007 Act.
2. 2008 Legislation
Following the Bush Administration’s Budget proposal, legislation was introduced in both the U.S. House of Representatives and the Senate to revise the con¬fi dence standards to address the confl ict of interest concern. More restrictive than the Administration’s proposal, the legislation introduced in 2008 in the House, H.R. 5719, and the Senate, S. 2851, retained
the “more likely than not” standard for “tax shelter” transactions where the taxpayer had a signifi cant purpose of avoidance or evasion of income tax. The legislative proposal to harmonize the taxpayer and preparer standards was later included in H.R. 6049, which contained, among other provisions, an extension of energy tax incentives and relief from the individual alternative minimum tax. Riding the coattails of the economic stimulus legislation that moved in the fall of 2008, H.R. 6049 and the proposal to again amend Code Sec. 6694 was included in a package of miscellaneous tax extender provisions and individual alternative minimum tax relief that was enacted as part of the stimulus legislation.33
As detailed below, the 2008 statutory change gen¬erally (but not completely) harmonized the taxpayer and return preparer penalty standards, thus address¬ing the troublesome gap between the substantial authority standard generally applicable to taxpayers and the return preparer standard. This general harmo¬nization was retroactive to May 25, 2007, although prospective changes were made by the 2008 Act subjecting a broad class of “tax shelter” transactions to the higher reasonable belief of more-likely-than¬not confi dence standard.
Table 3 summarizes the taxpayer standard and the evolution of the return preparer standard from May 2007 to current law.
3. December 2008 Final Regulations
The statutory changes made by the 2008 Act only modifi ed the confi dence standards for undisclosed positions under Code Sec. 6694, leaving unchanged the 2007 Act’s expansion of Code Sec. 6694 to cover all returns and to substantially increase the penalty amount. Accordingly, shortly after the 2008 Act passed, the Treasury and the IRS moved forward with fi nalizing the proposed June 2008 regulations to the extent that those regulations covered these and various other technical issues. Concurrent with publication of the fi nal regulations, the Treasury and the IRS released Notice 2009-5,34 which provided interim guidance on aspects of Code Sec. 6694 that were changed by the 2008 Act, including a defi nition of the new “substantial authority” standard. Notice 2009-5 also included interim guidance with respect to the elevated “reasonable belief of more likely than not” standard applicable to tax shelter transactions.
Open Issues and Concerns with the Current Preparer Penalty Regime
Recent legislative changes and administrative guid¬ance issued under Code Sec. 6694 have gone a long way in addressing some of the problems created by the 2007 Act, including the serious potential for confl ict between taxpayers and paid preparers. However, some of the administrative solutions to these problems, while perhaps justifi ed under the circumstances, have weakened the effect that the preparer penalty regime should have on improving compliance with the tax law. Since Congress contin¬ues to actively consider legislative measures to improve compliance and will likely return to the subject of paid preparers at some point in the near future, an ongoing discussion on recent and potential changes to Code Sec. 6694 is appropriate.
A. Application of Reasonable Belief of More-Likely-Than¬Not Standard to “Tax Shelter” Transactions
When enacted as part of the 1989 Act, the taxpayer accuracy-related penalty provisions in Code Sec. 6662 included special treatment for penalty defenses in the case of “tax shelter” transactions. Although the Code Sec. 6662(b) (2) penalty for substantial understatement of income tax could be avoided for an undisclosed position if there was “substantial authority” for that position, in the case of a “tax shelter” transaction, the confi dence standard was elevated in 1989 to reasonable belief of more likely than not. At the time, “tax shelter” was defi ned to include any transaction where “the principal purpose” was the “avoidance or evasion of Federal income tax.”35 Since 1989, this “tax shelter” exception has been modifi ed on several occasions, most signifi cantly in 1997, when the subjective “the principal purpose” test was lowered to the current “a significant purpose” test, greatly expand¬ing the scope of the tax shelter carve out for pen¬alty disclosure defenses.36
Without a meaningful ex¬planation of “a signifi cant purpose,” this defi nition of tax shelter has proven problematic both because of its scope and because it turns on a taxpayer’s subjective intent.37 As the ABA Section of Taxation recently noted, when combined with ambiguous reportable transaction reporting rules, the undefi ned nature of “tax shelter” creates “imprecision and com¬plexity [that] impairs effective enforcement and does little to encourage compliance.”38 Absent a meaning¬ful defi nition of tax shelter, conventional wisdom among practitioners is to assume that a transaction involving even a marginal amount of tax planning, even if it is otherwise consistent with Congressional intent and imbued with meaningful nontax purpose and benefi ts, can be swept into the broad defi nition of tax shelter.39
Against this backdrop, incorporation of the Code Sec. 6662 defi nition of “tax shelter” into the preparer penalty statute by the 2008 Act raises a number of concerns. First, the defi nition is inherently subjec¬tive, turning on the taxpayer’s intent in entering into a transaction. While a paid preparer will often be aware of a client/taxpayer’s tax-avoidance motive, this will not always be the case. Since 50 percent of their fee is on the line, preparers uncertain of the client’s intent will have to assume that there is a signifi cant purpose of tax avoidance. With that assumption, the preparer must (with the caveatof the “tax shelter speech rule” in Notice 2 009-5 discussed below) be at a confi dence level of more likely than not, or the preparer cannot prepare the return. This raises a signifi cant concern in the context of the myriad reporting positions that fall short of a more likely than not confi dence level because of an ambiguous statutory provision and the absence of interpretive guidance. It is these very “uncertain” positions on which taxpayers should be encouraged to seek help from paid preparers. The tax shelter pro¬visions of Code Sec. 6694, however, seem to drive
taxpayers in the opposite direction, away from the professionals who are in the best position to un¬derstand them.
Second, the Code Sec. 6662 definition of tax shelter is an imperfect fi t for the preparer pen¬alty regime. As noted, the 2007 Act expanded Code Sec. 6694 to apply to all returns, not just income tax returns. Linking the heightened confi dence standards for “tax shelters” to Code Sec. 6662, however, appears to limit the heightened standard to income tax returns since the defi nition of tax shelter in Code Sec. 6662(d)(2)(C) is limited to transactions with a signifi cant purpose of avoiding “Federal income tax.” Thus, although preparers of excise, employment, transfer and other tax returns are now subject to Code Sec. 6694, transactions with a “signifi cant purpose” of avoiding taxes other than income taxes are not covered by the heightened confi dence standard otherwise applicable to “tax shelters.”
In Notice 2009-5, the Treasury and the IRS rec¬ognized the problem with applying a heightened preparer confi dence standard to tax shelters. Indeed, Notice 2009-5 acknowledges the long-standing defi - nitional problem under Code Sec. 6662 generally, noting that the Treasury and the IRS are currently “consider[ing] further guidance for tax return prepar¬ers and taxpayers on the defi nition of tax shelter for purposes of Code Secs. 6694 and 6662(d)(2)(C).”40 This may be a signal that the Treasury and the IRS are considering a more targeted interpretation of “tax shelter,” although the statutory reference to “signifi - cant purpose” of tax avoidance or evasion may limit the options for administrative relief.
As a stop-gap measure, Notice 2009-5 provides interim guidance on application of the heightened preparer penalty standard applicable to tax shelters. Specifi cally, Section C of the Notice provides that a position with respect to a tax shelter will not be deemed “unreasonable,” and in turn will not trigger preparer penalties, if (i) there is substantial author¬ity for the position, and (ii) “the tax return preparer advises the taxpayer of the penalty standards appli¬cable to the taxpayer in the event that the transaction is deemed to have a signifi cant purpose of Federal tax avoidance or evasion.”41 In order to meet this modifi ed “tax shelter speech rule” safe harbor and trigger the lower “substantial authority” standard, the preparer “must explain [to the taxpayer] that, if the position has a significant purpose of tax avoidance or evasion, then there needs to be at a minimum substantial authority for the position, [and] the taxpayer must possess a reasonable belief that the tax treatment was more likely than not the proper treatment.”42 As a practical matter, it is not clear how a taxpayer could form a “reasonable belief of more likely than not” when the preparer could not reach that confi dence level.
While this “tax shelter speech rule” is an understandable and pragmatic rule under the cir¬cumstances, it raises a number of issues. First, it has no basis in the statute, which unambiguously requires a “reasonable belief of more likely than not” confi dence level for tax shelters, allows for no disclosure or other exceptions, and provides no grant of regulatory authority to narrow its scope.43 In fact, the 2008 Act specifi cally rejected the Bush Administration’s proposal to apply the lower substantial authority standard to tax shelter transactions.44 In contrast, the “disclosure speech rule” included in Notice 2008-13 and incorporated in the December 2008 fi nal regulations triggered lower confi dence standards for disclosed positions, keying off the statutory reference to “adequate disclosure.”45 The “disclosure speech rule” also had precedent in regulations dating back to 1977, of which Congress was presumably aware when it enacted changes to Code Sec. 6694 in 2007 and 2008. The “tax shelter speech rule” included in Notice 2009-5 has no similar basis in the statute or in historical interpretation.
Second, the “tax shelter speech rule” arguably weakens the statute by easily permitting return preparers to take return positions on tax structured transactions at confi dence levels below 50 percent.
In balancing application of the heightened standard to a wide range of nonabusive transactions that lack a clear answer under the Code against the prophylactic effect the statute might have on truly abusive transactions (since it would arguably pre¬vent preparers from taking return positions at all), the Notice probably reaches the right result, but only through an unconventional path that is diffi cult to reconcile with the statute. A more reasoned ap¬proach would be for Congress to revisit application of the heightened “tax shelter” standard to prepar¬ers, recognizing the problem that Notice 2009-5 attempts to address.
Finally, the “tax shelter speech rule” is problem¬atic because it is either wrong as a matter of law or, at a minimum, misleading in contexts outside income tax. Specifi cally, Notice 2009-5 states that “if the position has a signifi cant purpose of tax avoidance” then the preparer must inform the tax¬payer that there must be substantial authority and a reasonable belief of more likely than not in order for the taxpayer to avoid penalties.46 As noted above, positions with a signifi cant purpose of avoiding tax other than income tax are not subject to the height¬ened confi dence standards of Code Sec. 6694, nor do taxpayers need to meet a heightened confi dence standard to avoid accuracy-related penalties with respect to non–income tax return positions. Notice 2009-5 links the “tax shelter speech rule” to the ac¬curacy-related penalty under Code Sec. 6662(d),47 which applies only to income tax, but it makes no mention of this statutory limitation in contexts out¬side income tax. Code Sec. 6694 is illogical in its application outside income tax and Notice 2009-5 serves only to compound the problems created b
y the statutory cross-reference to Code Sec. 6662’s defi nition of “tax shelter.”
B. “List” of Returns Subject (and not Subject) to Code Sec. 6694
Since its enactment in the 1 970s, the penalty imposed by Code Sec. 6694 has been limited to preparation of returns that refl ect an understatement of a tax liability.48 However, the defi nition of “return preparer” (and, before the 2008 Act, “income tax return preparer”) under Code Sec. 7701 (a)(36), to¬gether with the long-standing regulatory defi nition of that term, have broadened the scope of the penalty, keying off the statutory reference to preparation of a “substantial part” of a return. Thus, although Code Sec. 6694 itself is limited to preparation of
returns that refl ect an understatement, the defi nition of “preparer” sweeps in a wide range of persons whose work is incorporated into a return but who may never have occasion to see the return. Since the phrase “substantial part” is defi ned by the regulations only in very general terms (although the regulations do have narrowing safe harbor rules), nonsigning preparers often must assume that their work makes them a “return preparer,” potentially exposing them to penalties.
Although the expansive defi nition of “preparer” has been in the Code and regulations for many years, it created few problems when the confi dence standard for disclosed positions was at “reasonable basis.” When that standard was elevated by the 2007 Act to “reasonable belief of
more likely than not,” the large universe of non-signing preparers whose work is incorporated into a return grew understandably concerned that, without extensive diligence into exactly how that work is incorporated, 50 percent of their fees could be at risk. This created a particular concern for “preparers” of Forms 1099, W-2 and other infor¬mation returns, which are often generated in large volumes with little or no payee-specifi c diligence by the preparer. This issue remains a concern even after the standard for undisclosed (non–tax shelter) positions was lowered to substantial authority by the 2008 Act. Notice 2008-13 addressed this is¬sue on an interim basis by including as Exhibit 1 to the Notice a schedule of “returns” that report a liability and were explicitly included within the scope of Code Sec. 6694. The Notice also included, as Exhibit 2, a schedule of fl ow-through and other information returns that “may” subject a preparer to penalties. To address the concerns of preparers of information returns, Exhibit 3 to Notice 2008- 13 categorically excluded from Code Sec. 6694 (absent willful or reckless conduct under Code Sec. 6694(b)) a schedule of certain “pure” information returns such as Forms 1099 and W-2.
Consistent with the interim guidance provided in Notice 2008-1 3, the December 2008 fi nal regula¬tions identify (by reference to guidance published in the Internal Revenue Bulletin) “returns” that “will”(assuming other requirements are met), “may,” and “do not” subject preparers to penalties under Code Sec. 6694.49 Given the critical role that information returns play in compliance, the risk that preparers of such returns might drop that work out of a con¬cern for penalty exposure make inclusion of these lists (the “do not” list for information returns in particular) understandable. Permanently incorporat¬ing into the regulations the list approach of Notice 2008-1 3, however, raises several issues.
First, the list is both over- and under-inclu¬sive. Although it is not clear that Congress fo¬cused on this issue when enacting recent changes to Code Sec. 6694,50 the regulatory defi nition of “substantial part” can, in theory, sweep in per
sons who prepare a wide
range of documents and other information that do not carry IRS form numbers on them. For example, depreciation schedules, cost allocation schedules and other similar documents, assuming they relate to signifi cant items on a return, could make preparers of those documents preparers of a “signifi cant part” of a return. For the multitudes of accountants, book¬keepers, and others who do not think of themselves as preparing “returns,” but whose work is ultimately incorporated into a return (although not refl ected on a document with an IRS form number on it), the “list” approach does nothing to provide them with any indication of whether they will be considered a return preparer.
Moreover, some of the pure information returns that are carved out of Code Sec. 6694 (absent willful or reckless conduct under Code Sec. 6694(b)) may themselves be problematic and lead to noncompli¬ance. For example, a Form 1 099 issued under the preparer’s erroneous determination that a service provider is an independent contractor rather than an employee can lead to an obvious compliance problem, but Code Sec. 6694 has no application in this context.51 Similarly, the preparer of a Form W-2 that erroneously reports or omits deferred compen¬sation gives rise to serious compliance problems, but Code Sec. 6694 has no application, even if the issue is a “signifi cant part” of the employee’s Form 1040 income tax return.
In addition to the fact that the line between “re¬turns” that are and are not subject to Code Sec. 6694 is now somewhat arbitrary, the “list” approach is also problematic in that it requires regular updates and requires preparers to constantly check the Internal Revenue Bulletin simply to determine whether they “are,” “may be” or “are not” subject to penalties. This adds another layer of complexity to what should be a straightforward penalty regime.52
A better approach would be to revisit the broad defi - nition of “preparer” as including persons who prepare a wide range of documents that feed into a return but do not themselves refl ect an understatement of tax li¬ability. This broad defi nition already raises issues for other reasons, because preparers of these documents may never have reason to see the return to determine if the work they perform is a “substantial portion” of the reported (or unreported) liability.53 Narrowing the defi nition of “preparer” to include only persons who determine and control numbers actually reported on the return (whether they actually input those num¬bers or not) would go a long way to addressing this problem. This narrower defi nition of preparer could be accompanied by special add-on rules to ensure inclusion of partnership and other passthrough entity returns, and other special situations.
C. Reliance on Information Provided Regulations promulgated under Code Sec. 6694 have long provided that preparers may rely on taxpayer representations in preparing a return.54 Such reliance has been conditioned, however, on application of a due diligence standard precluding preparers from relying on information provided by a taxpayer that they know or have reason to know is inaccurate or incomplete. With the heightened pressure on preparers imposed by the 2007 Act, and taking into consideration the growing complexity of the tax law, the 2008 proposed regulations expanded and modifi ed the historical reliance rule in several ways.55 First, the proposed regulations permitted reasonable reliance on information provided by other preparers including, for example, preparers of prior year returns or preparers of separate schedules for a current year return. Second, the proposed regulations permitted reasonable reliance on representations by any third party—a rule which effectively subsumes the separate rule permitting reliance on other preparers. Finally, the historical rule permitting reliance on taxpayer repre¬sentations was qualifi ed in the proposed regulations with a prohibition on relying on information provided by a taxpayer with respect to legal conclusions on federal tax issues.
The December 2008 fi nal regulations retained the expanded reliance rule for information provided by other preparers and third parties. Responding to comments on the challenge inherent in dis¬tinguishing between taxpayer legal and factual representations, the fi nal regulations eliminated the proposed rule prohibiting reliance on taxpayer representations with respect to legal conclusions on federal tax issues. The fi nal regulations make clear, however, that the general due diligence standard must still be met.56
Growth in the complexity of the tax law since the reliance rule was fi rst promulgated in the 1 970s has led to increased specialization in the preparation of tax returns, warranting a broader reliance rule. Com¬plex returns of multi-national businesses often have numerous “return preparers” all around the globe and it would bring the U.S. return preparation process to a standstill if a signing preparer were required to reach a substantial authority (or, for tax shelters, a more likely than not) comfort level with respect to each of the numerous inputs to a complex tax return.
Contrary to the goal of an expanded reliance rule, the practical effect of the rule is to lower the confi - dence standard for the person ultimately signing off on the return. So long as the signing preparer was not aware of any problems with the inputs to the return (which will be rare, given that there is no ap¬parent obligation to inquire), that preparer can meet a high confi dence standard even if the reporting position itself stands on shaky ground.57 The three “diligence” examples included in the fi nal regulations are focused on individual taxpayers and do little to articulate a generally applicable rule, to say nothing of a rule targeted to complex returns of multinational businesses. Although the IRS may be able to pursue penalties against the third-party preparer (assuming the “substantial portion” test is met), doing so im¬poses a signifi cant administrative burden on the IRS, multiplies the number of preparer penalty inquiries, and has no practical effect if the third-party preparer is outside the United States. Moreover, the responsi¬bility of the IRS to proceed against either the signing preparer (on an assertion that reliance on a third party was unreasonable) or a third-party preparer, will be complicated by the fact that the IRS has the burden of production on preparer penalties.58 In the end, the broad reliance rule materially weakens the heightened preparer confi dence standards.
To address this weakness, consideration should be given to additional language that would better de¬scribe a general due diligence standard. One possible method for accomplishing this would be to require a basic inquiry by the signing preparer into the inputs to a return, helping to ensure that those inputs are reli¬able.59 This could include, for example, a requirement that the preparer ask who prepared each input, inquire as to that person’s familiarity with the issue covered, and ask about that person’s historical relationship with the taxpayer. In many cases, the preparer will already know the answer to these questions, in which case no additional burden would be imposed. In other cases, mandating such basic inquiries would impose only a minimal burden unless the answers to those inquiries cannot be determined, in which case the reliability of the input should be questioned in any event. A paral¬lel set of diligence standards could be required for items omitted from returns, an issue relevant mostly to individuals and small businesses that do not have the compliance backstop of audited fi nancial statements. These parallel diligence standards could include, for example, a basic list of questions targeted to particular compliance issues associated with particular returns such as offshore bank accounts, household employees and cash and in-kind income not otherwise reported on information returns. Most preparers already make some type of general inquiry along these lines, but there is nothing in the 2008 fi nal regulations that requires any targeted diligence unless the preparer “knows or has reason to know” that the information actually being provided is inaccurate.
D. One Preparer Per Firm Rule
In regulations promulgated in 1991 (after the 1989 Act), the Treasury and the IRS considered changing the “one preparer per fi rm” rule, which historically re¬quired that for both signing and nonsigning preparers, only one person would be on the hook for penalties. This led to obvious inequities in situations where, for example, a mid-level manager at a large accounting fi rm takes direction from a corporate partner on the proper reporting of a complex merger transaction that leads to an understatement. When the manager signs the return and has responsibility for all aspects of its preparation other than with respect to the merger transaction, under the prior regulations the manager was liable for the penalty, notwithstanding that the corporate partner was the culpable individual. While acknowledging the unfairness of this situation, in the 1991 regulations the Treasury and the IRS explicitly rejected a more targeted rule on the grounds that it would be too complex for the IRS to administer and lead to irresolvable fi nger pointing within a fi rm.60
As with the reliance rule, under the heightened confi dence standards and increased penalty amounts imposed by the 2007 and 2008 Acts, there were prag¬matic and equitable reasons for the Treasury and the IRS to revisit the “one preparer per fi rm” rule. In an effort to address the countervailing administrative burden, the December 2008 fi nal regulations adopt a rebuttable presumption that the signing preparer or supervisory nonsigning preparer is liable.61 This approach gives the signing or supervisory nonsign ing preparer the ability to escape penalty liability if they can make a showing that some other person within their fi rm was responsible for the position giving rise to the understatement.62
Qualifying the “one preparer per fi rm” rule is clearly the right approach under the new, toughened statute. It does, however, again illustrate the practical problem of Congress imposing heightened confi - dence standards and penalty amounts. The rebuttable presumption gives signing and supervising preparers another “out” from penalty liability, weakening the effectiveness of the statute and again suggesting that the changes made by the 2007 Act and the 2008 Act will not have their desired affect of improving compliance. A better approach might be to heighten the due diligence standards, as discussed in Part 3(C) above, or revise the defi nition of “return preparer” so that it does not apply to such a large universe of individuals within a fi rm, in which case relief from the historical one preparer per fi rm rule might not be necessary.
E. Juxtaposition of Preparer Penalty and Taxpayer Defi ciency Proceedings
As an assessable penalty, Code Sec. 6694 cre¬ates a procedural issue and potential for conflict since it can be assessed against a preparer long before the taxpayer “understatement” on which it is based is finally determined. In the typical case, one would expect the IRS to open an examina¬tion of a taxpayer’s return and, at the end of the audit, make a deficiency determination, adding accuracy-related penalties in appropriate cases. Near the conclusion of the taxpayer’s audit, the IRS would also open an examination of the preparer (or preparers) of the return or position giving rise to the understatement. Although the taxpayer would have the right (after exhausting administrative ap¬peals) to challenge the deficiency determination in Tax Court—thus delaying assessment—the pre-parer would not.63 Parallel taxpayer deficiency and preparer penalty refund proceedings could force the preparer into a difficult position of personally defending against a Code Sec. 6694 penalty at the same time that the taxpayer is defending the transaction on its merits.
Whether and to what extent this procedural is¬sue and potential for confl ict creates problems for taxpayers, preparers and the courts under the heightened penalty standards remains to be seen. The possibility for confl ict could be mitigated by ap¬propriate IRS coordination and exercise of discretion in bringing preparer penalty claims only in cases that truly deserve them, rather than as a tactical tool to drive a wedge between preparers and their clients.64 Should this become an issue, an alternative approach might be to consider amending Code Sec. 6501 to toll the assessment limitations period for Code Sec. 6694 penalties until after resolution of the underlying defi ciency proceeding. While this could delay resolution of the preparer penalty, it would ensure that the penalty is not imposed if the taxpayer prevails in its case. Even under current law, ultimate resolution will always be delayed, since Code Sec. 6694 mandates that the preparer penalty be abated if the IRS makes a fi nal determination “at any time” that the taxpayer did not have an understatement(i.e., regardless of whether the refund limitations period for the preparer penalty has expired).
Conclusion
Although compliance rates in the United States compare favorably with those in other developed countries, they can and should be improved. With unprecedented federal budget deficits and the political appeal of raising revenue from improv¬ing compliance rather than raising taxes or cutting spending, policy makers will continue to focus sig¬nifi cant attention in this area. Given the critical role that paid return preparers play in facilitating compli¬ance and the shortcomings of the current preparer penalty regime, new proposals to modify Code Sec. 6694 can be expected. Those proposals should be debated in the context of broader changes to the pro¬cedural rules in the tax law, including the taxpayer penalty regime and the over-inclusive defi nition of “tax shelter.” In an ideal world, they would also be debated in the context of broader tax reform and simplifi cation, since complexity is perhaps the larg¬est driver of noncompliance. Until that day comes, incremental improvements to the preparer and tax¬payer penalty regimes can and should be made. The fl urry of legislative and regulatory activity since 2007 is by no means the last word in this area.
ENDNOTES
* Helpful comments on and a review of this article were provided by Ronald L. Buch, Jr.
1 See New IRS Study Provides Preliminary Tax Gap Estimate, IR-2005-38 (Mar. 29, 2005), available at www.irs.gov/news¬room/article/0,, id= 137247, 00.html; see also Understanding the Tax Gap (IRS Fact Sheet), FS-2005-14 (Mar. 2005), available at www.irs.gov/newsroom/ article/0,, id= 137246, 00.html.
2 Congressional Budget Office, The Bud¬get and Economic Outlook: Fiscal Years 2009–2019, at 1 (Jan. 2009), available at www.cbo.gov/ftpdocs/99xx/doc9957/01- 07-Outlook. pdf.
3 See, e.g., Heidi Glenn, Pay-Go Puts K Street on Guard, 2007 TNT 54-8 (Mar. 20, 2007).
4 See, e.g., Staff of the Joint Comm. on Taxation, 105th Cong., 1st Sess., Options to Improve Tax Compliance and Reform Tax Expenditures, at 6, JCS-02-05 (2005), available at www.house.gov/jct/s-2-05.pdf (detailing numerous proposals designed to improve compliance by “curtailing tax shelters, closing unintended loopholes, and addressing other areas of noncompliance in
present law”); Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2007 Revenue Proposals, at 123 (Feb. 2006), available at www.ustreas.gov/ offi ces/tax-policy/library/bluebk06.pdf (de¬tailing an expansion of the return preparer penalty to all tax return preparers).
5 See Government Accountability Offi ce, Paid Tax Return Preparers: In a Limited Study, Chain Preparers Made Serious Errors, at 1, GAO-06-563T (Apr. 4, 2006), avail¬able at www.gao.gov/new.items/d06563t. pdf (‘‘GAO Preparer Report’’) (noting that several hundred thousand individuals are authorized to practice before the IRS, while the estimate of unenrolled return preparers is as high as 600,000); see also National Taxpayer Advocate, 2007 Annual Report to Congress, Vol. 2, at 45, note 5, available at www.irs.gov/pub/irs-utl/arc_2007_vol_2. pdf (stating that there may be as many as 800,000 unenrolled tax return preparers).
6 See GAO Preparer Report, supra note 5.
7 See, e.g., Taxpayer Protection & Assistance Act of 2005, S. 832, 109th Cong., 1st Sess., §4 (2005).
8 T.D. 9165, 2005-1 CB 357 (effective date of
December 20, 2004).
9 In recent years, the IRS has seen a steady increase in its enforcement budget. Re¬cently passed legislation increased the IRS’s enforcement funding in fi scal year 2009 by $337 million over appropriated funding for 2008. See the Omnibus Appropriations Act of 2009 (P.L. 111-8), 123 Stat. 524 (2009). Additionally, the IRS’s enforcement budget grew by $93.5 million in FY 2008. See Department of the Treasury, Budget in Brief FY 2009, available at http://treas.gov/offi ces/ management/budget/budgetinbrief/fy2009/ irs.pdf.
10 Small Business and Work Opportunity Tax Act of 2007 (P.L. 110-28).
11 The Joint Committee on Taxation estimated that the changes to Code Sec. 6694 made by the 2007 Act would raise $82 million in revenue through 201 7, see Staff of the Joint Committee on Taxation, Estimated Revenue Effects of the Tax Provisions Contained in H.R. 1591, as Passed by the Senate on March 29, 2007, 110th Cong., 1st Sess., JCX-22-07 (Apr. 4, 2007), a number that many believed would be dwarfed by the increased cost of complying with those changes.
12 Alternative Minimum Relief Act of 2008 (P.L. 110-343), §506, 122 Stat. 3765 (2008).
13 Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239), §7732, 103 Stat. 2106 (1989); see also id., at §7721(a) (enacting taxpayer accuracy-related penalty provi¬sions, codifi ed at Code Sec. 6662).
14 Code Sec. 6694(a) (1988).
15 In this context, “disclosed” was defi ned to mean “disclosed as provided in Code Sec. 6662 (d)(2)(B)(ii)” which, in turn, meant “ad¬equately disclosed in the return or in a state¬ment attached to the return.” The concept of “disclosure” is discussed in more detail below, in the context of statutory changes made in 2007 and 2008.
16 Final regulations implementing the changes to Code Sec. 6694 made by the 1989 Act were released in 1991. T.D. 8382, 1992-1 CB 392, 394.
17 For a more detailed discussion regarding the background of industry ethical standards and return preparer regulation, see R. Pai &
C. Murphy, 2007 Amendments to Internal Revenue Code Section 6694 Raise New Is¬sues and Concerns for Taxpayers and Return
Preparers, DAILY TAX REP. (BNA), Oct. 31, 2007, No. 210, ISSN 1522-8800.
18 Staff of the Joint Comm. on Taxation, Study of Present-Law Penalty and Interest Provi¬sions as Required by Section 3801 of the IRS Restructuring and Reform Act of 1998 (Including Provisions Relating to Corporate Tax Shelters), Volume I, 106th Cong., 1st Sess., at 153, JCS-3-99 (1999), available at http://frwebgate.access.gpo.gov/cgi-bin/ getdoc.cgi?dbname= 1999_joint_commit¬tee_on_taxation&docid= f:57655.pdf.
19 See, e.g., Abusive Tax Shelter Shutdown and Taxpayer Accountability Act of 2005, H.R. 2626, 109th Cong., 1st Sess. (2005); Tax Shelter Transparency Act, S. 2498, 107th Cong., 2d Sess. (2002); Community Solu¬tions Act of 2001, H.R. 7, 107th Cong., 1st Sess. (2001).
20 See Code Sec. 7701 (a)(36)(A) (2006) (“[T]he preparation of a substantial portion of a return or claim for refund shall be treat¬ed as if it were the preparation of such return or claim for refund”); Reg. §301 .7701-15(b) (2006) (defi ning “substantial preparation”).
21 Code Sec. 6694(a). For understatements due to willful or reckless conduct, the 2007 Act increased the penalty to $5,000 or 50 percent of the income derived from such conduct. See Code Sec. 6694(b). Oddly, the maximum penalty is the same (50 percent of income derived) regardless of whether the position was “unreasonable” because the “more likely than not” standard could not be met (myriad positions, many of which have nothing to do with tax avoidance) or because of willful or reckless conduct by the preparer.
22 Code Sec. 6662(d)(2)(B)(i); Reg. §1 .6662-4- (a).
23 Reg. §1 .6662-3(b)(1) (“A return position that has a reasonable basis ... is not attributable to negligence”); see Staff of the Joint Comm. on Taxation, 106th Cong., 2d Sess., Com¬parison of Joint Committee Staff and Treasury Recommendations Relating to Penalty and Interest Provisions of the Internal Revenue Code, at 13, JCX-79-99 (1999), available at www.house.gov/jct/x-79-99.pdf (stating that “reasonable basis” generally has “at least a 20% likelihood of success if challenged”).
24 “Authority” in the context of taxpayer accuracy-related and preparer penalties is defi ned by Reg. §1 .6662-4(d)(3)(iii). See also Reg. §1 .6694-2(b)(2) (cross-referencing Reg. §1 .6662-4(d)(3)(iii)).
25 Dustin Stamper, Treasury to Address Preparer Disclosure Standard Changes, 115 TAX NOTES 1008 (June 11, 2007) (citing the statement of former IRS Chief Counsel Donald Korb, who noted that he was completely surprised by the change in law).
26 Notice 2007-54, 2007-2 CB 12.
27 Notice 2008-13, 2008-1 CB 282. Con¬temporaneous with the release of Notice 2008-13, the Treasury and the IRS released Notice 2008-12, 2008-1 CB 280, which provided interim guidance on the preparer signature requirement in Code Sec. 6695 (also amended and expanded in the 2007 Act), and released Notice 2008-11, 2008-1 CB 279, which clarifi ed the immediate tran¬sition relief provided by Notice 2007-54.
28 Precedent for the relaxed “adequate dis¬closure” standard has been in the regula¬tions under Code Sec. 6694 since 1977. Specifi cally, former Reg. §1.6694-2(c)(2) (A) provided that a nonsigning preparer who could not meet the “realistic possibil¬ity” standard would be deemed to have “adequately disclosed” the position if the preparer’s advice “include[d] a statement that the position lacks substantial authority and, therefore, may be subject to penalty under Code Sec. 6662(d) unless adequately disclosed [by the taxpayer].” Reg. §1.6694- 2(c)(2)(A) (2007) (adopted by T.D. 7519, 1978-1 CB 391 (Nov. 17, 1977)).
29 See H.R. 5719, 110th Cong., 2d Sess. (2008); S. 2851, 110th Cong., 2d Sess. (2008).
30 73 FR 34560-01 (June 17, 2008).
31 Department of the Treasury, General Ex¬planations of the Administration’s Fiscal Year 2009 Revenue Proposals, at 93 (Feb. 2008), available at www.ustreas.gov/offi ces/ tax-policy/library/bluebk08.pdf.
32 Under the Budget proposal, reportable avoidance transactions would remain subject to the higher “reasonable belief of more likely than not” standard. Reportable avoidance transactions are defi ned in Code Sec. 6662A(b)(2) to include listed transac¬tions (identifi ed pursuant to Reg. §1.6011-4 (b)(2)) and other reportable transactions (defi ned under Reg. §1.6011-4(b)(3)–(b)(6)) that have a “signifi cant purpose” of avoid
ance or evasion of income tax.
33 Tax Extenders & Alternative Minimum Tax Relief Act of 2008 (P.L. 110-343), §506, 122 Stat. 3765, 3862 (2008).
34 Notice 2009-5, IRB 2009-3, 309.
35 Code Sec. 6662(d)(2)(C)(ii) (1989).
36 Taxpayer Relief Act of 1997 (P.L. 105-34), §1028(c)(1), 111 Stat. 788 (1997). See Staff of the Joint Comm. on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997, at 221-25 (“1997 Blue Book”) (Comm. Print 1997) (noting that the change in the tax shelter standard was intended to “improve compli¬ance with the tax laws ... by discouraging taxpayers from entering into questionable transactions”).
37 The Treasury and the IRS attempted to defi ne “tax shelter” in this context in now superseded regulations under Code Sec. 6112. See T.D. 9046, 2003-1 CB 614 (prior fi nal Reg. §301.6112-2(b)); see also Reg. §1.6662-4(g)(3) (circular defi nition of “tax shelter,” as including an item “directly or indirectly linked to the principal purpose of a tax shelter to avoid or evade Federal income tax”). The regulations under Code Sec. 6662 have remained unchanged over 10 years after Code Sec. 6662 was amended from “the principal purpose” to “a signifi cant purpose.”
38 ABA Section of Taxation, Statement of Policy Favoring Reform of Federal Civil Tax Penal¬ties, at 6 (Apr. 21, 2009), available at www. abanet.org/tax/pubpolicy/2009/090421state mntciviltaxpenalties.pdf.
39 See, e.g., Michael L. Sch ler, Effects of Anti¬Tax-Shelter Rules on Nonshelter Tax Practice, 2005 TNT 219-41 (Nov. 14, 2005) (noting that “almost any transaction that results in tax savings might be said to have a signifi cant purpose of tax avoidance”); Nathan W. Gies¬selman, A Signifi cant Problem Defi ning a “Signifi cant Purpose” and the Signifi cant Dif¬ficulties that Result, 2006 TNT 108-34 (June 5, 2006) (discussing the meaning within the context of Circular 230). Problems created by the expansive but undefi ned scope of “tax shelter” have been compounded by incorporation of the Code Sec. 6662(d)(2) (C) “defi nition” into other provisions of the Code. See Code Secs. 461(i), 1274(b)(3) (B), 7525; see also Code Sec. 6662A(b)(2) (B) (linking heightened penalty provision to transactions with a “signifi cant purpose” of tax avoidance).
40 Notice 2009-5, IRB 2009-3, 309 (empha¬sis added). The current Priority Guidance Plan lists a project under Code Sec. 6662, which could provide a vehicle for the Treasury and the IRS to revisit the broad defi nition of tax shelter, although sugges¬tions on how to better defi ne “signifi cant purpose” of tax avoidance have been few and far between. Department of the Trea¬sury, 2008–2009 Priority Guidance Plan
Waiting for the Last Word on Tax Return Preparer Penalties
(Sept. 10, 2008), available at www.irs. gov/pub/irs-il/2008-2009pgp.pdf; see also March 13, 2009, Letter from Alan Einhorn, Chair, Executive Committee, AICPA, to IRS (responding to Notice 2009-5 and urging “the IRS and Treasury to place a high priority on providing further guidance that includes a clearly defi ned, objective test for determining what constitutes a tax shelter”), reprinted in 2009 TNT 54-27 (Mar. 24, 2009).
41 Notice 2009-5, IRB 2009-3, at 310.
42 Notice 2009-5, 2009-3 IRB, at 310–11.
43 Thus, any guidance promulgated under this section would presumably be under the general grant of regulatory authority found in Code Sec. 7805.
44 As detailed in the Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2009 Revenue Proposals, at 93 (Feb. 2008), available at www.ustreas.gov/ offi ces/tax-policy/library/bluebk08.pdf, the Administration’s proposal called for the substantial authority standard to apply to all transactions, regardless of whether they qualifi ed as tax shelters. H.R. 5719 and S. 2851 rejected this proposal and included the heightened standard for tax shelters in the fi nal statute.
45 For nonsigning preparers, the “speech rule” in Notice 2008-13 reduced the required confi dence level under the 2007 Act from reasonable belief of more likely than not to the reasonable basis standard applicable to “disclosed” positions. Similarly, the “disclosure speech rule” in the December 2008 fi nal regulations reduces the required confi dence level for transactions other than tax shelters from substantial authority to the reasonable basis standard that remains applicable to disclosed positions. Reg. §1 .6694-2(d)(3).
46 Notice 2009-5, IRB 2009-3, at 310.
47 The penalty is actually imposed by Code Sec. 6662(a) and (b)(2), but Code Sec. 6662(d) provides the defi nition.
48 The limitation is imposed by Code Sec. 6694(a), which triggers the preparer penalty only in the case of an “understatement of liability” on a return or claim for refund.
49 Reg. §301.7701-1 5(b)(4) (referencing returns identifi ed in Internal Revenue Bul¬letin guidance).
50 Staff of the Joint Comm. on Taxation, 110th Cong., 1st Sess., Technical Explanation of the “Small Business and Work Opportunity Tax Act of 2007” and Pension Related Provisions Contained in H.R. 2206 as Considered by the House of Representatives on May 24, 2007, at 34 (Comm. Print) (May 24, 2007), available at httpi/waysandmeans.house.gov/ media/pdf/tax/JCT_description_of_tax_title_ in_HR_2206.pdf (referencing only employ¬ment tax, excise tax, exempt organization, and estate and gift tax returns and related documents).
51 Arguably the same “position” might be re-fl ected on the service provider’s income tax return or employment tax returns fi led by the service recipient, although application of the “signifi cant part” test of Code Sec. 7701 (a)(36) might exclude the nonsigning preparer of those returns from penalty ex¬posure, whereas it may not if the preparer were deemed a nonsigning preparer of the service recipient’s return.
52 The IRS has, in the short history of the “list¬ing” procedure, already been forced to make corrections to its list. See Notice 2008-46, 2008-1 CB 868 (updating the list of returns originally included in Notice 2008-1 3).
53 See Code Sec. 7701 (a)(36) for complete defi nition of return preparer.
54 Reg. §1 .6694-1 (e) (2007).
55 Proposed Reg. §1.6694-1(e) (2008).
56 T.D. 9436, 2009-3 IRB 268, 73 FR 78430, 78433 (Dec. 22, 2008) (“While th[e] phrase [prohibiting reliance on taxpayer legal representations] is removed from the text of the fi nal regulations, the tax return preparer nevertheless must meet the diligence stan¬dards otherwise imposed by this regulation in order to rely properly on information and advice provided by taxpayers or other individuals”).
57 In describing the general due diligence stan¬dard, the final regulations appear to require that the preparer make further inquiries only “if the information as furnished appears to be incorrect or incomplete.” Reg. §1.6694-1 (e)(1).
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