Dealing with shades of gray: the realistic possibility standard.

Although finding an authoritative answer to a complicated tax question can be a challenge, resolving an issue for which there is no definitive answer is an even greater challenge. Before taking a tax position, CPAs must consider the technical provisions of the tax law, client interests, possible taxpayer and preparer penalties and the ethical application of professional standards--a process that's as clear-cut as distinguishing between shades of gray.

In recent years much attention has been focused on ethics--and especially on how practitioners resolve matters requiring professional judgment. The American Institute of CPAS tax division's statements on responsibilities in tax practice (SRTPs), the American Bar Association's (ABA's) Formal Opinion 85-352 and Internal Revenue Code section 6694 all establish "realistic possibility" as the standard for resolving uncertainty in such situations. The three rules are summarized in exhibit 1, page 53.

The realistic possibility standard supersedes the "reasonable basis" test that was thought to be an ineffective ethical guideline because it set such a low threshold. Reasonable basis exists if a position is arguable, even if it is likely to fail in the courts. In contrast, the realistic possibility standard requires a good faith belief a position has a realistic possibility of being sustained on its merits.

According to a survey of AICPA tax division members on how they interpreted the realistic possibility standard, CPAs who were very familiar with the standard were less aggressive than those unfamiliar with it. With the current emphasis on ethics and with court cases resulting from tax negligence outnumbering those resulting from audits, it is important for CPAs to gain a clear understanding of the standard so they can comply with it. The purpose of this article is to provide CPAs with guidance on implementing this stricter ethical standard.

DEVELOPING GUIDANCE

In 1985 the ABA adopted Opinion 85-352, which says a lawyer may advise a reporting position on a tax return as long as "the lawyer has a good faith belief ... [the position is! warranted under current law or can be supported by a good faith argument for an extension, modification or reversal of existing law ... and that there is some realistic possibility of success if the matter is litigated."

The Report of the Special Task Force on Formal Opinion 85-352 says the realistic possibility standard is met if there is a one-in-three chance of success should the tax position under consideration be litigated. Since the report was issued before IRC section 6694 was enacted, it does not mention an exception for disclosed positions. Rather than prepare a return that does not meet the realistic possibility standard a lawyer must, under ABA model rule of professional conduct 1.16(a), withdraw from the engagement.

The change was adopted because the existing reasonable basis standard was criticized as an ineffective ethical guideline by the tax bar, Internal Revenue Service officials and some members of Congress. The standard was quantified to improve the reliability of tax advice provided by lawyers and to provide an enforceable objective standard. The same concerns led the AICPA tax division and congress to adopt similar standards.

In 1988, the AICPA tax division revised advisory SRTP no. 1, Tax Return Positions, to inform CPAs of the standard to follow when recommending tax return positions. The standard requires CPAs to have "a good faith belief ... [a tax return] position has a realistic possibility of being sustained administratively or judicially on its merits if challenged."

The AICPA standard is substantially identical to IRC section 6694, which imposes a $250 penalty on tax return preparers if the tax liability on a return is understated because a tax position was taken that did not have a realistic possibility of being sustained on its merits. In revising section 6694 in 1989, Congress noted the realistic possibility standard was employed by both attorneys and CPAs.

In 1990, the tax division issued SRTP Interpretation no. 1-1, Realistic Possibility Standard, to provide guidance for complying with the realistic possibility standard through both a general interpretive discussion of the standard and specific examples. The statement specifically says the realistic possibility standard cannot be expressed in terms of percentage odds. It elaborates: "The realistic possibility standard is less stringent than the `substantial authority' and the `more likely than not' standards that apply ... [to] taxpayers. However, it is more strict than the `reasonable basis' standard under regulations issued prior to the Revenue Reconciliation Act of 1989."

One reason for rejecting a quantified standard is CPAs infrequently have information that can be quantified. Often, CPAs must proceed on the basis of court cases and administrative rulings involving situations that don't match their clients'. Moreover, the precedents to which they refer may involve diffirent courts (trial courts versus appeals courts, for instance) or may be based on laws that have since been modified.

SURVEY RESULTS

To gain insight into how practicing CPAs deal with the realistic possibility standard, 227 AICPA tax division members were surveyed using a randomly generated list of members. Respondents had from 2 to 45 years of experience with an average of 16.8 years. Most, 86.4%, were employed in public accounting, with half, 49.8%, employed by local firms.

Since both the ABA and the IRS identified one-in-three odds as appropriate, we were interested in how CPAs interpreted the AICPA standard. While CPAs ordinarily do not employ odds when recommending tax return positions, we wanted to see if they would think in such terms when applying the realistic possibility standard. Accordingly, we asked this question: "Assume there have been 10 cases dealing with an issue. In a typical situation, how many eases must have been decided in favor of the taxpayer in order to meet the `realistic possibility' standard?"

Another reason the AICPA tax division did not quantify the realistic possibility standard is its belief tax return positions should be based on administrative or judicial rulings on well-reasoned constructions of applicable statutory provisions. Accordingly, any effort to quantify the standard limits the ability of taxpayers and their advisers to rely on such rulings when formulating tax positions. Accordingly, only 1 CPA in 227 was willing to take a position when no cases were favorable to the client while 38 were willing to take a position when 1 case in 10 was favorable. This evidence suggests the availability of support determined whether the realistic possibility threshold was met, not the quantity of support.

On average, CPAs believed 3.9 favorable decisions out of 10 were necessary to meet the AICPA realistic possibility standard. Thus, practicing CPAs applied a slightly higher threshold than that established by either the ABA standard or IRC section 6694. Most (56.83%) said 3, 4 or 5 cases were needed to meet the standard, and only 18.94% required over 5 favorable cases out of 10.

Since the AICPA realistic possibility standard is relatively new, not all CPAs were equally familiar with it. We wanted to know whether the CPAs who were very familiar with the standard were more or less aggressive than those who were unfamiliar with it. We separated respondents into three groups based on whether they identified themselves as very familiar, familiar or unfamiliar with the standard. Exhibit 2, below, summarizes the response. Of the CPAs who were unfamiliar with the standard, 32.89% said they would take a position favorable to a client when fewer than 3 cases out of 10 favored the client compared with 21.31% of CPAs who were familiar with the standard and 18.89% who indicated they were very familiar with it. This suggests familiarity with the standard made CPAs less aggressive. Given that the former reasonable support threshold was thought to be too low, the new standard seems to have had the intended effect.

EXCEPTIONS

Clients often want to take deductions or losses when there is little or no support for those positions. If a practitioner decides such an aggressive position does not meet the ALCPA realistic possibility standard, what options are available? Is it permissible to take a favorable tax return position that does not meet the standard if a non-frivolous position is disclosed?

According to SRTP no. 1, "a `frivolous' position is one that is knowingly advanced in bad faith and is patently improper." SRTP no. 1 further says the determination of whether information is adequately disclosed by a client is based on the facts and circumstances of the particular case. Although SRTP no. 1 says disclosure requirements may be met in different ways depending on the facts and circumstances, the IRS established new and less flexible disclosure requirements. According to regulations section 1.6694-2(c)(3), disclosure must be made on a properly completed and filed form 8275 or 8275-R or on the return in accordance with the revenue procedure on this subject issued by the IRS each year.

Practitioners should note this position differs from the IRS's previous one, which permitted disclosure in the form of a supplemental statement attached to the return. Such supplemental disclosures are, according to the IRS, no longer adequate. This means supplemental statements may meet practitioners' professional obligation to disclose but may not protect either practitioners or taxpayers from IRS penalties.

However, revenue procedure 93-33 (1993-28 IRB) lists (among other things) several routine itemized deductions such as medical expenses and taxes as well as a few specified trade or business expenses such as taxes and bad debts that are treated as disclosed if

1. The amount claimed is verifiable.

2. The taxpayer can demonstrate the origin of the number and can show good faith in entering the item on the applicable form.

APPLYING THE STANDARD

SRTP Interpretation no. 1-1 illustrates 15 situations involving changes in the tax law, drafting errors, controversial IRS positions, tax positions unlikely to be detected by the IRS, complex provisions that will result in significant compliance costs, conflicting authority and reliance on attorneys' opinions. Exhibit 3, page 57, summarizes each illustration and explains the appropriate treatment of an item.

These illustrations indicate CPAs normally must follow clear and unambiguous authorities even when they are opposed by clients. When the tax law is ambiguous, CPAs may take positions supported by well-reasoned constructions of applicable statutory provisions. Similarly, if authorities do not say how an item should be handled, the applicable authorities are in conflict or are inconsistent with the code's intent, CPAs may choose how to handle the item themselves. The positions chosen should, however, be supported by well-reasoned constructions of applicable statutory authorities. High compliance costs or a client's belief a provision is burdensome or unfair are not sufficient reason to ignore unfavorable provisions.

RELATIONSHIP TO TAXPAYER STANDARDS AND PENALTIES

As with CPAs, taxpayers themselves are subject to compliance rules that may result in penalties. Specifically, IRC section 6662 establishes a taxpayer penalty of 20% of certain understatements of tax liability (see exhibit 4, page 58). The required levels of confidence associated with taxpayer penalties sometimes are stricter than the practitioner's realistic possibility standard. Because taxpayer penalties sometimes can be avoided through disclosure, the impact of a tax return position on the client's liability must be considered along with the practitioner's professional standards. As a result, it may be desirable to advise a client of the potential benefits of disclosure when the AICPA realistic possibility standard is met.

SRTP Interpretation no. 1-1, for example, says the substantial authority standard is more stringent than the realistic possibility standard. Thus, disclosing a position involving a substantial item may be desirable to protect the client from penalty even though professional standards do not require disclosure.

The Omnibus Budget Reconciliation Act of 1993 contains an important change affecting taxpayers. Beginning in 1994, disclosing the relevant facts will enable a client to avoid the 20% penalty for substantial underpayment of income tax only if there is a "reasonable basis" for the position taken. (See exhibit 4.) Previously, the penalty applied only if the disclosed position was frivolous. The congressional committee reports say the reasonable basis standard is relatively high and will not be satisfied if it is merely arguable or it is a colorable claim. Since CPA guidelines have not changed, CPAs may still ethically recommend disclosure of a non-frivolous position. When considering such a position, it is advisable to inform clients of the penalties they may face.

Even when a practitioner believes a position is consistent with the realistic possibility standard, some risk-averse clients may prefer to pay the tax to avoid potential disagreements with the IRS. When advising a client whether to take a position permitted by the realistic possibility standard, the CPA should consider the client's attitude toward risk. Further, SRTP no. 1 says, a "CPA's advice concerning alternative acceptable positions may include a discussion of the likelihood ... [a] position might or might not cause the client's return to be examined and whether the position would be challenged in an examination."

SHADES OF GRAY

Dealing with shades of gray is one of the most difficult challenges facing tax professionals. The realistic possibility standard is a useful guideline that

enables CPAs to resolve tax law questions while balancing ethical requirements with their professional responsibility to serve clients. Our survey of tax division members suggests CPAs familiar with the realistic possibility standard are less aggressive than those unfamiliar with it. Therefore, understanding the standard can reduce the risk CPAs and taxpayers will face tax penalties. In today's litigious environment, a clear understanding of the realistic possibility standard may be an effective defense against litigation. The realistic possibility standard establishes an appropriate guideline that promotes consistent and ethical tax compliance.

EXHIBIT 1

Summary of requirements

American Basis--"has a good faith belief that the position has a realistic Institute possibility of being sustained administratively or judicially on CPAs its merits if challenged."

Odds--not stated.

Exceptions--disclosure (if position is nonfrivolous) or good

faith (such as reliance on client representations).

American Basis--"realistic possibility of success if litigated." Bar Association Odds--one in three.

Exceptions--none mentioned.

Internal Basis--"realistic possibility of being sustained on its Revenue Code merits." section 6694 Odds-one in three (regulations sections 1.6694-2(b)).

Exceptions--disclosure of a nonfrivolous position or reasonable

cause and action in good faith.

[EXHIBIT 2 ILLUSTRATION OMITTED]

Summary of responses

EXHIBIT 3

Examples interpreting the realistic possibility standard

Change in law 1. A clear and unambiguous change in law adversely affects a

client.

The CPA ordinarily must follow the new provision.

2. A clear and unambiguous change in law adversely affects a

client, but a committee report specifically addresses the

client's situation and takes a position favorable to the

client.

Either position meets the standard.

3. A clear and unambiguous change in law adversely affects a

client. Although the congressional committee report does

not specifically address the client's situation, the

report can be interpreted as providing some support.

Because the committee report does not specifically mention

the client's situation, the realistic possibility standard

is not met. Because it provides some support, a favorable

position for the client is not frivolous. Disclosure is

needed if the report is followed. Errors in law 4. A new provision has a drafting error and a proposed

technical correction bill has been introduced. The error

is acknowledged by the Internal Revenue Service, which

interprets the provision in accordance with the proposed

technical correction.

Either return position meets the standard.

5. The correction of a drafting error is included in a

proposed technical correction bill but has not been

acknowledged by the IRS.

Disclosure of the position is appropriate if the proposed

correction is followed. Controversial 6. The IRS announces a position the CPA believes is IRS positions inconsistent with the intent of the code and committee

reports.

The CPA is not obligated to follow the IRS position.

7. The IRS issues a temporary regulation the CPA believes is

inconsistent with the intent of the code and committee

reports.

Depending on factors such as whether the regulation is

legislative or interpretive, disclosure of a position

contrary to the regulation may be appropriate.

8. An error in a tax form that favors the client was

acknowledged by the IRS.

Following the form is frivolous position. Position unlikely 9. A client wants to take a frivolous position that is to be detected unlikely to be questioned even if the return is examined by the IRS by the IRS.

The CPA cannot take the position even if it is disclosed. Complicated 10. A client wants to ignore a code provision that will provision that will result in significant compliance costs because of the result in significant need to implement new accounting procedures and make compliance costs computer purchases.

The CPA cannot ignore the provision.

11. A client wants to use good faith estimates to reduce

significant compliance costs.

Good faith estimates may be acceptable. Conflicting

12. A court case favors a client, but a revenue ruling authorities

is unfavorable.

Either position is appropriate. Unissued

13. A committee report directs the IRS to issue regulations

regulations that will require specific treatment

of an item. The regulations have not been issued.

It is appropriate to follow the committee report. Reliance on 14. The tax treatment of an item depends on the answer attorney's to a nontax legal issue. opinions

The opinion of the client's attorney may be relied

on if it seems reasonable.

15. A client's attorney expresses an opinion on the tax

treatment of an item.

The CPAS may follow the opinion if he of she is

satisfied regarding its source, relevance and

persuasiveness.

EXHIBIT 4

Major taxpayer standards and penalties

More likely Applicable to understatements relating to tax shelters unless than not "the taxpayer reasonably believed that the tax treatment of such

item by the taxpayer was more likely than not the proper

treatment"

(Internal Revenue Code section 6662(d)(2)(C)(i)(II)).

Disclosure does not excuse the taxpayer.

Substantial Applicable to substantial understatement of taxes unless there authority is substantial authority supporting the item

(section 6662(d)(2)(B)(i)).

In general, this standard is less strict than the more likely

than not standard but more stringent that the realistic

possibility standard.

Not applicable unless an item results in a substantial

understatement of tax (generally the greater of 10% of the tax or

$5,000, or $10,000 in the case of most C corporations). Not

applicable if there is reasonable support for the position and it

is adequately disclosed.

Negligence Applicable to understatements of taxes attributes to negligence

or disregard of rules or regulations. Accordingly, "the term

negligence includes any failure to make a reasonable attempt to

comply ..., and the term disregard includes any careless, reckless 

or intentional disregard" (section 6662(c)). Though not mentioned

in section 6662, regulations section 1.6662-3(b)(2) says the

disregard of rules is not subject to penalty if the position "has

a realistic possibility of being sustained on its merits."

A penalty is not applicable if a nonfrivolous position is

adequately disclosed and the taxpayer kept adequate records.

Frivolous Disclosure does not exempt taxpayers from understatement

penalties if the disclosed position is frivolous. A frivolous

position is one that is patently improper

(regulations section 1.6662-3(b)(2)).

EXECUTIVE SUMMARY

* WHEN DEALING WITH GRAY areas of the tax law, CPAs must consider technical provisions of the law, client interests and the ethical application of professional standards.

* THE AMERICAN INSTITUTE OF CPAs, the American Bar Association and the Internal Revenue Code all require application of a realistic possibility standard to positions taken on client tax returns. CPAs should have a good faith belief a tax return position has a realistic possibility of being sustained if it is challenged.

* A SURVEY OF AICPA tax division members suggests not all CPAs are equally familiar with the realistic possibility standard. On average, survey respondents believed 3.9 favorable decisions out of 10 were necessary in order to meet the standard and allow them to recommend a particular tax return position to a client.

* CPAs NORMALLY MUST FOLLOW an unambiguous authority even when it is opposed by a client. When the law is ambiguous, CPAs may take positions supported by well-reasoned constructions of the applicable statutes.

* TAXPAYERS THEMSELVES also are subject to compliance rules. IRC section 6662 establishes a taxpayer penalty of 20% of certain tax liability understatements.

* IN TODAY'S LITIGIOUS environment, a clear understanding of the realistic possibility standard may be an effective defense against litigation.

DALE BANDY, CPA, PhD, is professor of taxation at the University of Central Florida, Orlando. ANDREW J. JUDD, CPA, PhD, is an associate professor of accounting at the University of Central Florida. He is a member of the American Accounting Association. CHARLES KELLIHER, CPA, Phd, is an assistant professor of accounting at the University of Central Florida. He is a member of the AAA and the Florida Institute of CPAs.