The new civil tax penalty structure.

When Congress passed the Omnibus Budget Reconciliation Act of 1989, one of its many elements was subtitle G, the Improved Penalty Administration and Compliance Tax Act. Subtitle G contained a new penalty structure that governs both taxpayers and tax return preparers and applies to returns due, positions taken, documents prepared and activities after December 31, 1989. This article provides an overview of this new, stricter structure and analyzes what impact the changes will have on tax practitioners, who now must exercise a new standard of care in preparing tax returns.

ACCURACY-RELATED PENALTY

Exhibit 1 on page 45 outlines the revised accuracy-related penalty for taxpayers and reveals the following changes:

* New Internal Revenue Code section 6662(c) replaces the former 5% negligence penalty with a 20% rate to conform with the new 20% substantial understatement penalty (formerly 25%). CPAs who in past years picked up the tab for the client's 5% negligence penalty may wince at this new rate. However, its severity is diminished by the fact that it's imposed only on the portion of the underpayment attributable to negligence or disregard of rules or regulations rather than on the entire underpayment, which was the case under former section 6653(a).

* The substantial understatement penalty is now code section 6662(d) and, except for the drop in rate to 20% from 25%, is relatively unchanged. Despite use of the term understatement, the Tax Court held the penalty is limited to the amount of underpayment (Woods v. Commissioner, 91 T.C. 88 [1988]. acq. in result, 1988-2 C.B.1.). This ruling has been codified into the new law.

* Code section 6662 includes three 20% valuation penalties. These cover overstatements of value for income tax that are 200% or more of the correct value of the property or 200% or more of the correct actuarial determination of a pension liability. They also affect understatements for estate or gift tax if the claimed value is 50% or less of the correct amount. Penalties double to 40% for overstatements of 400% or more and for understatements of 25% or less.

WHICH 20% PENALTY?

Since the new law was meant to simplify penalties and avoid overlaps, one might question the distinction between the 20% negligence penalty and the 20% substantial understatement penalty. The answer is that the substantial understatement penalty applies when amounts are large enough to meet the "substantial test" because the taxpayer bears a heavy burden to avoid the penalty by showing either adequate disclosure or "substantial authority."

When a large tax shelter item is involved, the taxpayer can avoid the substantial understatement penalty only by showing substantial authority and a reasonable belief "more likely than not" that the return was correct. Given the passive activity loss rules and the heavy burden for avoiding the substantial understatement penalty, large shelter items may well have been penalized out of existence.

OTHER CHANGES IN TAXPAYER PENALTIES

The law retains the 75% civil fraud penalty but redesignates it section 6663. It remains applicable to the entire underpayment except for any portion that the taxpayer establishes by a preponderance of the evidence is not attributable to fraud.

Exhibit 2 on page 47 outlines this redesignated civil fraud penalty along with other changes in taxpayer penalties. The section 6663 civil fraud penalty now applies only to filed returns while the maximum delinquency penalty in section 6651(a) is raised to 75% for fraudulent failure to file.

The section 6656(a) penalty for failure to deposit tax now increases over time to encourage timely compliance, as does the section 6721 penalty for failure to file information returns, to encourage correction of errors.

There is a significant change in the section 6700 penalty for promoting abusive tax shelters. Two circuit courts of appeal had rejected the Internal Revenue Service claim that the $1,000 minimum applied to each transaction. The new law reversed these decisions by providing that for activities after December 31, 1989, the organization of an entity, plan or arrangement and the sale of each interest in an entity are separate activities penalized at $1,000 each or, if less, 100% of gross income.

The section 6701 civil aiding and abetting penalty is substantially unchanged. As one CPA learned during 1988 (Kuchan v. U.S., 88-1 USTC 9377 [N.D. Ill. 1988]), this is a powerful penalty that is not subject to any statute of limitations and does not require any proof that the understated returns were actually filed. The CPA, who prepared three transmittal letters to be attached to schedule C for a client to reproduce and send to investors, faced a penalty of $1,000 per duplicated letter for a total of $191,000. Under the new law, no section 6700 penalty applies to any document for which the section 6701 penalty is assessed.

NEW PREPARER PENALTIES

Exhibit 3 on page 47 outlines the new tax return preparer penalties. The section 6694(1) $100 preparer penalty for negligent or intentional disregard of rules or regulations has been replaced with a $250 penalty for "unrealistic positions." IRS notice 90-20 defines as unrealistic and subject to penalty under this stricter standard all positions that have less than a one-in-three likelihood of being sustained on their merits. As was the case under prior law, to avoid this penalty the preparer must make reasonable inquiries if the information furnished appears to be incorrect or incomplete.

The section 6694(b) $500 preparer penalty for willful understatement has been replaced

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with a $1,000 penalty that now includes "reckless or intentional disregard of rules or regulations." This language concerning "reckless" disregard of "rules" constructs a tightly woven net that may catch as many fish as the IRS net for "unrealistic positions."

Section 6695 contains several specific prohibitions on return preparers. They raise to $50 from $25 the penalty for preparers who don't furnish the taxpayer with a copy of the return, sign the return or provide their identifying numbers. A $50 penalty also is levied for each failure to set forth an item concerning persons who are employed as return prepares.

The predecessors to these new preparer penalties have already demonstrated their strength. One court upheld an assessment of $44,600 in $100 preparer penalties based on its finding that the attorney who prepared returns for limited partnerships was a "tax return preparer" of the limited partners' returns because he prepared the schedule K-1s that constituted significant portions of their returns (Goulding v. U.S., 89-1 USTC 9309 [D.C. Ill. 1989]).

In evaluating whether a penalty could be imposed on the preparer, it is essential first to consider possible penalties on taxpayers. Any positions that subject the taxpayer to penalty are most certainly "unrealistic" for the preparer and if they are contrary to any IRS ruling also would qualify as "reckless" because only a reckless or unrealistic preparer would expose a client to penalties.

CPAs thus face higher penalties that can be assessed on taxpayers as well as stricter preparer penalties. These come during a litigation explosion that has prompted more and more clients to sue those who prepare their tax returns when they face audits or penalties. As a result, the new structure's most significant effect is that positions that subject taxpayers to penalty can be disastrous for the return preparer, who may be required to reimburse the taxpayer for penalties and pay preparer penalties.

Both civil and criminal taxpayer penalties may be applied to preparers. For example, a law school graduate who was not a member of the bar claimed to have performed only typing services because he did not sign returns (U.S. v. Sassak, 881 F.2d 276 [6th Cir. 1989]). However, in affirming his felony conviction for aiding and abetting the filing of a false return in violation of section 7206(2), the Sixth Circuit said "the tax laws do not require one to meet the definition of 'income tax return preparer' in order to be guilty of aiding or abetting in the preparation of a false return." The court also said in this decision that a "good faith disagreement with the law as it is, or a good faith belief in what the law ought to be, does not negate willfulness."

DISCLOSURE TO AVOID PENALTIES

The various section 6662 penalties outlined in exhibit 1 are not imposed if "there was

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reasonable cause and the taxpayer acted in good faith." Disclosures that avoid penalties on taxpayers under this exception are outlined in IRS notice 90-20, which also defines disclosures that prevent the new $250 and $1,000 preparer penalties. (See exhibit 4 above.) As under prior law, disclosures don't prevent imposition of the substantial

EXHIBIT 5

Disclosure methods to
avoid the substantial
understatement penalty
Method         Description
Form 8275      Disclosure statement under
               section 6662(d).
Attachment     Labeled "disclosure state-
               ment" under section 6662(d).
Revenue        Completing prescribed
procedure      forms and schedules.
90-16
Schirmer v.    Provide sufficient informa-
Commissioner   tion to identify the potential
89 T.C. 277    controversy.
(1987)
Revenue        Disclosure concerning
procedure 85-  taxpayers subject to the IRS
26 or regula-  coordinated examination
tion section   program.
1.6661-4

understatement penalty on tax shelter items.

The disclosures necessary to avoid the section 6662(c) taxpayer negligence penalty and the $250 preparer penalty are identical. They require item-specific disclosure clearly identified as made to avoid the accuracy-related penalty. The relaxed disclosure rules of prior law for the substantial understatement penalty now prevent both the substantial understatement and the $1,000 preparer penalties. Taxpayers who fail to make the required disclosures can avoid the substantial understatement penalty only by showing substantial authority, which has been increased to include "published authority" included in the weekly Internal Revenue Bulletin; this includes proposed regulations, information or press releases, announcements and other similar documents. The relaxed disclosure methods of prior law that remain applicable are summarized in exhibit 5 at left.

STRONG MEDICINE

The new penalty structure will prove to be strong medicine for overly aggressive taxpayers and for large tax shelter items. For CPAs, the most important development is a new standard of care for tax practitioners that requires CPAs to avoid positions that subject the client to penalties.

DENZIL CAUSEY, CPA, DBA, JD, is professor of accountancy at Mississippi State University and a member of the Florida and Georgia bars. FRANCES M. McNAIR, CPA, PhD, is assistant professor of accountancy at Mississippi State. She is the coauthor, with Dr. Causey, of the 1990 edition of The Tax Practitioner (Accountant's Press).