The new civil tax penalty structure.When Congress passed the Omnibus omnibus: see bus. Budget Reconciliation Act of 1989, one of its many elements was subtitle sub·ti·tle
1. A secondary, usually explanatory title, as of a literary work.
2. A printed translation of the dialogue of a foreign-language film shown at the bottom of the screen.
tr.v. 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.
Exhibit 1 on page 45 outlines the revised accuracy-related penalty for taxpayers and reveals the following changes:
* New Internal Revenue Code The Internal Revenue Code is the body of law that codifies all federal tax laws, including income, estate, gift, excise, alcohol, tobacco, and employment taxes. These laws constitute title 26 of the U.S. Code (26 U.S.C.A. § 1 et seq. 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 . acq. in result, 1988-2 C.B.1.). This ruling has been codified cod·i·fy
tr.v. cod·i·fied, cod·i·fy·ing, cod·i·fies
1. To reduce to a code: codify laws.
2. To arrange or systematize. 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 ac·tu·ar·y
n. pl. ac·tu·ar·ies
A statistician who computes insurance risks and premiums.
[Latin 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 tax shelter: see tax exemption. 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 pe·nal·ize
tr.v. pe·nal·ized, pe·nal·iz·ing, pe·nal·iz·es
1. To subject to a penalty, especially for infringement of a law or official regulation. See Synonyms at punish.
2. 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 preponderance of the evidence n. the greater weight of the evidence required in a civil (non-criminal) lawsuit for the trier of fact (jury or judge without a jury) to decide in favor of one side or the other. 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 Abusive tax shelter
A limited partnership that the IRS judges to be claiming tax deductions illegally.
abusive tax shelter
A tax shelter in which an improper interpretation of the law is used to produce tax benefits that are . 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 a·bet
tr.v. a·bet·ted, a·bet·ting, a·bets
1. To approve, encourage, and support (an action or a plan of action); urge and help on.
2. penalty is substantially unchanged. As one CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. learned during 1988 (Kuchan v. U.S., 88-1 USTC USTC University of Science and Technology of China
USTC United States Tax Cases (Commerce Clearing House)
USTC United States Transportation Command (see USTRANSCOM) 9377 [N.D. Ill. 1988]), this is a powerful penalty that is not subject to any statute of limitations A type of federal or state law that restricts the time within which legal proceedings may be brought.
Statutes of limitations, which date back to early Roman Law, are a fundamental part of European and U.S. law. and does not require any proof that the understated returns were actually filed. The CPA, who prepared three transmittal letters Transmittal letter
A letter describing the contents and purpose of a transaction delivered with a security that is changing ownership. 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 negligent adj., adv. careless in not fulfilling responsibility. (See: negligence) or intentional disregard of rules or regulations has been replaced with a $250 penalty for "unrealistic positions." IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. 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 fur·nish
tr.v. fur·nished, fur·nish·ing, fur·nish·es
1. To equip with what is needed, especially to provide furniture for.
2. appears to be incorrect or incomplete.
The section 6694(b) $500 preparer penalty for willful Intentional; not accidental; voluntary; designed.
There is no precise definition of the term willful because its meaning largely depends on the context in which it appears. understatement has been replaced
1. Having a plane surface; flat.
2. Organized as a table or list.
3. Calculated by means of a table.
resembling a table. DATA OMITTED]
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 An action brought in court to enforce a particular right. The act or process of bringing a lawsuit in and of itself; a judicial contest; any dispute.
When a person begins a civil lawsuit, the person enters into a process called 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 re·im·burse
tr.v. re·im·bursed, re·im·burs·ing, re·im·burs·es
1. To repay (money spent); refund.
2. To pay back or compensate (another party) for money spent or losses incurred. 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 felony (fĕl`ənē), any grave crime, in contrast to a misdemeanor, that is so declared in statute or was so considered in common law. 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 ne·gate
tr.v. ne·gat·ed, ne·gat·ing, ne·gates
1. To make ineffective or invalid; nullify.
2. To rule out; deny. See Synonyms at deny.
DISCLOSURE TO AVOID PENALTIES
The various section 6662 penalties outlined in exhibit 1 are not imposed if "there was
[TABULAR DATA OMITTED]
[TABULAR DATA OMITTED]
[TABULAR DATA OMITTED]
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
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.
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 Causey is a village in County Durham, in England. It is situated a short distance to the north of Stanley. , CPA, DBA, JD, is professor of accountancy at Mississippi State University Mississippi State University, at Mississippi State, near Starkville; land-grant and state supported; coeducational; chartered 1878 as an agricultural and mechanical college, opened 1880. From 1932 to 1958 it was known as Mississippi State College. 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 co·au·thor or co-au·thor
A collaborating or joint author.
tr.v. co·au·thored, co·au·thor·ing, co·au·thors
To be a collaborating or joint author of: "He and a colleague . . . , with Dr. Causey, of the 1990 edition of The Tax Practitioner (Accountant's Press).