New preparer penalties: 'let's be careful out there'.
When preparing a tax return, accountants must be aware of two areas of the IRC: section 6694, Return-Preparer Penalties. The Small Business Tax Act of 2007 made major changes to the provisions of section 6694, placing additional burdens on accountants who prepare tax returns.
Understanding how the Small Business Tax Act of 2007 affects IRC section 6694 requires a working knowledge of section 6662 and the rules that preparers were subject to under section 6694 prior to the enactment of the Small Business Tax Act of 2007.
IRC Section 6662: Accuracy-Related Penalties
Pursuant to IRC section 6662 (b), an accuracy-related penalty can be asserted when an understatement of tax results from:
1) negligence or disregard of rules and regulations; 2) substantial understatement of income tax; 3) substantial valuation misstatement; 4) substantial overstatement of pension liabilities; or 5) any substantial valuation understatement of estate or gift tax.
Pursuant to IRC section 6662(c), the factors under Treasury Regulations section 1.6662-3(l)(i)-(iv) used to determine whether a tax return has been negligently prepared include the following:
* Failure to include income shown on an information return;
* Failure to reasonably attempt to ascertain the correctness of an item that to a reasonably prudent person would appear "too good to be true" under the circumstances; and
* Failure of a partner or an S corporation shareholder to treat partnership or subchapter S items on an individual return consistent with the treatment of such items on the partnership or S corporation tax return.
Pursuant to Treasury Regulations section 1.6662-3(b) (2), the term "disregard" means to carelessly, recklessly, or intentionally avoid conforming to Treasury regulations or IRS rulings and notices. Examples include the following:
* Failure to exercise reasonable diligence to determine the correctness of a return position contrary to a rule or regulation;
* Failure to determine whether a rule or regulation exists in a situation where a reasonable person would inquire; and
* Failure to comply with a known rule or regulation, unless the contrary position has a realistic possibility of being sustained.
Treasury Regulations section 1.6662-2(a) (3) stipulates that the accuracy-related penalty is applicable only if a return is filed. IRC section 6020 (b) provides that it is not applicable if the IRS prepares a substitute return for the taxpayer.
The penalty is 20% of the portion of the underpayment of tax resulting from the actions of the taxpayer that created the penalty under IRC section 6662, regardless of the frequency with which such actions are demonstrated. If a return is filed late, however, the delinquency penalty may be imposed on the same portion of an underpayment as the accuracy-related penalty. The penalty does not apply to the failure-to-collect and pay-over tax penalties provided by IRC section 6672. As provided by Treasury Regulations section 1.6662(d)(2), the penalty is increased to 40% if any part of the underpayment is attributable to a gross valuation misstatement.
According to IRC section 6662(d), a substantial understatement of income tax for individuals generally exists if the understatement amount exceeds either 10% of the tax required to be shown on the return for that year or $5,000, whichever is greater. For corporations, a substantial understatement exists if the amount exceeds the lesser of 10% of the tax required to be shown on the return for that year (or $10,000, if greater) or $10 million. The amount of the understatement will be reduced to the extent to which it is attributable to the treatment of an item (other than one attributable to a tax shelter) for which substantial authority exists for such treatment. The amount may also be reduced if there is adequate disclosure in the return (or in a statement attached thereto) of the relevant facts, and if a reasonable basis for the tax treatment exists.
IRC Section 6694: Return-Preparer Penalties
IRC section 6694 establishes the standards to which tax return preparers must adhere in order to avoid incurring a preparer penalty. On May 25, 2007. President Bush signed into law the Small Business Tax Act of 2007, which made substantial changes to the standards that apply, and significantly increased the penalty imposed for failure to comply with those standards.
Prior to the Act, IRC section 6694(a) imposed a $250 penalty on an "income" tax return preparer for filing a return or a refund claim that resulted in an understatement of tax based upon an "unrealistic position" on the filed tax return. This included the preparation of information returns filed by partnerships and S corporations, as well as amended returns.
Treasury Regulations section 1.6694-2(b)(1), Circular 230, defines an "unrealistic position" as one for which the preparer knew or should have known that: 1) a realistic possibility --a 331/3% or better chance --of being upheld on the merits did not exist, and 2) that the position was either frivolous or not appropriately disclosed in accordance with IRC section 6662(d). In this case, a realistic possibility implied that a reasonable and well-informed analysis by a person knowledgeable in tax law would lead to a conclusion that the position had an approximate one-in-three chance of being sustained.
Taking an unrealistic position would not necessarily result in the imposition of a penalty if the preparer showed a "reasonable basis" for the understatement and acted in good faith. [The reasonable-basis standard, while less than the realistic-possibility standard, is higher than a patently improper (plausible-basis) or frivolous (nonarguable-basis) position.] According to Treasury Regulations section 1.66623(b)(3),
if a return position was reasonable based on one or more authorities set forth in Treasury Regulations section 1.6662-4(d)(3)(iii), then the reasonable-basis standard would have been satisfied, even though it did not fulfill the substantial authority standard.
Even if a position contrary to a rule or regulation was taken on a return, an understatement penalty would not have been imposed if the position was adequately disclosed on a properly completed and filed Form 8275 or 8275-R. [Taxpayers use Form 8275 to disclose positions on a return. If, however, the position being taken is contrary to a regulation, then the taxpayer must use Form 8275-R to disclose such a position. See Treasury Regulations section 1.6662-3(c)(2).] Treasury Regulations section 1.6662-3(c)(l) provides that this exception for adequate disclosure would not apply if a reasonable basis for the position did not exist.
According to Treasury Regulations section l.6662-4(d), however, disclosure was not required and an understatement penalty would not have been imposed if substantial authority existed for the tax treatment of a return item. Substantial authority would exist if the authority supporting the treatment was substantial and weighed heavily in relation to the weight of contrary authority. This was an objective standard that involved an analysis of the law and its application to the relevant facts. It was also more strictly construed than the reasonable-basis standard.
Pursuant to IRC section 6694(b), the penalty was increased to $1,000 if the preparer made a willful attempt to understate a client's tax liability or intentionally disregarded rules and regulations without adequate disclosure.
Changes Made by the Small Business Tax Act of 2007
As previously mentioned, the Small Business Tax Act of 2007 made significant changes to the reporting standards of tax return preparers and increased the penalties under IRC sections 6694(a) and 6694(b). Pursuant to the Act, the changes are effective for returns prepared after May 25, 2007 (see transitional rules discussed herein).
Prior to the 2007 Act provisions, IRC section 6694 applied only to "income tax return preparers." An income tax return preparer was anyone who prepared all or a substantial portion of an income tax return or income tax refund claim. The word "income" was removed. As a result of this change, all tax return preparers are now liable for any applicable section 6694 penalties. This includes income tax returns, estate and gift tax returns, employment tax returns, excise tax returns, and information returns.
A tax return preparer can also include an employee who is not the signatory on the tax return. For a signing preparer, the relevant date is the date the preparer signs and dates the tax return or refund claim. If the preparer did not enter the date, then the relevant date is the date of the taxpayer's signature or the filing date, if the taxpayer did not also date the return or claim. For a nonsigning preparer, the relevant date is the date the preparer provides the advice.
Prior to the Act, IRC section 6694 adopted the "realistic possibility" standard for the nondisclosure of a position taken on a tax return. It generally meant that the position taken on a return had an approximate one-in-three likelihood of being sustained on its merits.
The amended section 6694 adopts a "more-likely-than-not" standard and now provides that a penalty for the nondisclosure of a position taken on a tax return will be imposed, unless the return preparer has a reasonable belief that the position would have a greater-than-50% likelihood of being sustained on its merits.
Under the 2007 Act, taking a position that does not meet the more-likely-than-not standard on a tax return will now result in the imposition of a penalty on the tax return preparer. A position is deemed unreasonable if the following conditions are met:
* The preparer knew (or reasonably should have known) of the position;
* There was no reasonable belief that the position would more likely than not be sustained on its merits; and
* The position was not disclosed or there was no reasonable basis for the position.
A penalty will not be imposed for an understatement due to an unreasonable position, even without a reasonable belief, if this position is adequately disclosed and there is a reasonable basis (a higher standard than nonfrivolous) for the tax treatment.
Example. A taxpayer claims that various items are business expenses, but, upon review, the tax return preparer determined that some of these expenses could be deemed personal and nondeductible.
Under the pre-Act law, if the return preparer believed the likelihood of sustaining these deductions exceeded 33 1/3 %, the tax return could be signed without disclosure, because the realistic-possibility standard would have been met.
Under the Act, however, a preparer penalty would be imposed if the preparer signed the return without disclosure, unless the likelihood of sustaining these deductions exceeded 50%, which is the more-likely-than-not standard introduced by the 2007 Act. The preparer can avoid the penalty by attaching the appropriate disclosure form to the return.
Treasury Regulations section 1.6694-(2)(d) continues the exception to the penalty if reasonable cause for the understatement existed and the tax return preparer acted in good faith. Several factors must be considered:
* The nature of the error causing the understatement. Was the applicable provision so complex, uncommon, or highly technical that a competent preparer of such returns could reasonably make the same error? (This exception does not apply to an error that would be apparent from a general review of the return or refund claim.)
* Frequency of errors. Did the understatement result from a single, isolated error, unless that error itself is so obvious or flagrant that it should have been discovered upon review? (This exception is inapplicable where there is a pattern of errors.)
* Materiality of errors. Was the understatement material, with respect to the correct tax amount? (This exception will not apply, even to an immaterial understatement, if the error was sufficiently obvious.)
* Preparer's normal office practice. Would the error have occurred if normal office practice for ensuring accuracy and consistency--including checklists, a review of the prior year's return, and current review procedures--were followed? (This exception is inapplicable if the error is flagrant, if a pattern of errors exists, or if the same error is repeated on numerous returns.)
* Reliance on advice of another preparer. Did the preparer rely on advice or schedules prepared by other individuals in good faith, and did the preparer have reason to believe that the other preparer was competent? (This exception is inapplicable if the advice is unreasonable on its face, if the preparer knew that the other preparer was unaware of all relevant facts, or if the preparer knew or should have known that the advice was no longer reliable due to recent legal developments.)
The 2007 Act has increased the prior $250 penalty. The penalty is now the greater of $1,000 or 50% of the income that the tax return preparer has derived or will derive from the preparation of a tax return or refund claim.
Example. An accountant prepares and signs, as preparer, an income tax return for a client and receives a fee of $1,200 for these services. Upon examination of the return by the IRS, items are disallowed that are determined not to have met the 50% more-likely-than-not standard, thereby subjecting the accountant to a section 6694(a) penalty.
Because 50% of the fee received for the preparation of the return would be only $600, the penalty would be $1,000. If the fee were $4,000, the penalty amount would be $2,000 (50% of the fee).
Before the 2007 Act, IRC section 6694(b) stated that the willful or reckless conduct of the income tax preparer resulted in the imposition of a $l,000-per-return penalty. Section 6694(b) describes willful or reckless conduct as a willful attempt, in any manner, to understate the liability for tax on the return or claim, or a reckless or intentional disregard of rules and regulations.
The new section 6694(b) increases this penalty to the greater of $5,000 or 50% of the income that the preparer (of any type of tax return) has derived or will derive from the preparation of such return or refund claim. In many instances, a penalty of $5,000 will be greater than 50% of the fee.
Notice 2007-54. On June 11, 2007, the IRS issued Notice 2007-54 (2007-27 IRB 1) to assist tax return preparers in familiarizing themselves with and adjusting to the new rules. This notice provides guidance and transitional relief from the return preparer penalty rules. However, the transitional relief applies only to those penalties imposed under IRC section 6694(a). This notice provides no transitional relief for willful or reckless conduct.
For income tax returns (including amended returns) and refund claims, standards previously in effect for determining if the IRS would impose a penalty under section 6694(a) will apply during the transitional relief period. Thus, disclosure will be deemed adequate if made on Form 8275 or Form 8275-R.
For all other types of tax returns, the reasonable-basis standard established in the regulations under section 6662 (without regard to the disclosure requirements contained therein) will be applied in determining if the IRS will impose a preparer penalty.
As stated in Notice 2007-54, the period of transitional relief covers:
* All returns, amended returns, and refund claims due on or before December 31, 2007, determined with regard to any extension of time for filing;
* 2007 estimated tax returns due on or before January 15, 2008; and
* 2007 employment and excise tax returns due on or before January 15, 2008.
Notice 2008-11. On December 31,2007, the U.S. Department of the Treasury and the IRS issued Notice 2008-11 (2008-3 IRB, effective May 25, 2007), which clarifies that the transition relief described in Notice 2007-54 applies to the following:
* Timely amended returns or claims for refund filed on or before December 31, 2007 (for amended employment and excise tax returns, the rules apply to returns filed on or before January 31, 2008);
* Original returns filed on or before December 31, 2007 (as to employment and excise tax returns, the rules apply to returns filed on or before January 31, 2008); and
* Advice provided on or before December 31, 2007 (for nonsigning preparers).
Notice 2008-13. On December 31, 2007, the Treasury Department and IRS issued guidance and provided interim rules implementing and interpreting the new provisions of IRC section 6694 (Notice 2008-13, IRB 2008-3). In this notice, the IRS stated its intention to revise the regulations governing preparer penalties in 2008. Preparers can use this notice as interim guidance regarding definitions and standards of conduct they must adhere to in order to avoid penalties under section 6694. The notice cautions preparers that when the regulations are finalized they may be substantially different from the rules in the notice "and in some cases more stringent."
The interim guidance focuses on the following issues:
* Tax returns or claims for refund covered by IRC section 6694;
* The definition of a "tax return preparer";
* Standards of conduct for disclosed and undisclosed positions; and
* Interim penalty compliance obligations.
Returns or claims for refunds covered by IRC section 6694. Notice 2008-13 includes a number of exhibits. Exhibit 1 of the notice sets forth the returns that are covered by the new preparer penalty under the interim guidance, divided into the following categories:
* Income tax returns, including Forms 1040, 1041, and 1120;
* Estate and gift tax returns, including Forms 706, 709, and 843;
* Employment tax returns, including Forms 940, 941, and 1040SE;
* Miscellaneous excise tax returns, including Forms 720, 990PF, and 8849; and
* Alcohol, tobacco, and certain other excise tax returns, including Forms 8725 and 8876.
In addition, the notice includes Exhibit 2, which sets forth information returns that report information reported on another return. The new IRC section 6694 will apply to the preparer of these information returns if the information contained therein is a "substantial portion" of the other return. Forms in this category included--
* Form 1065
* Form 1120S
* Form 5500
Finally, the notice contains Exhibit 3, which sets forth a schedule of the tax forms that will not create a penalty under IRC section 6694, unless the return is prepared willfully in any manner that will understate the tax liability or that demonstrates a reckless or intentional disregard of rules or regulations. This category includes the following:
* Form 1099 series of returns;
* Form W-2 series of returns;
* Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding;
* Form 990, Return of Organization Exempt from Income Tax;
* Form 1040ES, Estimated Income Tax Payment;
* Form 1120W, Estimated Tax for Corporations;
* Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return;
* Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips; and
* Form 8919, Uncollected Social Security and Medicare Tax on Wages.
Definition of a tax return preparer. IRC section 7701 (a) (36)(A) defines a tax return preparer as someone who, for compensation, prepares all or a substantial portion of a tax return or claim for refund with respect to such return. In interpreting the term "substantial portion," the notice includes a schedule, entry, or other position that, if adjusted or disallowed, could result in a deficiency (or disallowance of a claim for refund) that the preparer knows or should have known is a significant portion of the tax liability reported on the return. Whether someone is a tax preparer is a question of fact and will depend upon the relative size of the deficiency attributable to the schedule, entry, or other position prepared or taken by the preparer.
Example. Smith, an accountant, prepares a partnership return, including Schedules K-1, allocating losses to each partner in proportion to his or her original investment. Smith does not prepare the individual return of Partner A, but knows that A's share of the partnership loss is the most significant portion of A's individual income tax computation. Smith is a preparer of Partner A's individual income tax return, pursuant to IRC section 6694.
Standards of conduct for disclosed and undisclosed positions. For undisclosed positions, Notice 2008-13 requires the preparer to analyze the pertinent facts and authorities in the manner described in Treasury Regulations section 1.6662-4(d)(3) (ii) and to reasonably conclude in good faith that there is a greater than 50% likelihood that the position will be upheld if challenged. This determination must be made without taking into account the possibility that the return will not be audited.
The return preparer may rely in good faith, without verification, upon information furnished by the taxpayer. In addition, the preparer may rely in good faith and without verification upon information furnished by another advisor, tax return preparer, or other third party. The preparer may not, however, ignore the implications of information furnished to him or actually known by him. In addition, the preparer must make reasonable inquiries if the information furnished by another tax return preparer or third party appears to be incomplete or incorrect.
Example. Returning to the facts in the previous example, Jones is the preparer of Partner A's individual income tax return. She can rely, without verification, on the Form K-1 prepared by Smith. Unless she has reason to know that it is incorrect or incomplete, she will not be subject to the IRC section 6694 penalty with regard to the information contained on the Form K-1. She is responsible for determining if Partner A has sufficient basis to claim all or a portion of the loss from the partnership.
Notice 2008-13 reiterates the reasonable cause and good faith exceptions contained in both the old section 6694 provisions and the new section 6694 rules. Regarding reliance on the advice of a third party, the notice provides that the third party may not be a member of the same firm as the tax return preparer. In addition, the third party must be a person that the preparer has reason to believe is competent to render the advice. The advice can be either oral or written, but, in either event, the burden of establishing that the advice was received is on the preparer.
For a position that was disclosed, new rules replace the nonfrivolous standard with the requirement that there be a reasonable basis for the tax treatment of the position taken.
Interim penalty compliance obligations.
If a signing preparer believes that a reasonable basis exists for the position taken but does not have a reasonable belief that the position would more likely than not be sustained on audit, the preparer will not be subject to the penalty under section 6694 if any of the following requirements are met:
* The position is disclosed on a properly completed and filed Form 8275 or 8275-R.
* If the position would not meet the standard to avoid the section 6662 penalty without disclosure, then the preparer provides the taxpayer with the prepared return that includes the disclosure.
* If the position would otherwise meet the section 6662 requirement for nondisclosure, then the preparer advises the taxpayer of the difference between the require ments of section 6662 and section 6694 and contemporaneously documents that this advice was given.
If a taxpayer is advised by a nonsign-ing preparer that a position does have a more-than-50% chance of being sustained on audit, then the nonsigning preparer will not be subject to the section 6694 penalty, if the advice to the taxpayer includes a statement informing the taxpayer of the penalties under section 6662 and the disclosure requirements. If such advice is given to another preparer, the penalty will be avoided if the advice includes a statement that disclosure under section 6694 may be required. In either case, the non-signing preparer should contemporaneously document to establish the fact that the statement was given to the taxpayer or other preparer.
Revenue Procedure 2008-14. On January 25, 2008, the IRS issued an advance copy of Revenue Procedure 2008-14 (2008-7 IRB), which updates Revenue Procedure 2006-48 (2006-47 IRB 934). Revenue Procedure 2008-14 discusses when disclosure of an item on a taxpayer's return is adequate for the purpose of avoiding either the accuracy-related penalties under IRC section 6662 or the return preparer penalties under section 6694(a). Revenue Procedure 2008-14 applies to any return filed on 2007 tax forms for taxable years beginning in 2007 and to any return filed on 2007 tax forms in 2008 for short, taxable years beginning in 2008.
Preparers planning on disclosing positions taken on a return should be certain to familiarize themselves with Revenue Procedure 2008-14 and all future guidance, to ensure that the disclosure is adequate to avoid the imposition of penalties. The procedure contains detailed rules as to the requirements for completing forms and attachments "in a clear manner and in accordance with their instructions" to satisfy an "adequate disclosure" test.
Circular 230. Following the issuance of Notice 2007-54 (IRB 2007-27), the IRS announced on September 26, 2007 (IRB 2007-45, TD 9359), that it will incorporate the new tax return preparer reporting requirements [i.e., the more-likely-than-not standard found in the revised language of IRC section 6694(a)] in the provisions of Circular 230. Circular 230 addresses only the right to practice before the IRS, however; it does not address the imposition of monetary penalties.
Unless a tax preparer has a reasonable belief that the tax treatment of an item on a tax return has a better-than-50% chance of being sustained on its merits, or unless a reasonable (not frivolous) basis exists for such a position that is adequately disclosed, the preparer may not sign the tax return.
Similarly, a tax preparer may not advise a taxpayer to take a position on a tax return unless the preparer has a reasonable belief that the more-likely-than-not standard (i.e., more than 50% chance of being sustained on its merits) will be met, or a reasonable basis exists for such position and is adequately disclosed.
A tax preparer must inform a taxpayer of any penalties that will more than likely be applicable with respect to a position taken on a tax return for which the preparer either advised the individual or prepared and signed the tax return. The practitioner must also notify a taxpayer of the opportunity to avoid such penalties by making adequate disclosure, following the requirements for making the disclosure, and also contemporaneously documenting such advice.
It should be noted that the House of Representatives recently passed a bill that would reduce the preparer penalty standards to the penalty standards that apply to taxpayers under IRC section 6662. As of this writing, no similar action has been taken by the Senate.
Robert Katz, Esq., is the Chaykin Distinguished Teaching Professor of Taxation at the Zarb School of Business, Hofstra University, Hempstead, N.Y., and the director of its graduate tax program. Anthony Basile, PhD, MS (Tax), CPA, is an assistant professor of accounting, taxation, and legal studies in business, also at Hofstra University. Neil D. Katz, Esq., is managing partner of the law firm Katz, Bernstein & Katz, LLP, Syosset, N. Y., and an adjunct professor of taxation at Hofstra University. Harold Finkelstein, Esq., is of counsel to Katz, Bernstein & Katz, LLP, and is the former lead appeals team manager of the Long Island appeals office of the IRS.
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|Title Annotation:||federal taxation|
|Author:||Basile, Anthony; Katz, Robert; Katz, Neil D.; Finkelstein, Harold|
|Publication:||The CPA Journal|
|Date:||Jul 1, 2008|
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