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Prop. regs. heighten the "reasonable basis" standard for return positions.

Income tax return preparers have long had to navigate a compliance minefield in determining whether positions taken on their client's returns could subject them to Sec. 6694 return preparer penalties or their clients to Sec. 6662 accuracy-related penalties.(1) Interpretations of such nebulous compliance standards as "not frivolous," "reasonable basis," "realistic possibility of being sustained" and "substantial authority" have assumed great importance as a means of avoiding potentially stiff monetary penalties and professional sanctions. Before the Revenue Reconciliation Act of 1993 (RRA '93), Section 13251 (a), enacted stricter rules for disclosed return positions, return preparers confronted with the murky compliance standards and concerned with the prospect of harsh penalties could seek refuge in the disclosure safe harbor under Sec. 6662(d)(2)(B)(ii); penalties could be avoided by adequate disclosure of "nonfrivolous" return positions.(2) The relatively low and easily interpreted standard for disclosed return positions made disclosure a palatable fallback position, particularly for aggressive return positions.

RRA '93 undermined (at least in part) the relative certainty of the disclosure mechanism by adding the requirement that there be a "reasonable basis" for the tax treatment of the disclosed item, a standard intended to be "significantly higher" than the nonfrivolous standard.(3) Congress may have overlooked the potential for the new standard to discourage disclosure; the rules required taxpayers who intended to disclose return positions to wade through the same morass of compliance standards as nondisclosing taxpayers.

New Rules

Proposed regulations issued in November 1996 further raised the threshold for disclosed return positions.(4) Prop. Regs. Sec. 1.6662-3(b)(3) defines reasonable basis as follows:

Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in [sections] 1.66624(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in [sections] 1.66624(d)(2) ....

Consistent with the RRA '93's legislative history, Prop. Regs. Sec. 1.6662-3(b)(3) provides that the reasonable basis standard is not satisfied by a position that is merely arguable or colorable; further, the disclosed return position must now be "reasonably based on one or more of the authorities" set forth in Regs. Sec. 1.6662-4(d)(3)(iii) (e.g., the Code, regulations, revenue rulings and procedures, tax treaties, court cases, committee reports, etc.). This new definition of "reasonable basis" is more rigorous than under prior law and will bring the compliance standard for disclosed positions closer to the "substantial authority" standard for undisclosed positions.(5) As a result, disclosure will become a less attractive option in many cases.

Because disclosure substantially raises the audit potential of the position and the entire return, the new reasonable basis rules will require careful consideration to determine whether disclosure is appropriate in close cases. Because of the stakes and the complexities involved in interpreting the new rules, conflicts will undoubtedly arise between return preparers and their clients. Practitioners will need to take affirmative steps to protect themselves, their clients and their client relationships.

Accuracy-Related and Preparer Penalties

The basic penalty framework must be understood to evaluate appropriately the pros and cons of disclosure. Currently, the Sec. 6662 accuracy-related penalty is assessed for the following transgressions:

* Negligence or disregard of the rules or regulations (Sec. 6662(b) (1)).

* A substantial understatement of income tax liability (Sec. 6662(b)(2)).

* A substantial valuation misstatement under Chapter 1 (Sec. 6662(b)(3)).

* A substantial overstatement of pension liabilities (Sec. 6662(b)(4)).

* A substantial understatement of an estate or gift tax valuation (Sec. 6662(b)(5)).

In each case, the penalty is 20% of the underpayment attributable to the penalized conduct (e.g., in the case of negligence, the penalty is assessed on the amount of any underpayment attributable to negligence).

Negligence and Disregard

The negligence, disregard of rules or regulations and substantial understatement penalties are the more commonly assessed accuracy-related penalties. According to Sec. 6662(c), the negligence penalty applies to taxpayers who fail to make a reasonable attempt to comply with the tax laws.(6) The penalty for disregard of the rules or regulations is imposed on taxpayers who do not use reasonable diligence to determine the correctness of a return position contrary to a rule or regulation (defined by Regs. Sec. 1.6662-3(b)(2) to include the Code, temporary or final regulations issued thereunder and revenue rulings or notices published in the IRB). Regs. Sec. 1.6662-3(a) and (c) provide that a taxpayer may avoid imposition of the negligence or disregard penalty by adequately disclosing on the return a position having a reasonable basis or by demonstrating reasonable, cause and good faith for the position.

Substantial Understatement

According to Sec. 6662(d), the substantial understatement penalty is imposed for understatements (defined below) exceeding the greater of (1) 10% of the income tax required to be shown on the return or (2) (a) $5,000 (for individuals) or (b) $10,000-(for C corporations). Sec. 6662(d)(2)(A) defines an understatement as the excess of the amount of tax required to be shown on the return for the tax year over the amount of tax shown on the return. An understatement is reduced by the portion for which:

1. There is or was "substantial authority" for the taxpayer's treatment of an item, if the taxpayer has not disclosed the treatment of such item on the return (Sec. 6662(d)(2)(B)(i)).

2. The relevant facts affecting the tax treatment of the item were adequately disclosed on the return or on a statement attached thereto and there is a reasonable basis for such treatment (Sec. 6662(d)(2)(B)(ii)).(7)

3. The taxpayer has reasonable cause and acts in good faith with respect to the treatment (whether or not there has been disclosure) (Sec. 6664(c)(1)).(8)

Preparer Penalties

Income tax return preparers are subject to a different set of penalties. First, they may be assessed a $250 penalty under Sec. 6694(a) for any return that understates a taxpayer's tax liability due to an undisclosed position for which there was not a realistic possibility of being sustained on the merits. Second, the may be subject to a $1,000 penalty under Sec. 6694(b) for any willful, reckless or intentional understatement of tax liability.

While these penalties are relatively minor and often pale in comparison to accuracy-related and other penalties that may be at issue, the assertion of preparer penalties can create major professional problems for the tax practitioner. The imposition of a preparer penalty often serves as the basis for a disciplinary report to the Treasury's Director of Practice (DOP). Repeated reports could result in a referral to the DOP for disciplinary proceedings, which could lead to suspension or disbarment from practice before the IRS.(9) As with the accuracy-related penalties, the Sec. 6694(a) penalty can be avoided by adequate disclosure or reasonable cause and good faith. According to Regs. Sec. 1.6694-2(c)(1), the penalty can be avoided if the position was disclosed and was not frivolous, a standard that does not apply to the Sec. 6662 penalties. This discrepancy in compliance standards, which has existed since the RRA '93 and is expanded under the proposed reasonable basis rules, will presumably create additional taxpayer-preparer conflicts over disclosure issues.

Negotiating the quagmire of accuracy-related and preparer penalties requires careful attention. The vagueness and subjectivity of these standards complicates the compliance process. Moreover, because of the heightened reasonable basis requirement set forth in the proposed regulations, disclosure no longer offers the protection that it offered in the past; now, disclosing a position that does not satisfy the stricter reasonable basis standard may invite penalties in addition to an audit.

Compliance Standards for Return Positions

The distinction between "reasonable basis" and "substantial authority" is a critical one. Whether a return position has a reasonable basis determines whether it is appropriate to take in the first instance; whether it is further supported by substantial authority determines whether disclosure will avoid Sec. 6662 penalties. Because the "spread" between the two standards is narrowed under the proposed regulations, the issue of whether to disclose will become more difficult. Preparers must familiarize themselves with the difference between reasonable basis and substantial authority to make the appropriate disclosure decision.

"Reasonable Basis"

As was previously noted, Prop. Regs. Sec. 1.6662-3(b)(3) provides that the reasonable basis standard is met when a return position is reasonably based on one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii), the same authorities used to determine whether a position is based on substantial authority (i.e., the Code; proposed, temporary and final regulations; revenue rulings and procedures; tax treaties; court cases; committee reports, etc.) Thus, a belief that a position has a reasonable basis under thee RRA '93 standards will no longer suffice, nor will the reasonable basis standard be satisfied by a return position that is merely arguable or a colorable claim.

"Substantial Authority"

Regs. Sec. 1.6662-4(d)(2) defines "substantial authority" as an objective standard involving an analysis of and application of the law to relevant facts. The standard is less rigorous than "more likely than not" but more stringent than "reasonable basis." According to Regs. Sec. 1.6662-4(d) (3) (i) and (ii), in determining whether a return position is supported by substantial authority, a taxpayer must weigh objectively all favorable and unfavorable authorities relevant to the tax treatment of an item. The test is met if the supporting authorities are "substantial" in relation to the opposing authorities, after weighing each authority appropriately given its relevance and persuasiveness. If the supporting authorities are not substantial in relation to the contrary authorities, the test is not met and the taxpayer will be subject to penalties in the absence of disclosure.

The requirement that the taxpayer "weigh" the supporting and contrary positions distinguishes the "reasonable basis" and substantial authority" standards under the regulations. Both standards refer to the same set of authorities in Regs. Sec. 1.6662-4(d)(3)(iii). Unlike the "substantial authority" standard, however, the "reasonable basis" standard does not require that the authorities supporting a position bear any particular relationship to the contrary authorities. Nevertheless, determining whether one standard is met and the other is not by reference to the same set of authorities may often amount to a judgment call. This problematic "weighing" of supporting and contrary authorities determines whether disclosure is required in any given set of circumstances.

Example: T is filing a return that includes a position for which there is a large degree of ambiguity in the tax law; he wants to assert that property he disposed of during the tax year was held for investment purposes and report the income as capital gain. There appears to be some support in the case law for this treatment (as opposed to treatment as trade or business property triggering ordinary income), but the authorities do not involve facts analogous to those at hand. Contrary authority also exists, but applies to different types of income items. A judgment call will be required as to whether to disclose the position. If the supporting authority rises to the level of reasonable basis, T can take the return position and avoid penalties via disclosure.(10) However, if the supporting authority is "substantial" in relation to the contrary authority, T will obtain no benefit from disclosure, because he will not be subject to accuracy-related penalties. The consequences of the wrong decision can be monumental.

Practice Protection

The disclosure dilemma involves balancing the prospect of incurring accuracy-related penalties against the consequences of red flagging audit issues. The gap between compliance standards for disclosed and undisclosed return positions largely determines the attractiveness of disclosure as a means of avoiding penalties. Because the standards have converged, there is currently less incentive to disclose than in the past.

In addition, the uncertainty associated with the more stringent standards will prove confusing to IRS examiners and give the IRS greater flexibility to assert the accuracy-related and preparer penalties. In many examinations, it will be a difficult exercise for the taxpayer, the preparer and the IRS auditor to collectively agree on whether a position has a reasonable basis or is supported by substantial authority. Backed by Congress's clear intent in RRA '93 to encourage a higher level of compliance, an IRS agent is more likely than ever to assert penalties in close cases and as a bargaining chip in audit negotiations.

The proposed regulations' reasonable basis standard also raises the potential for taxpayer-preparer conflicts by increasing the level of uncertainty involved in assessing disclosure standards. Taxpayers who face a relatively low likelihood of audit may be more inclined to run the risk of penalties and avoid disclosure. Preparers, by contrast, are precluded from taking return positions based on the audit lottery. Such machinations could result in Sec. 6694 penalties, damage to professional reputation and the risk of loss of one's CPA license; thus, preparers typically have more to gain (and less to lose) in persuading clients to disclose return positions in close cases. The heightened disclosure standard will exacerbate these conflicts by making reasonable basis more difficult to assess and by increasing the possibility of miscalculation.

A second source of potential taxpayer-preparer conflict stems from die higher disclosure standard for purposes of Sec. 6662 penalties compared to the standards for Sec. 6694 preparer penalties (i.e., "reasonable basis" versus "nonfrivolous"); specifically, disclosure of a nonfrivolous item may protect die preparer, but not the client, from penalties.(11) Presumably, the AICPA's Statements of Responsibilities in Tax Practice will be modified to conform to the new rules, to avoid this anomaly.

The proposed regulations greatly complicate compliance for taxpayers and present even greater challenges for preparers. As a practical matter, however, taxpayers may often be able to overcome or mitigate the IRS's assertion of penalties by demonstrating reasonable cause and good faith.

The existence of reasonable cause and good faith is determined on a case-by-case basis, taking into account all pertinent facts and circumstances. Generally, according to Regs. Sec. 1.6664-4(b)(1), the most important factor is the taxpayer's effort to assess his proper tax liability. Regs. Sec. 1.66644(c) indicates that this test is met if the taxpayer retained a competent tax adviser, supplied all pertinent information and reasonably relied on the adviser's advice.(12) Obviously, it is better to take preemptive steps to avoid the assertion of penalties, rather than attempt to rely on the reasonable cause and good faith defense later on.

Conclusion

Preparers should take the following steps to protect themselves and their clients under the proposed reasonable basis standard:

* Understand the subtle interplay of the "reasonable basis" and "substantial authority" rules in analyzing whether a return position is appropriate and, if so, whether it should be disclosed.

* Effectively communicate the appropriate options to the client.

* Advise the client of any potentially applicable penalties.

* Adequately document for the files an analysis of the issues, the conclusions drawn and the advice provided to the client.

* Prepare a "sanitized" memorandum to be furnished to the Service in the event penalties are asserted against the client. The memorandum should be written when the return is prepared or the advice is rendered, and should contain all of the pertinent facts-provided by die client and the arguments supporting the "reasonable basis" or "substantial authority" position taken on the return.

A preparer who rushes through the compliance labyrinth without mapping out a careful strategy could damage his client relationships and professional reputation and subject himself to malpractice claims, all excellent reasons to tread very carefully in this area.

(1) This article does not discuss individual return compliance standards for tax shelters, which are subject to specific rules under Sec. 6662(d)(2)(c) and Regs. Sec. 1.6662-4(g)(1)(i) and (iii).

(2) "Nonfrivolous" was defined as a claim that was not "merely arguable," "merely colorable" or "patently improper"; see Regs. Secs. 1.6662-3(b)(3) and 1.6694-2(c)(2).

(3) See H. Rep. No. 103-213, 103d Cong., 1st Sess. 205 (1993).

(4) IA-42-95 (11/8/96).

(5) "Reasonable basis" and "substantial authority" require reliance on a similar list of authorities. Prop. Regs. Sec. 1.6662-3(b)(3) also clarifies that a taxpayer not satisfying the reasonable basis standard nevertheless may be able to rely on the reasonable cause and good faith exception set forth in Regs. Sec. 1.6664-4.

(6) Regs. Sec. 1.6662-3(b)(1) provides that negligence includes any failure to (1) exercise ordinary and reasonable care in the preparation of a tax return, (2) have a reasonable basis for the position taken or (3) maintain adequate books and records.

(7) Rev. Proc. 96-58, IR-B 1996-53, 16, explains that a disclosure is adequate if made by a statement of the relevant facts or legal issues involved, either on the return itself or on an attachment to the return. The statement must include (1) a caption identifying the statement as a disclosure under Sec. 6662; (2) an identification of the item or group of similar items disclosed; (3) the amount of the item or group of similar items; and (4) any facts affecting the item that may reasonably be expected to apprise the IRS of the nature of the potential controversy concerning the tax treatment of the item. form 8275, Disclosure Statement, may be used; to disclose a position contrary to a regulation, Form 8275-R, Regulation Disclosure Statement, may be used.

(8) See Regs. Secs. 1.6662-4(a) and 1.6664-4.

(9) See Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries and Appraisers Before the Internal Revenue Service, Sections 10.50 and 16.51(j).

(10) Whether a return position is appropriate is complicated by the Sec. 6694(a)(1) compliance requirements for return preparers; preparers can only take positions on their clients' returns "having a reasonable possibility of being sustained on the merits." Regs. Sec. 1.6694-2(b)(1) provides that the standard is met if "a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits."

(11) The proposed regulations' reasonable basis standard is higher than the preparer standard under AICPA guidelines; AICPA Professional Standards, TX Section 112.02c (August 1988), provides that a CPA may recommend a position that is not frivolous so long as the position is adequately disclosed on the return or claim for refund. This standard may be dated and subject to change in the near future.

(12) However, the extensive case law indicates that even the availability of this defense is limited; see, e.g., William H. Houle, TC Memo 1985-389 (the taxpayers' reliance on an accountant did not insulate them from the negligence penalty); Robert W. Boyle, 469 US 241 (1984) (55 AFTR2d 85-1535, 85-1 USTC [paragraph]13,602) (taxpayer could not avoid delinquency penalties due to reliance on an attorney to timely file his mother's estate tax return, it taking no special training or effort for the taxpayer to ascertain a deadline and ensure that it was met).

EXECUTIVE SUMMARY

* According to the proposed regulations, "reasonable basis" is not satisfied if the return position is merely arguable or a colorable claim.

* Under the proposed rules, the reasonableness of a disclosed return position is to be tested under the same types of authorities as contained in the definition of "substantial authority."

* The difference between "reasonable basis" and "substantial authority" is that the former does not require a weighing of the supporting and contrary authorities.
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Author:Sirotic, Steven A.
Publication:The Tax Adviser
Date:Aug 1, 1997
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