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The realistic possibility standard - final regulations.

Regulations finalized in late December 1991 explain the so-called "realistic possibility standard," included in the 1989 penalty reform legislation, for measuring the conduct of tax return preparers.

Under Sec. 669(a), a tax return preparer can be assessed a $250 penalty if the return contains an understatement of tax resulting from a tax treatment that does not have a "realistic possibility of being sustained on its merits." The penalty applies only if the preparer knew (or should have known) of the treatment when the return was signed. In the case of a nonsigning preparer who gives advice relating to a return position, the relevant time is the date advice was given (rather than when the return was signed).

Regs. Sec. 1.6694-2(b) sets forth the realistic possibility standard in terms of percentage odds. A position meets the realistic possibility standard when it is one that would be taken by a person knowledgeable in the tax law who, after a "reasonable and well-informed analysis," would conclude that the position has at least a one in three likelihood of being sustained if challenged by the IRS. In reaching this conclusion, the knowledgeable person cannot consider the chances of audit by the Services or the chances that the issue will be raised if an audit does occur.

This reasonable and well-informed standard requires a preparer to use essentially the same analysis as in determining whether the position has "substantial authority" under the tests of Sec. 6662 (relating to the substantial understatement penalty assessable against taxpayers). Similarly, acceptable authorities for determining whether a position has a likelihood of being sustained are the same as those authorities under the Sec. 6662 regulations. Thus, the preparer's analysis must rely on the Code, regulations, court cases, congressional reports and IRS rulings. Textbooks and tax treatises are not acceptable authority by themselves, but the reasoning of such documents and authorities cited therein might be useful in determining if a particular case meets the realistic possibility standard. The Sec. 6694 regulations give extensive examples of the type of analysis needed to meet the realistic possibility standard.

Regs. Sec. 1.6694-2(c) provides a safe-harbor exception to the $250 penalty if two conditions are met. 1. The position taken is not "frivolous," defined as "patently improper." 2. The position is "adequately disclosed."

For a preparer required to sign the return in which the position is taken, disclosure must be made as required under the "substantial authority" rules of Regs. Sec. 1.6662-4(f). The requires disclosure on the return, usually on Form 8275, Disclosure Statement, or 8275R, Regulation Disclosure Statement, as applicable. (The form is not required, however, for certain trade or business expenses and other specified items disclosed on the return in accordance with Rev. Proc. 92-23.)

For a preparer not required to sign the return in which the position the return in which the position is taken, a statement regarding the necessary disclosure must accompany the advice given. The statement must be written if the advice is written. Also, the position actually taken must be disclosed in the return (as previously described).

A "reasonable cause" exception to the $250 penalty is also provided. Under Regs. Sec. 1.6694-2(d), the Service can waive the penalty if, considering all surrounding facts and circumstances, the preparer acted in good faith with regard to the position taken. Factors considered in making this determination include the nature, frequency and materiality of the errors; the preparer's normal office procedures; and whether the preparer relied on advice of another preparer.

Sec. 6694(b) and Regs. Sec. 1.6694-3 described a $1,000 preparer penalty that can result from willful attempts to understate tax, or from the reckless or intentional disregard of rules or regulations. Reckless or intentional disregard is not deemed to occur for nonfrivolous positions that are adequately disclosed, provided that if a position is contrary to a regulation, the position represents a good faith challenge to the validity of the regulations. For positions contrary to IRS rulings and notices, meeting the realistic possibility standard precludes a finding of reckless or intentional disregard.

The regulations make it clear that preparers do not have to "verify independently the taxpayer's information" to avoid both the $250 and $1,000 penalties. The preparer can rely on taxpayer information, but the preparer must not ignore inconsistencies or incomplete information. Furthermore, preparers "must make appropriate inquiries" when the Code or regulations require taxpayers to meet specific conditions for claiming a deduction. An example in Regs. Sec. 1.6694-1(e) relates to a prepare who took an erroneous deduction for travel and entertainment expenses based on the taxpayer's information. The preparer had inquired about the existence of proper documentation, and had no reason to believe either that the documentation was inadequate or that expenses presented were incorrect. This preparer cannot be subjected to either penalty.

All tax return preparers need to understand the realistic possibility standard, which is a new way for the Service to look at preparer actions. The AICPA had used this standard in its Statements on Responsibilities in Tax Practice (1988 Revision, No. 1, and Interpretation 1-1 thereof). While the Code and regulations relating to preparer penalties do not adopt directly or exactly the AICPA's version of the standard, preparers would be advised to consider the AICPA documents together with the IRS regulations in determining proper conduct when actually preparing a tax return and when giving tax advice that could have a significant effect on a return.
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Author:Ward, David R.
Publication:The Tax Adviser
Date:Sep 1, 1992
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