Spring 2009 Newsletter
Tax Return Preparer Penalties under Internal Revenue Code § 6694: New Regulations Let in the Light
By: Timothy R. Mucha, Esq.
Internal Revenue Code (I.R.C.) §6694 penalizes understatements of tax liability due to “unreasonable”positions tax return preparers take on returns or claims for refund.1 After leaving it alone for years, Congress changed the rules regarding tax return preparer penalties as a part of the Small Business and Work Opportunity Tax Act of 2007 (the “2007 Act”) enacted on May 25, 2007.2 I.R.C. §6694 now applies to many more preparers of tax returns and claims for refund than just income tax return preparers, as was the case under prior law.3 Applicable standards are tougher, as are the penalties. Since the 2007 Act, there has been a flurry of notices, regulatory actions and even another statutory amendment. The picture became clearer once the IRS published final regulations on return preparer penalties effective December 22, 2008.4 These regulations apply to returns and claims for refund made after January 1,2009.5 Various notices supplying transitional relief and interim guidance with respect to the new penalty regime that were issued prior to the final regulations are obsolete as of January 1, 2009.6 However, those notices may still apply to returns or claims for refund filed during the periods covered by those notices.7
II. THE STATUTE TODAY
The statute currently reads as follows:
Sec. 6694. Understatement of taxpayer’s liability by tax return preparer.
(a) UNDERSTATEMENT DUE TO UNREASONABLE POSITIONS
(1) IN GENERAL.-If a tax return preparer-
(A) prepares any return or claim for refund with respect to which any part of an under statement of liability is due to a position described in paragraph (2) and (B) knew (or reasonably should have known) of the position, such tax return preparer shall pay a penalty with respect to each such return or claim in an amount equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.
(A) INGENERAL.-Except as otherwise provided in this paragraph, a position is described in this paragraph unless there is or was substantial authority for the position.
(B) DISCLOSED POSITIONS.-If the position was disclosed as provided in section 6662(d)(2)(B)(ii)(I) and is not a position to which subparagraph (C) applies, the position is described in this paragraph unless there is a reasonable basis for the position.
(C) TAX SHELTERS AND REPORTABLE TRANSACTIONS.-If the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies, the position is described in this paragraph unless it is reasonable to believe that the position would more likely than not be sustained on its merits.
(3) REASONABLE CAUSE EXCEPTION.-No penalty shall be imposed under this subsection if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith.
(b) UNDERSTATEMENT DUE TO WILLFUL OR RECKLESS CONDUCT.-
(1) IN GENERAL.-
Any tax return preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to a conduct described in paragraph
(2) shall pay a penalty with respect to each such return or claim in an amount equal to the greater of-
(A) $5,000, or
(B) 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.
(2) WILLFUL OR RECKLESS CONDUCT.- Conduct described in this paragraph is conduct by the tax return preparer which is-
(A) a willful attempt in any manner to understate the liability for tax on the return or claim or
(B) a reckless or intentional disregard of rules or regulations.
(3) REDUCTION IN PENALTY.-The amount of any penalty payable by any person by reason of this subsection for any return or claim for refund shall be reduced by the amount of the penalty paid by such person by reason of subsection (a).
A. Who Is Subject To §6694 Penalties?
The statute does not define a tax return preparer. However, the final regulations define a tax return preparer as any person who prepares for compensation, or who employs one or more persons to prepare for compensation, all or a substantial portion of any return of tax or any claim for refund of tax under the Internal Revenue Code.8 Whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion is determined based upon whether the person knows or reasonably should know that the tax attributable to the schedule, entry, or other portion of a return or claim for refund is a substantial portion of the tax required to be shown on the return or claim for refund.9 Also, a person who renders tax advice on a position that is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund will be regarded as having prepared that entry.10
Even if the individual meets the definition of a tax return preparer, he or she is only subject to §6694 if primarily responsible for the position(s) giving rise to an understatement.11 Only one individual within a firm is primarily responsible for each position.12 A“signing tax return preparer”13 is presumed to be primarily responsible for all positions on a return, but that presumption can be overcome with evidence that a “non signing tax return preparer”14 is responsible for the position(s) giving rise to an understatement.15 In that case, the non signing tax return preparer with overall supervisory responsibility for the position(s) is presumed to be primarily responsible, unless evidence indicates that another non signing tax return preparer is primarily responsible.16 If information indicates that either the signing or a non signing tax return preparer could be primarily responsible, the penalty may be assessed against either individual, but not both.17 Under limited circumstances, §6694 may apply to both the individual and the individual’s firm.18
Some what generously, a tax return preparer may rely in good faith and without verification on information supplied by the taxpayer, another advisor, another tax return preparer or another party or information on a previously filed return.19 An important qualification to this rule is that a tax return preparer may not ignore the implications of information that appears to be wrong.20 If there appears to be a problem, the tax return preparer must inquire further.21
B. How Much Are The Penalties?
The statute creates a two tier penalty system, the first tier of which penalizes a tax return preparer for an understatement due to an unreasonable position and the second tier of which penalizes willful and reckless acts.22 The 2007 Act raised the standards for first tier violations of §6694 from $500 to the greater of $1,000 or 50% of the income derived or to be derived by the tax return preparer with respect to the return or claim for refund.23 Second tier violations were increased from a flat $1,000 to the greater of $5,000 or 50% of the income derived or to be derived.24
C.What Standards Must Be Met?
1. Undisclosed Positions
If §6694 penalties could apply to the tax return preparer, he or she must meet different standards to avoid penalties depending on whether the position is disclosed or undisclosed. For undisclosed positions, the standard has become much tougher since the time before the 2007 Act. That Act raised the standard for undisclosed positions from the low “realistic possibility of being sustained on the merits” to “reasonable belief that the position would more likely than not be sustained on the merits.”25 However, since the tax-payer penalty standard for undisclosed positions was the lower “substantial authority” standard under §6662, practitioners complained that competing standards created a risk of conflict between preparers and taxpayers. The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (the “2008 Act”) lowered the standard applicable to undisclosed positions made by a tax return preparer to “substantial authority” for the position, thus unifying the standards.”26 Practitioners commonly believe that substantial authority represents an approximately 40% likelihood of success.
Because the 2008 Act changed the standard solate in the regulatory process, the IRS decided to reserve Reg. §1.6694-2(c) for future guidance about the substantial authority standard. However, the IRS issued Notice 2009-5 in conjunction with the final regulations to provide interim guidance. Notice 2009-5 defers to the accuracy-related penalty regulations under §6662 applicable to taxpayers for details about the substantial authority standard.27 Weight is accorded an authority depending on its relevance and persuasiveness and the type of authority.28 The regulations list the authorities that a tax return preparer may rely on.29 A “written determination” will result in substantial authority for the position.30 Court cases from a taxpayer’s particular jurisdiction cannot be taken into account, except decisions from the United States Court of Appeals to which the taxpayer would have a right of appeal.31
2. Disclosed Positions
To encourage transparency, the statute provides a lower standard for tax return preparers who choose to disclose positions on the tax return. The 2007 Act provides that a tax return preparer will not face a §6694 penalty if the position is adequately disclosed and there is a “reasonable basis” for the position. Practitioners generally believe that reasonable basis is between a 10% and 20% likelihood of success. Still, reasonable basis is “significantly higher” than not frivolous (the standard for disclosed positions before the 2007 Act).32 Again, the §6694 regulations defer to the §6662 accuracy-related penalty regulations to provide the details about the reasonable basis standard itself.33
There are different options for adequate disclosure depending on whether the tax return preparer is a signing or non signing tax return preparer. A signing tax return preparer may adequately disclose the position by one of three different methods. First, he may submit Form 8275, 8275-R or disclose the position on the return in accordance with the annual revenue procedure.34 Second, he may provide the taxpayer with the return that includes disclosure under one of the mentioned methods.35 Finally, as long as the taxpayer would not be subject to a §6662 penalty attributable to a substantial understatement of income tax, a tax return preparer may also advise the taxpayer of the penalties applicable to the taxpayer under §6662and document that advice.36
Similarly, a non signing tax return preparer may adequately disclose a position providing disclosure on Form 8275, 8275-R or in accordance with the annual revenue procedure.37 For advice given to a taxpayer, a non signing tax return preparer may also adequately disclose a position by advising the taxpayer about penalties applicable under §6662 and the standards related to disclosure and documents that advice.38 For advice given to another tax return preparer, a non signing tax return preparer may give adequate disclosure by advising the tax return preparer that disclosure may be required and documents that advice.39 Whenever a tax return preparer attempts to meet the disclosure requirement by advising the tax-payer or another tax return preparer, as the case maybe, the advice must be particular to the situation, general disclaimers are not sufficient.40
3. Tax Shelter Transactions
Although the 2008 Act lowered the standard for undisclosed positions from the “more likely than not”standard to “substantial authority,” it kept the higher“more likely than not” standard for positions involving tax shelters and reportable transactions.41 This bifurcation is only relevant for returns prepared for taxable years ending after October 3, 2008, the date of enactment of the 2008 Act.42 It is important to note that the “more likely than not” standard applies whether the position is disclosed or undisclosed.43 For the purposes of applying the standards, the term tax shelter is defined as it is in §6662.44 A tax shelter is a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of Federal income tax.45 The application of this definition to the return preparer rules is controversial due to the seemingly broad definition of tax shelter. Until the IRS can provide additional guidance, Notice 2009-5 gives some relief to tax return preparers who believe they are dealing with a tax shelter position. Notice 2009-5 provides that the tax return preparer will not be subject to §6694 penalties if there is substantial authority for the position and the tax return preparer advises that taxpayer of the penalties that would apply if the transaction was deemed to have a significant purpose of Federal tax avoidance or evasion. The advice must be documented in the tax return preparer’s files and must state that (i) there must be a minimum of substantial authority for the position, (ii) the taxpayer must have a reasonable belief that the tax treatment was more likely than not the proper tax treatment in order to avoid §6662 penalties and (iii) disclosure will not protect the tax-payer if §6662(d)(2)(C) applies to the position. For a non-signing tax return preparer advising another tax return preparer, he must advise that tax return preparer that there must be substantial authority for the position, and the non-signing tax return preparer must communicate the applicable penalty standards and document the advice in his file.
4. Reportable transactions to which §6662A apply
Notice 2009-5 expressly does not apply to reportable transactions to which §6662A applies (are portable transaction with a significant purpose of Federal tax avoidance or evasion or a listed transaction). Therefore, these transactions should not receive any special treatment, and the standard is“reasonable to believe that [the] position would more likely than not be sustained on its merits.”46 Regulations47 refer to the same analysis used in Reg.§1.6662-4(d)(3)(ii) to determine whether the standard has been met. Whether the standard is met is a facts-and-circumstances test and includes the tax return preparer’s diligence.48 The tax return preparer’s experience with a particular area of tax law, familiarity with the taxpayer’s affairs and complexity of issues are taken into account in setting the diligence level.49
D. Reasonable Cause Exception
One final escape exists for a tax return preparer if he or she can show reasonable cause for the understatement and good faith.50 The test is facts-and-circumstances, and the regulations describe six relevant factors.51
Although some open items still remain, final regulations have done much to solidify the law regarding tax return preparer penalties. Tougher standards and tougher penalties increase the importance of understanding the recent changes to this area.
Timothy Muchais an attorney with Hunton & Williams LLP in Richmond, Virginia. His practice focuses on tax-exempt organizations, estate and trust administration, and estate planning. Mr. Mucha received his undergraduate degree from the University of Virginia and his J.D. degree from the Wake Forest University School of Law where he was a staff editor of the Wake Forest University Law Review and a member of the Moot Court Board.
Author’s Note: This article endeavors to create a synopsis of the new rules relating to return preparer penalties so the reader may gain a better familiarity with these important changes. However, due to space constraints, it was not possible to include every aspect of the applicable regulations and notices. This article does not constitute legal advice and should not be used as a substitute for the legal analysis required in any given instance where these rules apply.
1See I.R.C. §6694.
2See The Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28, §8246 (hereinafter, the “2007 Act”).
3See Rev. Proc. 2009-11, I.R.B. 2009-3, for the latest listings of returns and claims for refund subject to §6694. This list includes Form 706 and Form 709, among others.
7See Notice 2009-5, 2009-3 I.R.B. 309, simultaneously issued with the final regulations, for a synopsis of these prior notices and their effective dates.
8Reg. §301.7701-15(a). The regulations exclude some categories of individuals and organizations from the definition of tax return preparer. For example, an individual preparing a return or claim for refund for a trust, estate or other entity of which the individual either is a fiduciary or is an officer, general partner or employee of the fiduciary, is not a tax return preparer. See 301.7701-15(f)(1)(x).
9Reg. §301.7701-15(b)(3)(i). Factors to consider include the size and complexity of the item relative to the taxpayer’s gross income and the size of the understatement attributable to the item compared to the taxpayer’s reported tax liability. Id. Some de minimis relief exists. See Reg. §301.7701-15(b)(3)(ii).
12Id. The regulations explain, though, that there may be more than one primarily responsible tax return preparer if multiple tax return preparers are employed by, or associated with, different firms. Id.
13A signing tax return preparer is the individual tax return preparer who has the primary responsibility for the overall substantive accuracy of the preparation of the return or claim for refund. Reg.§301.7701-15(b)(1).
14A non signing tax return preparer is a tax return preparer who is not a signing tax return preparer but who prepares all or a substantial portion of a return or claim for refund with respect to events that have occurred at the time the advice is rendered. Reg. §1.301-7701-15(b)(2). However, advice given after events have occurred that represents less than 5% of the time on the position(s) giving rise to the understatement is not taken into account. Reg. §301.7701-15(b)(2)(i). Also, advice given before the events will be taken into account if the position(s) giving rise to the understatement are attributable to the advice, the advice was given before the events to avoid treatment as a tax return preparer, and the advice was confirmed after the events for the purposes of preparing a tax return. Id. Examples of non signing tax return preparers are tax return preparers who provide advice (written or oral) to a taxpayer (or to another tax return preparer) when that advice leads to a position or entry that constitutes a substantial portion of the return. Id.
17Reg. §1.6694-1(b)(4). This rule avoids joint and several liability.
22See I.R.C. §6694(a)-(b).
23The 2007 Act, §8246(b).
26The Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Division C of P.L. 110-343, §506 (hereinafter, the“2008 Act”).
27See §1.6662-4(d)(3) generally.
35Reg. §1.6694-2(d)(3)(i)(B). The tax return preparer apparently does not have to make sure the taxpayer then makes the disclosure. This may provide the preparer some relief if the taxpayer insists the preparer not make a disclosure.
41See the 2008 Act.
42See Notice 2009-5. That is because the 2007 act never distinguished between positions related to a tax shelter or reportable transaction and other positions.
43This is clear from the structure of the 2008 Act.
44See Notice 2009-5.
45See I.R.C. § 6662(d)(2)(C)(ii).
46See the 2008 Act.
47Reg. § 1.6694-2(b).
50I.R.C. § 6694(a)(3).
51See Reg. § 1.6694-2(e).