Practical Considerations for the New Paid Preparer Penalty Rules and FIN 48

By Anthony P. Vernaglia, CPA, MST, Restivo Monacelli LLP, Providence, RI (Not Affiliated with CPAmerica International)

Editor: Michael D. Koppel, CPA, PFS

Return preparers have recently become subject to new, higher standards from two sources: Congress and the Financial Accounting Standards Board (FASB). This item compares the new “more likely than not” standard and explores the pitfalls that CPAs may encounter under FIN 48 and the Code.

Preparer Standards Under the Code

The Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), which was signed into law on May 25, 2007, includes a provision that modifies the existing preparer penalty rules. SBWOTA amended Sec. 6694 by making the following changes:

1. It expanded the preparer penalties to apply not only to income tax returns but also to estate and gift, excise, exempt organization, and employment tax returns.

2. It increased the dollar amount of preparer penalties:

  • For an “unreasonable position,” the penalty is increased from $250 per return to the greater of $1,000 or 50% of the income derived by the preparer (per return or claim for refund).
  • For “willful or reckless conduct,” the penalty is increased from $1,000 per return to the greater of $5,000 or 50% of the income derived by the preparer (per return or claim for refund).

3. It modified the standards of conduct that must be met to avoid the imposition of preparer penalties associated with the understatement of a tax liability:

  • The “not frivolous” standard for under-
    statements involving a disclosed position is raised to a “reasonable basis” requirement.
  • The “realistic possibility of being sustained on its merits” standard for an undisclosed position has been raised to a “more likely than not” requirement.

The Service has issued Notice 2007-54, which provides transitional relief from the new preparer penalty rules. This transitional relief will allow return preparers to follow the previous law under Sec. 6694 for income tax returns, amended returns, and refund claims. For all other returns, including estate, gift, and generation-skipping transfer tax returns, employment tax returns, and excise tax returns, the reasonable basis standard set forth in the regulations under Sec. 6662 will be applied in determining whether the IRS will impose a preparer penalty. The Notice 2007-54 relief will apply to all returns, amended returns, and refund claims due on or before December 31, 2007 (determined with regard to any extension of time for filing), to 2007 estimated taxes due on or before January 15, 2008, and to employment and excise tax returns due on or before January 31, 2008. No transitional relief is available where there is willful or reckless conduct, regardless of the type of return prepared.

The “reasonable basis” standard for disclosed positions is defined in Regs. Sec. 1.6662-3(b)(3) to be a relatively high standard of tax reporting—significantly higher than “not frivolous” or “not patently improper.” Under the regulations, a return position that is “merely arguable or that is merely a colorable claim” does not satisfy the reasonable basis standard. If a return position is reasonably based on one or more of the authorities set forth in Regs. Sec. 1.6662-4(d)(3)(iii) (taking into accountthe 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 Regs. Sec. 1.6662-4(d)(2).

The former “realistic possibility of being sustained on its merits” standard for undisclosed positions was defined in Regs. Sec. 1.6694-2(b) as one in which 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 chance of being sustained on its own merits.

Sec. 6694 does not define the new “more likely than not” (MLTN) standard. However, the plain meaning of the term and its interpretation in other instances indicate that it means a greater than 50% possibility.


Circular 230 §10.35(b)(4) describes a reliance opinion as written advice “if the advice concludes at a confidence level of at least more likely than not (a greater than 50 percent likelihood) that one or more significant federal tax issues would be resolved in the taxpayer’s favor.” (The IRS has issued proposed regulations to conform Circular 230 to the new Sec. 6694 MLTN standard; see News Notes, p. 705.)

MLTN Under FIN 48

FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, which generally applies to fiscal years beginning on or after December 15, 2006, addresses the recognition and measurement of income tax positions using an MLTN threshold. Under FIN 48, the MLTN threshold means that:

  • A benefit related to an uncertain tax position may not be recognized in the financial statements unless it is more likely than not that the position will be sustained based on its technical merits; and
  • There must be more than a 50% likelihood that the position would be sustained if challenged and considered by the highest court in the relevant jurisdiction.

FIN 48 requires a “cumulative probability” approach to recognize the largest amount of a tax benefit that is more than 50% likely to be realized after settlement with a tax authority that has full knowledge of all relevant information.

In practice, FIN 48 will require a business to assess its worldwide tax position using these MLTN criteria in determining the adequacy of its tax reserves and its inventory of temporary differences and the resulting measurement of its deferred tax assets. It will require a great deal of judgment for an enterprise to properly implement FIN 48.

Prior to FIN 48, a business used Statement of Financial Accounting Standards (FAS) No. 5, Accounting for Contingencies, to assess the reasonableness of its tax reserves. Aggressive tax positions were generally recorded as a component of a business’s FAS 5 reserve (also referred to as a company’s tax “cushion”). Under FAS 5, a business identified uncertain tax benefits and determined the likelihood of losing those benefits. A loss contingency was accrued only if the loss was probable and could be reasonably estimated.

A deferred tax asset is generally measured based on all available data readily available and in accordance with FAS No. 109, Accounting for Income Taxes. If management determines, based on the weight of the evidence available, that it is more likely than not (more than 50%) that some portion or all of the deferred tax assets will not be realized, a valuation allowance should be recorded to reduce the deferred tax asset to the amount that is more likely than not to be realized.

Under FIN 48, an additional measurement has been added due to the MLTN measurement criteria requirement to determine the “best estimate” required by FIN 48. As a result, there are three measurements to consider: financial statement basis, “best estimate” tax basis, and the “as filed” tax basis.

Expanded Disclosure Requirements

A controversial issue of FIN 48 is the expanded disclosure requirements. For example, at each annual reporting period, the following disclosures are required:

  • A tabular reconciliation of the total amount of unrecognized tax benefits from the beginning through the end of each period;
  • For positions for which it is reasonably possible that the total amount of unrecognized tax benefits will in-
    crease or decrease significantly within 12 months of the reporting date, the nature of the uncertainty, the nature of the event that could occur within 12 months that would create the change, and an estimate of the range of the change or a statement that an estimate cannot be determined;
  • A description of the tax periods that remain open to examination by major tax jurisdictions;
  • The total amount of interest and penalty recognized in the statements of operations and financial position; and
  • The impact on the effective tax rate associated with the total amount of unrecognized tax benefits, if they were recognized.

The obvious concern here is that FIN 48 disclosures and workpapers can provide a great deal of information about a business enterprise’s worldwide tax position. Access to this information would provide an auditor a great deal of insight into the “Achilles heel” of a company’s uncertain tax positions. Historically, under its policy of restraint, the Service has not requested tax accrual workpapers as a standard examination technique. Its current policy is to request them only when a business has been involved in a listed transaction (IRM

Recent IRS guidance on FIN 48 gives some insight into the Service’s view of this new accounting pronouncement’s relevance for use in an IRS examination.

Chief Counsel Memorandum AM 2007-0012 (6/8/07): The IRS Chief Counsel’s Office concludes that documents produced by a taxpayer and/or its auditors to document uncertain tax positions according to FIN 48 are treated as tax accrual workpapers (TAWs) as defined by Internal Revenue Manual (IRM) Section

Field Examiner’s Guide LMSB-04-0507-045, FIN 48 Implications (May 2007), and LMSB Commissioner Mem o randum LMSB-04-0507-044, FIN 48 and Tax Accrual Workpaper (TAW) Policy Update (5/10/07): The field examiner’s guide and LMSB memo say that documents produced by a taxpayer and its auditors to document uncertain tax positions in accordance with FIN 48 are included in the IRS’s interpretation of TAWs and are subject to the Service’s policy of restraint in requesting provision workpapers. The field guide does suggest to IRS auditors that tax footnotes including FIN 48 disclosures should be reviewed as part of the audit planning process, subject to warnings that the IRS’s restraint policy on requesting tax provision workpapers should be

Chief Counsel Notice 2007-015 (6/20/07): CC-2007-015 concludes that effective tax rate reconciliation workpapers are neither tax accrual workpapers nor audit workpapers. Therefore, they are not included in the documents that the IRS will not routinely request during an audit.

Issues to Consider

CPAs may want to consider the following issues in light of the increased level of scrutiny required under the MLTN criteria by both Sec. 6694 and FIN 48:

  • The MLTN criteria and the analysis and documentation required by FIN 48 can be a useful best-practices tool for clients to assess and manage their global tax positions.
  • Will allowable tax preparer standards less than the MLTN criteria under the new Sec. 6694 rules result in a different tax position for financial reporting purposes under FIN 48 than the tax position taken on an income tax return?
  • Will the use of Schedule M-3 reporting deter the use of legitimate tax planning strategies?
  • Will there be an increase in either IRS or state tax audit activity as a result of the increased reporting requirements associated with FIN 48?
  • Will the Service abandon its long-held policy of restraint in requesting tax provision workpapers during a corporation’s income tax examination?
  • What is the correlation in value with the use of the MLTN criteria under either FIN 48 and Sec. 6694, and what are the associated costs of compliance with either of these regulatory requirements?


The MLTN standard has effectively raised the bar on CPAs who provide tax compliance and tax advisory services for their clients. With the ever-increasing regulatory requirements imposed on the profession coupled with resource constraints, CPAs must be extremely careful and diligent when providing tax services to their clients under the MLTN requirement.

If you would like additional information about these items, contact Mr. Koppel at (781) 407-0300 or
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