Scope and Size of Tax Preparer Penalties Increase

Editor: Frank J. O’Connell, Jr., CPA, Esq.

The Small Business and Work Opportunity Tax Act of 2007, enacted in May, increases penalties on preparers and raises the standard of nondisclosure positions from “realistic possibility of success” to “more likely than not.” The legislation also extends the reach of these penalties beyond “income tax return preparers” to all tax return preparers. Therefore, the penalties will now apply to preparers of non-income-based tax returns.

Under prior law, Sec. 7701(a)(36) defined an income tax preparer as any person who prepares, or employs other people to prepare, all or a significant part of an income tax return or refund claim for compensation. Preparer penalties did not apply to a person preparing a non-income-tax return, including an estate, gift, excise, or employment tax return. Prior Sec. 6694 stated that the preparation of an income tax return for which there is an understatement of tax related to an undisclosed position, for which there is not a realistic possibility of being sustained on its merits or is a frivolous position, resulted in a first-tier penalty of $250 if the preparer knew or reasonably should have known of the position. The preparation of a return for which the preparer engaged in willful or reckless conduct would result in a return penalty of $1,000.

Revised Sec. 7701(a)(36) defines a tax return preparer as any person who prepares, or employs other people to prepare, any return of tax imposed under the Code or refund claim for tax. Also, the new law raises the standard for undisclosed return positions. This standard requires that the preparer have a reasonable belief that the treatment of a tax position was more likely than not the proper treatment. Also, the first-tier penalty is increased to the greater of $1,000 or 50% of the income derived or to be derived by the tax return preparer from the preparation of the return for which the penalty is being assessed. Further, the penalty for which a preparer engages in willful or reckless conduct also is increased to the greater of $5,000 or 50% of the income derived to the preparer from the tax return. Therefore, the application of these preparer penalties now applies to non-income-tax returns, such as estate, gift, excise, and employment tax returns, and the returns of exempt organizations.

The IRS issued Notice 2007-54 shortly after the law was enacted to provide transitional relief for the return-preparer penalty provisions. This relief extends the application date of the law, which initially applied to all tax returns prepared after May 25, 2007. Therefore, the penalty provisions will apply to all returns, amended returns, and refund claims with extended due dates occurring after December 31, 2007; all estimated tax returns due after January 15, 2008; and all employment and excise tax returns due after January 31, 2008. For example, businesses that file income tax returns with tax years ended April 30, 2007, or later will not be eligible for transition relief. Also, transitional relief will not be available to return preparers who exhibit willful or reckless conduct, regardless of the type of return prepared.

Under both the prior and current laws, disclosure under Sec. 6694(a) is still adequate if made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, and attached to the return, amended return, or refund claim. Further, the penalty under Sec. 6694(a) will not be imposed if it is shown that there is a reasonable cause for the understatement and the tax preparer acted in good faith.

The IRS is in the process of writing proposed and temporary regulations that it plans to issue before the transitional relief expires in December 2007. It is also in the process of reviewing all federal returns and forms to determine whether a paid-preparer section should be added. Federal payroll tax Forms 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, and 941, Employer’s Quarterly Federal Tax Return, for 2007 currently contain paid-preparer sections, but they are indicated as optional. Based on current law, however, it appears that the absence of a return’s paid preparer section would not preclude the IRS from assessing a penalty if the preparer received compensation for preparing the return.

Note: For more on the AICPA’s efforts regarding this issue, see DC Currents, The Tax Adviser (August 2007), p. 472.

EditorsNotes

Frank J. O’Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.

Unless otherwise noted, contributors are independent members of Crowe Chizek.

If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.