Proposed Preparer Penalty Regs. Released

The Service has issued proposed regulations that implement changes made by the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28, to the return preparer penalties in Secs. 6694 and 6695 and related provisions (REG-129243-07). The Service describes the proposed regulations as “the first significant step” in a “comprehensive review and overhaul of all the tax return preparer penalties and related regulatory provisions.” The provisions of the proposed regulations would generally be effective for returns and claims for refund filed after the final regulations are published.

Addressing one concern of tax practitioners, the proposed regulations clarify that the IRS will not mandate a referral to the Office of Professional Responsibility (OPR) when penalties are assessed against a preparer under Sec. 6694. In cases of nonwillful conduct, the Service says it will look for a pattern of failure to meet the Sec. 6694 standards before making a referral to OPR. They caution that “egregious” conduct may form the basis for an OPR referral.

Return preparation date: The proposed regulations define the date a return or claim for refund is prepared as the date it is signed by the preparer (Prop. Regs. Sec. 1.6694-1(a)(2)). If the preparer fails to sign the return, the return preparation date is deemed to be the date the return was filed. For nonsigning preparers, the relevant date is the date the person provides the advice on the position that results in the understatement.

One preparer per firm: In the past, the Service has employed a “one preparer per firm” rule when determining penalties. With these proposed regulations, the IRS is abandoning that rule and moving to a structure in which each position taken on a return can have a different preparer. One person in a firm will be considered primarily responsible for each position taken (Prop. Regs. Sec. 1.6694-1(b)). The person who signs the return will generally be considered primarily responsible for all the positions on the return (Prop. Regs. Sec. 1.6694-1(b)(2)), but that presumption can be overcome by evidence that another preparer is primarily responsible for a particular position.

Reliance in good faith: The proposed regulations allow a return preparer to rely in good faith—and without verification—on information supplied by the taxpayer, another adviser, return preparer, or other party, and on tax returns prepared by other preparers and filed with the IRS (Prop. Regs. Sec. 1.6694-1(e)). The preparer cannot ignore the implications of information supplied by the taxpayer or actually known to the preparer, and the preparer cannot rely on information provided by the taxpayer with respect to legal conclusions about federal tax law.

Income derived: Sec. 6694 subjects preparers to penalties of up to 50% of the income derived (or to be derived) “with respect to the return or claim.” The proposed regulations define “income derived (or to be derived)” to mean all compensation the tax return preparer receives or expects to receive with respect to the engagement of preparing the return or providing tax advice with respect to positions taken (Prop. Regs. Sec. 1.6694-1(f)). In the case of a preparer who works for a firm, this means compensation the preparer receives from the firm that can reasonably be allocated to the return preparation engagement or to providing tax advice. Where the firm itself is subject to penalties, “income derived” means the compensation the firm receives for the engagement.

The same income will not be taken into account more than once in computing penalties against a preparer and his or her firm. The IRS also states in the preamble to the proposed regulations that it anticipates that Circular 230 will be revised to state that the Service will not stack the Sec. 6694 penalties and Circular 230 penalties for the same conduct.

If a particular position gives rise to the understatement and the compensation for that position is less than the compensation for the whole engagement, the compensation allocated to that position for purposes of computing the penalty may be less than the total compensation for the engagement.

Only compensation earned for tax advice given about events that have already occurred is covered for purposes of calculating the Sec. 6694 penalties (this is consistent with the definition of return preparer in Regs. Sec. 301.7701-15(a)(2)(i), under which a person is not considered a return preparer if he or she gives advice with respect to the consequences of contemplated actions).

Meeting the standards: The proposed regulations state that a preparer will meet the “more likely than not” (MLTN) standard if the preparer analyzes the “pertinent facts and authorities” (i.e., the authorities in Regs. Sec. 1.6662-4(d)(3)(iii)) and “reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits.” This will be determined based on the facts and circumstances, including the preparer’s due diligence.

In the absence of other authority, the preparer may rely on a “well-reasoned construction” of applicable statutes to meet the MLTN standard. A well-reasoned construction may also meet the MLTN standard when practitoners rely on information provided by the taxpayer or third parties (Prop. Regs. Sec. 1.6694-1(e)).

The proposed regulations provide examples to illustrate positions that meet the MLTN standard (Prop. Regs. Sec. 1.6694-2(b)(4)). These include examples of situations where there is no published IRS guidance, where temporary regulations overrule earlier private letter rulings, and where circuit courts have split on an issue.

The proposed regulations provide that the “reasonable basis” standard that must be met for disclosed positions is the same as defined in Regs. Sec. 1.6662-3(b)(3). To meet the “reasonable basis” standard, a tax return preparer may rely in good faith, without verification, upon information furnished by a taxpayer, adviser, another tax return preparer, or other party (even when the adviser or tax return preparer is within the tax return preparer’s same firm) (Prop. Regs. Sec. 1.6694-1(e)).

Disclosure rules: The proposed regulations provide rules for disclosing positions for which the preparer has a reasonable basis but that do not meet the MLTN standard (Prop. Regs. Sec. 1.6694-2(c)(3)). For signing preparers:

1. Disclosure may be made on Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, or on the return itself in accordance with the annual revenue procedure (Rev. Proc. 2008-14).

2. For income tax returns, if the position does not meet the “substantial authority” standard, disclosure is adequate if the preparer provides the taxpayer with a prepared tax return that includes the appropriate disclosure.

3. For income tax returns, if the position meets the substantial authority standard, disclosure is adequate if the preparer advises the taxpayer of all the penalty standards applicable under Sec. 6662.

4. For tax shelters and reportable transactions, disclosure is adequate if the preparer advises the taxpayer that there needs to be at least substantial authority for the position, that the taxpayer must have “a reasonable belief that the tax treatment is more likely than not” the proper treatment, and that disclosure will not protect the taxpayer from assessment of an accuracy-related penalty.

5. For returns or claims for refund that are subject to penalties other than the accuracy-related penalty, disclosure is adequate if the preparer advises the taxpayer of all the penalty standards applicable under Sec. 6662.

For nonsigning preparers, a position must be disclosed in one of three ways:

1. On Form 8275 or Form 8275-R, or on the return itself in accordance with the annual revenue procedure;

2. By advising the taxpayer of all opportunities to avoid penalties under Sec. 6662 and of all applicable disclosure standards; or

3. By advising the taxpayer that disclosure under Sec. 6694(a) may be required. A nonsigning preparer must contemporaneously document that this advice was provided.

Each position that is not disclosed on the return, if the preparer believes there is a reasonable basis for the position but not a reasonable belief that it is more likely than not to be sustained on its merits, must be addressed by the preparer. General boilerplate disclaimers are not allowed—the advice must be tailored to the particular taxpayer’s facts and circumstances.

Follow-up advice: One concern among practitioners has been whether providing follow-up advice after a transaction has occurred would make the adviser a nonsigning return preparer. The proposed regulations contain a de minimis safe harbor in the definition of “nonsigning tax return preparer.” Under this safe harbor, if the time spent on advice given with respect to events that have occurred is less than 5% of the aggregate time incurred by the person with respect to the position(s) giving rise to the understatement, that time will not be taken into account in determining whether the individual is a nonsigning tax return preparer (Prop. Regs. Sec. 301.7701-15(b)(2)).

This safe harbor is designed to encourage tax professionals who principally rendered advice regarding events that have not yet occurred to provide follow-up advice requested by a taxpayer without the concern that, by providing such advice, they would become a tax return preparer under Prop. Regs. Secs. 301.7701-15(b)(2) and (3).

Substantial portion: Only a person who prepares all or a substantial portion of a return or claim for refund will be considered a preparer of that return or claim for refund (Prop. Regs. Sec. 301.7701-15(b)(3)). The proposed regulations contain a de minimis rule regarding whether a schedule, entry, or other portion of a return amounts to a substantial portion for nonsigning return preparers. Under the de minimis exception, if the item giving rise to the understatement is (1) less than $10,000 or (2) less than $400,000 if the item is also less than 20% of the taxpayer’s gross income (or, for an individual, the individual’s AGI), then the item is not considered a substantial portion of the return (Prop. Regs. Sec. 301.7701-15(b)(3)(ii)).

Caution: This de minimis rule does not apply to signing return preparers.

The Service is also planning to publish a list of returns (similar to the list published in Notice 2008-13) that will or will not subject return preparers to the Sec. 6694 penalties.