On June 16, 2008, the IRS issued proposed regulations (REG-129243-07) on tax return preparer penalty standards that it hopes to have finalized by the end of the year. The proposed regulations amend existing regulations to take into account the provisions in the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA). A result of increased IRS scrutiny of the number of fraudulent tax returns and tax return preparers engaged in abusive practices, these regulations are relevant to tax return preparers who know or reasonably should know of unreasonable tax return positions.
The proposed regulations address IRS areas of concern to (1) provide for a broader definition of income tax preparer; (2) amend standards of conduct that must be met to avoid tax return preparer penalties; and (3) provide for higher penalty amounts for return positions that result in an understatement of tax. The IRS would like to finalize these regulations by the end of 2008 so that final regulations will apply to returns prepared beginning in 2009. (For an in-depth discussion of the proposed regulations, see Tillinger, “An Analysis of the New Preparer Penalty Proposed Regulations,” on p. 576.)
Standards of ConductThe proposed regulations amend the standards of conduct that must be met to avoid imposition of the tax return preparer penalties for disclosed and undisclosed tax return positions. The standards as discussed below differ depending on whether a return position is disclosed or undisclosed within the tax return.
For a disclosed return position, the tax return preparer may avoid a penalty for understatement of tax if there is a reasonable basis for the disclosed position. For an undisclosed return position, the tax return preparer may avoid penalty only if the preparer has a reasonable belief that the position would more likely than not (MLTN) be sustained on its merits, which translates into a more than 50% chance of being sustained.
The MLTN standard imposed on the tax return preparer for an undisclosed return position is stricter than the standard imposed on the taxpayer (substantial authority). There is the potential for a conflict of interest for the tax return preparer who wishes to advise a client on a return position but does not want to be subject to penalties for a return position that the client ultimately decides to report on the return. However, under the proposed regulations, a tax return preparer can file a return without disclosure (although the preparer does not reasonably believe that a position would more likely than not be sustained on its merits) and avoid imposition of preparer penalties if the tax return preparer adequately discloses information to the taxpayer.
Adequate DisclosureSBWOTA and the proposed regulations alike do not state that a tax return preparer must disclose all known issues to the IRS. Instead, the IRS has dealt with the taxpayer versus tax return preparer standards by defining how a tax return preparer can meet the adequate disclosure standard without filing Form 8275, Disclosure Statement, with the IRS. For undisclosed positions, the proposed regulations close the gap between the lower taxpayer standards and the higher tax return preparer standards by providing for adequate disclosure of known issues by the tax return preparer to the taxpayer. For undisclosed positions that have a reasonable basis but do not meet the MLTN standard, the tax return preparer must disclose the issue to the taxpayer.
The proposed regulations indicate that a tax return preparer is not required to inform the IRS about an issue that the taxpayer does not wish to disclose when a position does not meet the MLTN standard. Instead, the tax return preparer must adequately disclose the position to the taxpayer (Prop. Regs. Sec. 1.6694-2(c)(3)(i)). The allowable methods of disclosure differ for signing and nonsigning return preparers.
Signing return preparers: For signing tax return preparers, the IRS provides five methods to disclose such position to a taxpayer:
- Disclose the position on a properly filed Form 8275 (or Form 8275-R, Regulation Disclosure Statement, if the position is contrary to a regulation).
- If the position does not meet the taxpayer’s substantial authority standard, the tax return preparer must provide the taxpayer with a prepared tax return that includes the appropriate disclosure.
- If the position does meet the substantial authority standard, the tax return preparer must advise the taxpayer of all penalty standards applicable to the taxpayer under Sec. 6662.
- If the position is a tax shelter or reportable transaction to which Sec. 6662A applies, the tax return preparer must advise the taxpayer that there needs to be at a minimum substantial authority for the position, that the taxpayer must possess a “reasonable belief that the tax treatment was more likely than not” the proper treatment, and that disclosure will not protect the taxpayer from assessment of an accuracy-related penalty for substantial understatements. In addition, the preparer must advise the taxpayer of the applicable penalty standards under Sec. 6662.
- For returns or claims of refund that are subject to penalties other than the accuracy-related penalty for substantial understatements, the preparer must advise the taxpayer of the applicable penalty standards under Sec. 6662.
Nonsigning return preparers: For nonsigning tax return preparers, the IRS provides three disclosure methods:
- Disclose the position on a properly filed Form 8275 or Form 8275-R.
- Advise the taxpayer of all opportunities to avoid penalties under Sec. 6662 that could apply to the position and advise the taxpayer of the standards for disclosure.
- Advise another tax return preparer that disclosure under Sec. 6694(a) may be required.
Under each scenario, in order to establish that the disclosure was adequate and the obligation satisfied, the tax return preparer must document contemporaneously in his or her files that the information and advice required by the proposed regulations were provided. The disclosure to the taxpayer cannot be a boilerplate disclosure and must be specific to the facts and circumstances surrounding the taxpayer.
ConclusionSBWOTA is the framework for revisions and the foundation for the standards of conduct related to tax return preparer penalties. The proposed regulations offer what the IRS believes is necessary to deter misconduct by tax return preparers and aid the IRS in detecting returns that were inaccurately prepared. Although the tax return preparers are not required to disclose to the IRS questionable return positions, they must be careful to follow the provisions discussed above to avoid tax return preparer penalties.
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.