Tax return position vs. tax return preparation

Standards of practice and the tax preparer penalty regime treat tax return positions and tax preparation differently. For example, a client emails her CPA to ask about substantiation requirements for donating a car to charity. Would providing the answer to that question be considered a tax return position since the CPA might be advising on a position to take on a tax return? Or would it constitute preparing a tax return since the CPA might be instructing the client to fill out Form 8283, Noncash Charitable Contributions? The issue is important because as a tax practitioner, simply preparing a return may invoke different ethical and legal standards than if the CPA is providing tax advice.

When confronting this issue, it is important to understand how a tax return position is defined. When looking at the definition, two questions arise:

1. What is tax advice?
2. Has the tax practitioner made a conclusion on a matter where he or she has all the material facts?

Subtle differences exist between preparing a tax return and taking a tax return position. Statement on Standards for Tax Services (SSTS) No. 1, Tax Return Positions, provides the standards for tax return positions. Under SSTS No. 1, a tax return positionis:

(i) a position reflected on a tax return on which a member has specifically advised a taxpayer or (ii) a position about which a member has knowledge of all material facts and, on the basis of those facts, has concluded whether the position is appropriate. [SSTS No. 1, ¶1(a)]

Thus, for a position to be considered a tax return position, a tax practitioner must either advise the client on the position or the tax practitioner must have knowledge of all material facts and conclude the position is appropriate to report on the tax return.

While SSTS No. 1 provides the definition of a tax return position, it does not go into detail on what is considered tax advice. One place to look for guidance on this is the Internal Revenue Code. Sec. 7525 defines tax advice as "advice given by an individual with respect to a matter which is within the scope of the individual's authority to practice" under 31 U.S.C. Section 330, generally meaning CPAs, attorneys, and enrolled agents (Sec. 7525(a)(3)(B)).

"Within the scope of an individual's authority to practice" is a rather broad statement. For CPAs, anything within the scope of their ability to practice, i.e., being CPAs, would relate to any tax advice they provide. Therefore, when considering the first prong of a tax return position as defined by SSTS No. 1, tax advice will be anything that is even remotely related to tax that falls under a CPA's authorization to practice before the IRS, as set forth in 5 U.S.C. Section 500(c).

For tax advice to be a tax return position, it must be reflected somewhere on a tax return (SSTS No. 1, ¶1(a)). Reflecting advice on the return can be both explicit and implicit. For example, if a CPA tax practitioner tells a client that she should report $2,000 of original issue discount (OID) interest on her tax return and she reports the $2,000 on the tax return, then it is explicitly disclosed on the tax return. If the tax practitioner tells the client not to report the $2,000 on the tax return, then the tax return position regarding the OID interest is reflected on the return precisely because it is omitted from the return. The advice then is implicitly disclosed on the tax return.

The other important distinction is that not all tax advice is a tax return position. Situations arise where a client may ask for advice that would never be explicitly or implicitly reflected on a tax return. For example, a client asks his CPA if he needs to file a gift tax return after giving his son $5,000. Here, no return would be required, so it could never be reflected on a tax return. The tax practitioner, in this case the CPA, provided tax advice relating to gift tax filing requirements but did not provide a tax return position.

The second prong of a tax return position is "a position about which a member has knowledge of all material facts and, on the basis of those facts, has concluded whether the position is appropriate" (SSTS No. 1, ¶1(a)). The main issue here is whether the tax practitioner has made a conclusion on a set of facts that he or she has been presented. The standard does provide flexibility if a client is not forthcoming on all the relevant facts in that the tax practitioner must know all material facts for any conclusion to become a tax return position.

Again, when considering whether preparing a return is equivalent to taking a tax return position, the question that arises is whether a tax practitioner preparing a return can exercise due diligence if he or she did not have knowledge of all material facts. Section 10.22 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), requires that practitioners exercise due diligence when preparing or assisting in the preparation of a tax return. If a tax practitioner cannot ethically prepare a return without all the material facts, then the tax practitioner either will always take a tax return position (since he or she is making conclusions based on all material facts) or will violate Circular 230 (since he or she is preparing a return without knowledge of all reasonable facts).

Suppose a client provides in a Form 1040 organizer that he made $10,000 of charitable donations. He does not say to what charity he donated the money or when he donated the money. All that the client provides is the amount paid to charitable organizations.

Had the CPA previously served this client, he or she may have enough knowledge to trust the numbers provided. The CPA can also look at the ratio of the charitable contribution to adjusted gross income to see if the number is reasonable. The CPA can take all these steps to exercise due diligence and still be ignorant of the material facts surrounding the number that ultimately goes on a tax return.

From analyzing the two prongs of a tax return position, preparing a tax return often will be considered as taking a tax return position; however, in some areas, these two definitions will not overlap. Where the definitions do not overlap, it is important to know the precise definition of a tax return preparer to determine if the tax practitioner is considered a preparer.

Signing a tax return is an overt act, where someone can point to the return to see who signed it. Unfortunately, a tax return preparer is not simply defined as a person who prepares a tax return. The Code contains a broader definition of who is a tax return preparer. A tax return preparer is:

any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax imposed by this title or any claim for refund of tax imposed by this title. [Sec. 7701(a)(36)(A)]

Also included in the tax return preparer definition is:

[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. [Regs. Sec. 301.7701-15(b)(3)(i)]

Therefore, the term tax return preparer can also encompass a person who provides a tax return position on a transaction, even if he or she did not prepare any part of the tax return. However, for this to be considered tax return preparation, the portion of the return affected by the position must be substantially all of the tax return.

Example: A client goes to his CPA for advice on a "deadly D reorganization." His CPA has no idea what a deadly D reorganization is and instead refers the matter to his friend at a different firm. The client gets advice on the reorganization along with a calculation on the tax treatment of any capital or ordinary gains in the reorganization. The client goes back to his CPA with these numbers, and that CPA prepares the return.

Here, the original tax practitioner, the CPA, would have exercised due diligence when preparing the return because he relied on the advice of someone with the proper knowledge to handle the transaction, but he does not know any material facts in this situation (see Circular 230, §10.22(b)). He also did not advise the client on the matter. Therefore, when preparing the return, with respect to the gain or loss on reorganization, the CPA has not made a tax return position under SSTS No. 1.

However, the CPA's friend will not only have provided a tax return position under SSTS No. 1, but he will also be considered a tax return preparer for the numbers relating to the reorganization under the Code even though he and his firm had nothing to do with actually preparing the return.

A similar situation is brought up in Regs. Sec. 301.7701-15(b)(2), which defines these types of advisers as "nonsigning tax return preparer[s]." The regulations include an example of an attorney providing legal advice to a corporation on a completed corporate transaction. The advice is relevant to the determination of an entry on the taxpayer's tax return, and the entry constitutes a substantial portion of the return. Even though the attorney does not prepare any of the tax return, he is considered a nonsigning tax return preparer.

The definitions of a tax return position and a tax return preparer contain direct overlaps. Really, any time a tax practitioner is providing a tax return position, he or she is preparing a tax return (as long as the position meets the substantial-portion test), even if he or she never saw the tax return. On the other hand, a tax practitioner can prepare a tax return without ever providing a tax return position.

A classic illustration of this comes from firms that use outside tax preparers during tax season. This may occur when a firm has more demand to produce tax returns than it has supply of tax professionals to prepare them. These firms often contract with outside parties to help with tax preparation. These people are often not credentialed. The third party prepares the entire return based on information provided in a tax organizer. The return is then provided to the CPA firm for a CPA to review.

Here, the CPA did not advise on any matters or render a conclusion on any matter where he or she knew the material facts. However, the CPA did hire the third party to prepare the tax return, so he would fall into the definition of a tax return preparer when answering the client's email.

Going back to the original question: If a client emails and asks about substantiation requirements for donating a car, is this a tax return position or is it considered preparing a tax return? The answer is both. The CPA specifically advised on the form to fill out, so under SSTS No. 1, it is a tax return position. Under Regs. Sec. 301.7701-15(b)(2)(i),the CPA is advising specifically on a position or entry on the tax return, so if that position or entry constitutes a substantial portion of the final return, the tax practitioner would also be considered the preparer.

Three main sources contain standards of tax return positions and tax return preparation: SSTS No. 1, Circular 230, and the Internal Revenue Code.

In most of the enumerated standards under SSTS No. 1, a tax return position is mentioned jointly with preparing or signing a tax return, so the same standards apply to both. The only time this is not the case is under paragraph 8, which states:

When recommending a tax return position, a member has both the right and the responsibility to be an advocate for the taxpayer with respect to any position satisfying the aforementioned standards.

The absence of a reference to "tax return preparation" in this paragraph is interesting because it seems to imply that when preparing or signing a tax return, the tax preparer does not have the right and responsibility to be an advocate for the taxpayer. When going back to the definition of a tax return position, this makes sense because, when he or she is just preparing a return but not taking a tax return position, the tax practitioner will either not specifically advise the client about taking that position or does not know the material facts to take that position. When tax practitioners have not advised clients on an issue and do not know the material facts around the issue, they must act conservatively and not as a client advocate.

For CPAs, under SSTS No. 7, Form and Content of Advice to Taxpayers, tax advice can be either oral or written. The standards for oral advice are actually stricter under SSTS No. 7 than under Circular 230. Circular 230 only provides a standard of exercising due diligence and that oral advice cannot be false or misleading (Circular 230, §§10.22 and 10.51(a)(4)). Under the SSTS No. 7, when giving oral tax advice, a tax practitioner "should consider, when relevant, (a) return reporting and disclosure standards applicable to the related tax return position and (b) the potential penalty consequences of the return position" (SSTS No. 7, ¶3). The SSTS also requires tax practitioners to be cognizant of confidentiality when providing oral tax advice, whereas Circular 230 does not (SSTS No. 7, ¶11).

The SSTSs contain more-stringent rules on written advice than Circular 230 as well. For written advice, tax practitioners need to be cognizant of Circular 230, Section 10.37, which says the written advice must:

1. Be based on reasonable factual and legal assumptions;
2. Consider all relevant facts and circumstances that the practitioner knows or should reasonably know;
3. Not rely on the taxpayer's statements if relying on them would be unreasonable;
4. Relate the facts the practitioner should know to the relevant law and authorities; and
5. Not consider the audit lottery.

To contrast this, the SSTSs bring in Circular 230's requirements and also require a tax practitioner to use professional judgment that the advice reflects competence and appropriately serves the client's needs as well as incorporating the standards applicable from any taxing jurisdiction when providing tax advice (SSTS No. 7, ¶2). A tax practitioner also needs to consider return reporting and disclosure standards applicable to the related tax return position and the potential penalty consequences for any tax advice of the return position (SSTS No. 7, ¶3).

The other place where the difference between a tax return position and tax return preparation really matters is under the Code. Generally, under Sec. 6694, only a tax return preparer can be subject to practitioner penalties. The distinction that sometimes a person can provide a tax return position without preparing a tax return is very important here because a tax practitioner could potentially avoid Sec. 6694 penalties if the practitioner only provided a tax return position, without falling into the definition of a tax return preparer.

While tax return positions and tax return preparation often overlap, the slight differences between them can trip different ethical and legal standards that any tax practitioner should be aware of in the hopes of avoiding violations of those standards.