Tax Law and Business Organization Strategy

New Return Preparer Penalties Effectively Increase Return Disclosure Requirements

Buried in legislation enacted last May are major changes to the rules imposed on return preparers. The law was passed without much possibility for discussion or input from tax practitioners or even the IRS. It came as a such a surprise to the IRS that the IRS delayed the effective date of the new standards and sanctions under Section 6694(a).

Some of the effects of these new rules are likely to be:

  • conflicts arising from the fact that taxpayers need only meet a substantial-authority test on most tax positions, but preparers must meet a more-likely-than-not test that, if not met, requires a disclosure on the return.
  • an increase in the fees of return preparers to cover the increased work necessitated by and the increased exposure to higher penalties.

Changes under Code Section 6694(a)

Higher Penalty Threshold. The revised Section 6694(a) subjects return preparers to a penalty if they take an “unreasonable position” on a tax return. An “unreasonable position” is defined under new Section 6694(a)(2) as a position meeting the following requirements:

  • The tax return preparer knew (or reasonably should have known) of the position.
  • There was not a reasonable belief that the position would more likely than not be sustained on its merits.
  • The position was not disclosed or there was no reasonable basis for the position.

Under Section 6694(a)(3), the return preparer is absolved from the penalty if he or she can show reasonable cause and good faith for the understatement.

These changes raise the tax preparer’s disclosure threshold. The more-likely-than-not standard means the preparer has to have a more than 50% confidence level that a position will be sustained before he or she can sign a tax return without disclosure.

Higher Penalty Amounts. Not only is the standard raised for when disclosure is necessary, the penalty for failing to disclose under Section 6694(a) has been significantly raised. Before, Section 6694(a) provided a penalty of $250 per return. The new penalty equals the greater of $1,000 or 50% of the income derived (or to be derived) by the tax return preparer for preparing the return or claim. This change makes what was a relatively insignificant penalty amount into a very significant one.

Changes under Code Section 6694(b)

The revised penalty for willful or reckless conduct by a return preparer is now the greater of $5,000, or 50% of the income derived (or to be derived) by the tax return preparer with respect to the return or claim. Willful or reckless conduct is defined as either:

  • A willful attempt in any manner to understate the liability for tax on the return or claim.
  • A reckless or intentional disregard of rules or regulations.

These provisions have been in effect since May 25 and the IRS has not extended their effective date.

Probable Changes Resulting from New Rules

  • Tax return preparers will probably develop formal plans for documenting their decision process on disclosing an item on a tax return.
  • Engagement letters with return preparers will probably change in the following fashions:
    • the definition of the scope of work to be performed will probably change.
    • they will contain a detailed disclosure of the conflict the new rules may create as taxpayers need only meet a substantial-authority test on most tax positions, but preparers must now meet the more-likely-than-not test.
    • they will probably contain an acknowledgement by the client of the disclosure of the conflict.
    • they should contain a way to resolve that conflict if it arises in the engagement.
  • Fees for return preparation will probably increase to cover the combination of increased work and increased exposure to penalties.
  • Tax engagements will probably be broken down between fees for return preparation and fees for other services.
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