Tax Law and Business Organization Strategy

Problems with Return Preparer Penalties

We previously commented on the new return preparer penalties and the problems they will cause. Richard Lipton provides some additional insight into those problems in RIA's Federal Taxes Weekly Alert:

First, Congress has created a “disconnect” under which a return preparer could be subject to penalty in a situation in which the understatement did not result in any penalty for the taxpayer.

For example, assume that a preparer does not disclose a position for which there is substantial authority but which the preparer doesn't believe is more likely than not to be correct. IRS determines that the position results in an understatement of liability. The taxpayer would not be subject to penalty because there was substantial authority for the position, but the return preparer would because the position wasn't disclosed. Congress could easily address this problem by providing that taxpayers (as well as return preparers) are subject to penalty any time that a position on a return wasn't reasonably believed to be more likely than not correct at the time the return was filed.

The more significant problem with this revision is that Congress did not take into account the fact that a practitioner often will not be able to determine whether a position is more likely than not correct. There are no clear answers to numerous common issues with respect to items reported on tax returns, including such simple (and recurring) problems such as whether an asset is held for investment or sale, whether an expense should be capitalized or deducted, or the value of an asset donated to charity. Under the prior version of Code Sec. 6694, the return preparer would not be subject to penalty if the position taken on the return satisfied the realistic possibility standard; now the preparer would need a much higher level of certainty concerning the correctness of the position taken on the return.

This is particularly a problem for factual issues. Under prior law, a practitioner simply needed to make certain that with respect to a factual issue, such as the deduction of expenses or the tax treatment of an acquired asset, there was a realistic possibility of success on the merits. Since many factual issues reasonably may be viewed in more than one way, as long as the position taken by the return preparer was solidly grounded in the facts, there was little risk that the preparer would be subject to a penalty even if IRS ultimately determined that there was an understatement of liability.

Now, every understatement could result in a penalty because, by definition, an understatement only arises if the position taken on the return was, at a minimum, not more likely than not correct. Thus, under the new Code Sec. 6694, a preparer can avoid the penalty only by establishing his or her reasonable belief at the time the return was filed, or through adequate disclosure.

The problems described above will be compounded by the extension of Code Sec. 6694 to non-income tax returns. For example, one of the more troubling recurring tax issues is whether an individual should be characterized as an employee or an independent contractor. Previously, if a preparer did not cause an Form W-2 to be issued to the individual (but instead caused income to be reported on an Form 1099), the preparer would not be subject to penalty. Under the new Code Sec. 6694 , the preparer could be subject to a penalty (up to half of his fees) for every individual who wasn't properly characterized as an employee or an independent contractor. It is easy to imagine similar problems arising with other regularly filed employment-related returns.

This problem is not limited to return preparers. Every practitioner who gives tax advice with respect to a completed transaction could be viewed as a nonsigning preparer who would be subject to penalties under Code Sec. 6694 unless that advice satisfied the “more likely than not” standard. Thus, any lawyer who discussed with a client the manner in which a sale should be reported (e.g., whether gain from the sale of land is ordinary income or capital gains) could be subject to penalty if he didn't reasonably believe that the advice was more likely than not correct. A practitioner who plans a transaction for a taxpayer may not be willing to discuss the reporting after the transaction is completed, because although the planning is not subject to penalty, the reporting would bring Code Sec. 6694 into play.

Conclusion. The basic problem is that the “more likely than not” standard does not comport with everyday tax return advice and preparation. Practitioners are (and should) be required to give only advice that they believe is based on the applicable law and facts, and to take only nonfrivolous positions on a return, and it may have been appropriate for Congress to require that every position taken on a tax return (and all tax advice) be at least reasonable. Because of the uncertainty as to whether a position is more likely than not correct, however, there will be many situations in which a practitioner will be faced with the choice between a significant penalty (up to half his fees) and disclosure.

The new Code Sec. 6694 makes practitioners the ensurer of the accuracy of their clients' returns. Practitioners likely will react very cautiously to this change in the law. Indeed, some practitioners may conclude that they are better off disclosing every position taken on a return on Form 8275 rather than risk the penalty, and IRS will be flooded with returns disclosing, on a line-by-line basis, that there is no certainty that each number reflected on the return is more likely than not correct. IRS would be swamped by disclosures, effectively eliminating some of the benefit of the amendment to Code Sec. 6694 by offsetting administrative costs. Other practitioners may become more circumspect in the advice they give their clients, which ultimately may lead to less compliance.

It also can be anticipated that law and accounting firms will include legends on their e-mails and memoranda advising clients to disclose any position that does not meet the “more likely than not” standard. The disclosure recommendation could soon become as ubiquitous as the Circular 230 legend which now appears on every firm's correspondence.
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