Tax Law and Business Organization Strategy

Taxpayer Advocate Recognizes Conflict of Interest Between Return Preparers and Their Clients

The National Taxpayer Advocate has released its 2007 Annual Report to Congress in IR 2008-4. The Advocate highlights the issues raised by newly amended Code Sec. 6694, the return preparer's penalty, and how it may affect the way tax preparers dispense advice. The Report says that new standard may, in some cases, lead to conflicts of interest between preparers and their clients.

As previously noted in this blog, the Small Business and Work Opportunity Act of 2007 amended the preparers' Code Sec. 6694 penalty by :

  • Raising the penalties imposed on return preparers for understatements due to unreasonable positions from $250 to the greater of $1,000 or 50% of the income derived (or to be derived) by the preparer regarding the return or claim.
  • Raised penalties for understatements due to willful or reckless conduct from $1,000 to the greater of $5,000 or 50% of the income derived by the preparer with respect to the return or claim.
  • Expanding the penalties to all types of tax returns, including estate and gift tax, employment tax, and excise tax returns.
  • Establishing a higher standard of conduct for preparers to avoid imposition of penalties when IRS alleges that the preparer knew or reasonably should have known of an unreasonable position. The new standard requires “a reasonable belief that the position would more likely than not be sustained on its merits,” which translates to approximately 51% or greater likelihood. This is significantly higher than the substantial authority standard that applies to taxpayers other than preparers.
  • Establishing a higher standard of conduct for disclosed unreasonable positions. The new standard requires a preparer to have a reasonable basis for the disclosed position—the same standard for disclosed positions as for taxpayers other than preparers.

The Advocate expressed particular concern that the new penalty rules create a significant disparity between the standard applicable to preparers and that applicable to taxpayers. Potentially, this could lead to ethical problems for preparers, which in turn will affect how they advise their clients.
The practitioner standard which requires that a position be more likely than not sustained on its merits is considerably stricter than the standard that applies to the taxpayer for whom the preparer prepares the return. For a taxpayer, an undisclosed position on a return he prepares himself is subject to the substantial authority standard under Code Sec. 6662(d)(2). As Reg. § 1.6662-4(d)(2) specifically states, the substantial authority standard is less stringent than the more-likely-than-not standard.

As a result of the changes to the standard of conduct, preparers may recommend that their clients include numerous disclosures in their tax returns. This has the potential for placing the preparer in an ethical dilemma because the preparer needs to recommend a course of action to protect his own interest even though it may not be in the client's best interest.

Form 8725, Disclosure Statement, was designed for taxpayers to disclose information to avoid Code Sec. 6662 penalties. In cases where there is substantial authority for a certain position taken on a return and the client is confident that IRS will not impose Code Sec. 6662 penalties, the client has no incentive to sign a disclosure statement to protect the preparer. In such a case, the preparer may be placed in a very difficult position if he wants to be assured of avoiding preparer penalties.

Further, the more-likely-than-not standard may discourage preparers from interpreting ambiguous tax rules to a taxpayer's advantage. Preparers can avoid significant penalties only if they disclose a reasonably based position or ensure there is at least a 51% possibility that any undisclosed position would be sustained on its merits. Fearing sizable penalties, preparers may shy away from undisclosed positions that are aggressive yet reasonable interpretations of the law where the tax law is ambiguous or not well developed. Preparers may also have ethical reasons to avoid disclosing certain tax return positions to the IRS if the taxpayers' substantial authority standard of conduct has been met, but the preparers' more likely than not standard has not.

The Advocate's Report also notes that the standard of conduct in Code Sec. 6694 is at odds with the standard of conduct currently in Circular 230 (which provides the rules governing practice before IRS). Currently, §10.34 of Circular 230 includes the previous law standards with the results that practitioners have a lower standard of conduct to avoid sanctions under Circular 230. The Report concludes that this inconsistency creates potential confusion.

The Advocate states that it will continue to monitor the recent changes to Code Sec. 6694, and specifically the effect that the new increased standards of conduct have on preparer behavior and how IRS plans to enforce the provisions.

Query: Is this a waivable conflict of interest?

According to Circular 230, § 10.29: a practitioner shall not represent a client before the IRS if the representation involves a conflict of interest. A conflict of interest exists if there is a significant risk that the representation of one or more clients will be materially limited by the personal interest of the practitioner.

    • Even if a conflict of interest exists under the above rules, the practitioner may represent a client if:
    • the practitioner reasonably believes that the practitioner will be able to provide competent and diligent representation to each affected client;
    • the representation is not prohibited by law; and
    • each affected client waives the conflict of interest and gives informed consent, confirmed in writing by each affected client, at the time the existence of the conflict of interest is known by the practitioner. The confirmation may be made within a reasonable period after the informed consent, but in no event later than 30 days.

Contrast that to the ABA's Model Rule 1.7 on Conflict Of Interest:

(a) Except as provided in paragraph (b), a lawyer shall not represent a client if the representation involves a concurrent conflict of interest. A concurrent conflict of interest exists if:

    (1) the representation of one client will be directly adverse to another client; or

    (2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer's responsibilities to another client, a former client or a third person or by a personal interest of the lawyer.

(b) Notwithstanding the existence of a concurrent conflict of interest under paragraph (a), a lawyer may represent a client if:

    (1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client;

    (2) the representation is not prohibited by law;

    (3) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal; and

    (4) each affected client gives informed consent, confirmed in writing.

Circular 230 and the ABA rules define a waivable conflict as one where the practitioner reasonably believes that the practitioner "will be able to provide competent and diligent representation to each affected client."

So, the question each practitioner is going to have to ask themselves before they can even obtain a consent to the conflict is: if disclosure must occur to avoid the practitioner penalty, but the client need not disclose to avoid penalties, is it even possible "to provide competent and diligent representation" to the client?


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